Now that we've followed Alice as she's set up a Lightning Wallet and purchased a coffee from Bob, we'll look under the hood and unpack the different components of the Lightning Network involved in that process.
The goal is rather to help you to become aware of the most important concepts and building blocks of the Lightning Network.
If you have experience in computer science, cryptography, Bitcoin, and protocol development, then this chapter should be enough for you to be able to fill out the connecting details by yourself.
If you are less experienced, this chapter shall give you a good enough overview so that you will have an easier time reading through the formal protocol specifications, known as BOLTs (Basis of Lightning Technology).
In case you are a beginner, this chapter will help you better understand the technical chapters of the book.
However, we are aware that some readers may have a hard time following high level descriptions without explaining all the details.
If you are one of those readers you may want to skip this chapter.
We'll start with a one sentence definition of what the Lightning Network (LN) is and break it down in the remainder of this chapter.
**The Lightning Network (LN) is both a peer-to-peer network of _payment channels_ on top of the _Bitcoin protocol_ as well as a communication protocol that defines how participants set up and execute the smart contracts on the Bitcoin network**
We will see that a payment channel is simply a 2-out-of-2 multisignature address on the Bitcoin network for which you hold one key and your channel partner holds the other key.
This multisignature address comes with a cryptographic protocol that is established by creating a sequence of transactions that spend from this address.
The latest transaction in the sequence encodes the balance of the channel and defines how the funds locked into the multisignature address are to be divided between you and your channel partner.
Thus adding a new transaction to this sequence is equivalent to moving ownership of funds in the channel, without the Bitcoin network being aware of it.
Each transaction in the sequence makes use of Bitcoin's scripting language, and thus the negotiation of funds between you and your channel partner is managed by a Bitcoin smart contract.
The contract is set up such as to penalize a channel member if it tries to steal funds by submitting an earlier invalidated state of the channel.
When someone says they 'own' bitcoin they typically mean that they know the private key of a bitcoin address that has some unspent transaction outputs (UTXOs).
If you have an unpublished but signed transaction from a 2-out-of-2 multisignature address, where some outputs are sent to an address you own, and additionally you own one of the private keys of the multisignature address, then you effectively own the bitcoin of that output.
Without your help no other transaction from the 2-out-of-2 multisignature address can be produced.
However, without the help of anybody else you can transfer the funds to an address which you control.
On the Lightning Network ownership of your funds is almost always encoded with you having a pre-signed transaction spending from a 2-out-of-2 multisignature address.
For example, Alice can send money to Bob if Alice had a channel with Mallory and Mallory had a channel with Bob.
By the design of the Lightning Network, it is possible to extend the smart contracts which operate the channel so that Mallory has no way of stealing the funds that are being routed through her.
Not only does the construction of the payment channel work for the partners without the necessity to trust each other but the entire network works without the necessity to trust any other participant.
Since the channels are funds on multisignature addresses and as the contracts are unpublished but presigned Bitcoin transactions, all the trust that is needed to operate the Lightning Network comes from the trust in the decentralized Bitcoin network!
This information is needed for Alice to be aware of the fact that Mallory has a channel with Bob so that she can decide to send a payment indirectly via Mallory to Bob.
Last but not least, it is important to understand that the Lightning Network is nothing but Bitcoin.
We emphasize this as you might find people who will try to spread misinformation and create a false barrier between the "real" Bitcoin and the Lightning Network or even use terms like the Lightning Network coin. At any point in time, any value held in the Lightning Network is exclusively held as bitcoin and exclusively secured by the Bitcoin network.
We rather hope that this book enables you to critically do your own research to understand and verify the following (instead of trusting us):
Besides all the technical primitives, the Lightning Network protocol is a creative way to get more benefits out of Bitcoin by allowing an arbitrary amount of instant payments with instant settlements without the necessity to trust anyone else but the Bitcoin network.
As you have seen in the last chapter, in order to use the Lightning Network, Alice had to use her wallet software to create a payment channel with another LN participant.
