Say, you and I wish to open a fee channel.
We negotiate to every ship 0.05 BTC right into a shared 2-of-2 multisig output, the channel funding output.¹ This may require a transaction on the Bitcoin blockchain.
As a “steadiness sheet” and escape hatch, we negotiate a 2-of-2 multisig transaction that pays out 0.05 BTC to you and 0.05 BTC to me. We name this the dedication transaction.
The dedication transaction comes truly in two variants. I signal your dedication transaction and provides it to you. If you wish to put it in impact, you want solely add your individual signature and broadcast it to the Bitcoin community. Vice versa, you signal and provides me my copy of the dedication transaction. The dedication transactions are future transactions for the Bitcoin community, they’re simply not legitimate but as a result of we’ve got not truly created the channel funding output but, and since they’re every lacking one signature. The dedication transaction is available in two variants as a result of the copy you and I maintain are uneven: your dedication transaction places a timelock in your Settlement Output, and mine locks my Settlement Output. We’ll see beneath why we want that.
The dedication transaction ensures that both of us can shut the channel and return the funds to our respective controls by themselves. Now that we’re assured to have the ability to to get again our funds, we will signal and broadcast the funding transaction:
We’re later going to make use of the next shorthand to signify a channel and its present balances: 
Now, I wish to pay you 0.01 BTC. We every create a brand new dedication transaction (“steadiness sheet”) as earlier than, however this one says that you just get 0.06 BTC and I get 0.04 BTC. Every of us will get a brand new dedication transaction signed by the opposite to that impact as earlier than.
To make it possible for neither of us can use the outdated dedication transaction the opposite signed beforehand, we every create a justice transaction to stop dishonest. The justice transaction permits the channel companion to spend our timelocked output from our first dedication transaction to the themselves if we use the outdated dedication. If we use the right dedication, the funds go to ourselves after the timelock passes, till then the counterparty can take the funds if we cheated.
I.e. when I attempt to activate the (now out of date) 0.05 – 0.05 BTC steadiness sheet, my paid-out funds are locked for a variety of blocks. This provides you time to broadcast the justice transaction through which I signed off on my 0.05 BTC output being despatched to you.
It is secure for me to offer you your justice transaction, or actually to anybody, as a result of the justice transaction will solely be legitimate as a response to the fraudulent use of the outdated dedication transaction.²
With the setup as described above, I might have to return on-line earlier than the timelock expires to catch an try at dishonest, however clearly it would not be secure for me to maintain fee channels open if I could be offline for prolonged intervals. Fortunately, there are watchtower providers that take a small fee to observe for dishonest and may broadcast the justice transaction in your behalf after they detect it.
Alright, now you and I can ship cash backwards and forwards 1000’s of occasions, with virtually instantaneous impact (relying solely on how briskly we will talk with one another) with out including any further transaction to the Bitcoin blockchain. But, alternatively, if considered one of us ever tried to defraud the opposite, they might be immediately taken to court docket by having the dispute resolved on the blockchain to their very own detriment. Fairly spiffy, however not terribly helpful but.
By the idea of six levels of separation, everyone seems to be related to every other participant through just a few hops.
For instance you’re getting some espresso from Bob the Barista. You would not have a fee channel with Bob, however you have got the channel with me, and each Bob and me every have a fee channel with Alice. Let’s assume that every fee channel has 100 m₿ in it, break up equally.
Our “community” now seems to be like this:
Now, since you do not have a direct fee channel to Bob (and it will be very inefficient in case you needed to create a fee channel with each enterprise companion you ever meet), you route your fee via the community. As a substitute of solely writing an replace of the steadiness between Bob and also you as I described above, this turns into a concerted effort: Your pockets finds a route from you to Bob that has a) adequate liquidity, b) least charges, and c) fewest hops. To make a fee, every concerned fee channel updates its balances. With a fee of 1 m₿ for the espresso, this updates our community to:
As you may see, the balances on the ends have shifted appropriately from you to Bob, however the different individuals have the identical steadiness (though shifted to different fee channels). It is vital to understand, that the fee can solely undergo utterly or by no means. Both all of us replace the balances, or nobody does.
Now, think about that you do not have solely the one fee channel with me, however you have got perhaps a half a dozen fee channels with different customers! 🙂
Aside from within the above case the place one facet closes the channel unilaterally, considered one of us can request to cooperatively shut a channel from the opposite. Once we agree, we collaborate to create a last payout transaction that does not lock any funds and permits rapid spending after affirmation. We might even use this transaction to spend a few of our steadiness on to a 3rd occasion on the blockchain, or to create one other totally different fee channel. Let’s say I wish to pay Carol on-chain after we shut the channel after the second dedication transactions have been exchanged.
- You can not obtain more cash via the Lightning Community in a single fee than the sum of your channel counterparties’ balances.
- Sender and receiver must be on-line for a fee to be carried out.
- Your Lightning Community funds do not get recorded on the blockchain for eternity, (i.e. higher fee privateness), however your Lightning node has a everlasting identification and your introduced channels’ funding outputs are publicly related along with your node’s identification (observers might guess how a lot funds you have got deployed to the Lightning Community), or which outputs went to you when channels get closed.
- Immediate funds! However your funds are tied up in fee channels. When you want these funds for an on-chain fee, it’s essential to shut the channel or splice out a fee with the help of your channel companion.
- Decrease charges! Funds on Lightning do not require an on-chain transaction payment, however in case you route funds via others fee channels, they’ll cost a proportional payment for the liquidity they supply. Nevertheless, as different Lightning nodes are competing to switch your fee for you, this prices a lot lower than an on-chain transaction payment (except the fee quantity is big).
¹ This examples is a so-called “dual-funded” channel. Many channels are funded solely by one occasion upon creation. Channels funded by one occasion begin off with all the steadiness on one facet and subsequently solely able to sending funds however not receiving. Twin funded channels have been just lately carried out by some Lightning Community implementations for the primary time.
² The dedication transactions and justice transaction mechanism are why Lightning wanted the transaction malleability repair from segwit. We will solely depend on this chain of half-signed, unconfirmed transactions if the transaction id’s of the prior transactions could be predicted reliably.