* If the channel is open, making a payment does not require the confirmation of Bitcoin blocks. In fact - as long as you and your channel partner follow the protocol - it does not require any interaction with the Bitcoin network or anyone else other than with your channel partner.
* The cryptographic protocol is constructed in a way that there is little to no trust involved between you and your channel partner. If your partner becomes unresponsive or tries to cheat you, you can ask the Bitcoin network to act as a court system resolving the conflict according to the rules that you and your partner have previously agreed upon.
* The capacity of the channel will be split between you and your partner. In that sense at that level you already will have gained privacy compared to the Bitcoin network where every transaction is public. Within payment channels the amounts and values of payments are only known to you and your partner. Only the final balance which is the aggregate of all payments in that channel will become visible on the Bitcoin blockchain if and when the payment channel is closed.
* As the time to update the channel is primarily bound by the communication speed of the internet, making a payment on a payment channel is almost instant.
Bitcoin was about 5 years old when talented developers first figured out how payment channels could be constructed and by now there are at least 3 different methods known.
This chapter will only focus on the channel construction method proposed by Joseph Poon and Thaddeus Dryja in 2015 since it is actually being used in the Lightning Network and was first described in the Lightning Network whitepaper.
The two other proposed methods are the "Duplex Micropayment" channels which have been introduced by Christian Decker around the same time as the "Poon and Dryja" channels and the "eltoo" channels which have been introduced in 2018 by Christian Decker, Rusty Russel and our co-author Olaoluwa Osuntokun.
However, these "eltoo" channels require a new OP_CODE in the Bitcoin scripting language and can therefore currently not be implemented on top of the Bitcoin mainnet.
A deep dive into the topic discussed here is presented in chapter 7 of Mastering Bitcoin which can be found at: https://github.com/bitcoinbook/bitcoinbook/blob/develop/ch07.asciidoc.
Also, in case you are not familiar with P2PKH addresses and the basic format and scripting language of Bitcoin we encourage you to study chapter 6 of Mastering Bitcoin which can be found at: https://github.com/bitcoinbook/bitcoinbook/blob/develop/ch06.asciidoc.
There is also a video on Rene's YouTube channel which dissects the bits and bytes of a transaction spending from a P2PKH output at: https://youtu.be/1n4g3eYX1UI
To allow escrow services and complex ownership configurations between several stakeholders, the Bitcoin scripting language provides multisignature addresses.
The Bitcoin transaction that sends bitcoin to that 2-out-of-2 multisignature address is called the funding transaction.
It is included in the Bitcoin blockchain.
While the payment channel opened by two participants of the Lightning Network can be private, the funding transaction will always be publicly visible to the Bitcoin network.
The amount of bitcoin sent to the multisignature address forms an upper limit on how much Bitcoin can be transacted using the channel, and is called the capacity of the channel.
While the Bitcoin network can see that funds have been committed to a channel using a funding transaction, it is unable to determine how those funds are distributed between the two channel partners.
If a channel partner should not respond, one will always have the chance to fall back to the on-chain transactions without the necessity for the channel partner to help to do so.
On-chain fees and Bitcoin confirmation times make moving bitcoin on the Bitcoin network more expensive and slower than moving bitcoin on the Lightning Network.
As Alice wasn't aware of the protocol to open the channel she now has to trust that Mallory will provide her signature if Alice wants to spend from the multisignature address.
Mallory on the other side has the chance to execute a blackmail attack on Alice by holding back her signature and denying Alice access to her funds.
In order to prevent Mallory from performing such an attack Alice will need to create a spend transaction from the funding transaction and have that transaction signed by Mallory before she broadcasts her funding transaction to the Bitcoin network.
This transaction that protects Alice is called Commitment transaction and we will study it now.
You have just learnt that a payment channel needs to be opened by preparing a funding transaction which sends the capacity of the payment channel to a 2-2 multisignature address.
From the example in the last section you learnt that more ingredients are necessary to open and operate a payment channel that does not rely on trusting the channel partner.
They are used to make sure that everyone on the channel is able to get their own funds back in case the channel partner becomes unresponsive or, even worse, if the channel partner deliberately or by accident tries to cheat with the execution of the protocol.
. Bob also creates a new private / public key pair and agrees to accept a channel from Alice while sending his public key to Alice via the `accept_channel` message.
. Alice now creates a funding transaction from her wallet that sends 10 mBTC to the multisignature address with a locking script `2 <Public Key A> <Public Key B> 2 CHECKMULTISIG`.
. Alice does not broadcast the funding transaction but informs Bob about the transaction id of the funding transaction by sending a `funding_created` message.
. Both Alice and Bob create their version of a commitment transaction. This Transaction will spend from the funding transaction and send all the bitcoin back to an address controlled by Alice.
With this protocol Alice did not give up ownership of her 10 mBTC even though the funds have been sent to a 2-2 multisignature wallet for which Alice controls only one key.
If Bob stops responding to Alice she will be able to broadcast her commitment transaction and receive her funds back.
The commitment transactions will not only serve the purpose of allowing Alice to withdraw her funds directly after opening the channel in case Bob does not answer.
More commitment transactions are created during the lifetime of the channel to encode the balance between Alice and Bob.
If Alice wanted to send 3 mBTC to Bob to pay him for a service he offered, both would create a new version of their commitment transaction which would now send 7mBTC to Alice and 3 mBTC to Bob and share signatures with each other.
However you will probably have realized that there is a major flaw with this particular design.
**Do you see any way how Alice could cheat on Bob?**
We hope you recognize that with the so far described system nothing could stop Alice from publishing her old or even initial commitment transaction which grants her 10 mBTC.
Since that commitment transaction has previously been signed by Bob he can't prevent Alice from doing so.
Obviously Alice could tell Bob that she has deleted the old commitment transaction but as we mentioned several times the Lightning Network does operate without trust so a smarter mechanism is needed to prevent Alice from publishing an old commitment transaction.
As Bitcoin is censorship resistant no one can prevent a participant from the Lightning Network to publish an old commitment transaction.
However the commitment transactions can be slightly modified so that publishing an outdated commitment transaction is discouraged by a rather high punishment.
The penalty for broadcasting an old commitment transaction is to give the other channel partner the ability to claim the funds that belonged to the broadcaster of the transaction.
This means that Bob would have the ability to claim 10 mBTC from the output that belonged to Alice in her original Commitment transaction if she publishes it after she has agreed to a second commitment transaction in which she would only own 7 mBTC and Bob would own 3 mBTC.
With such a strong penalty mechanism in place Alice should never purposely publish an old state as she would almost always lose her remaining funds in the channel.
A key characteristic of bitcoin is that once a transaction is valid, it remains valid and does not expire. The only way to cancel a transaction is by double-spending its inputs with another transaction before it was mined. That's why we used timelocks [...] to ensure that more recent commitments could be spent before older commitments were valid.
The timelock prevents the owner of the output to spend it directly once the commitment transaction was included in a block.
The timelock is usually measured in blocktime and can be up to 2016 which is statistically speaking two weeks (assuming a blocktime of 10 minutes which is the target for the Bitcoin network).
Within the timelock anyone who knows the revocation secret can spend the output even well before the timelock was over.
Alice and Bob know only one half of the revocation secret but if they share their half with the other party, the other party knows the full secret.
In order to update the balance and receive a signature from Bob, Alice will have to share her half of the revocation secret of the current commitment transaction with Bob.
Note that even for private channels which are not announced over the gossip protocol, the funding transaction is always publicly stored in the Bitcoin blockchain.
However as it is just a regular transaction to a 2-2 multisignature address, participants of the Bitcoin network do not know if this particular transaction is used to maintain a payment channel.
Private channel can still be used in routing payments but only by the subset of nodes which are aware of their existence.
If a channel and its capacity is publicly announced on the gossip protocol, the channel partners will also be able to announce some meta data about the channel.
This meta data includes the routing fees a node charges to forward payments on that channel, information about what kind and how many Hash Time-Locked Contracts (HTLCs) will be accepted.
As we have not discussed HTLCs yet we will just mention that they are additional conditional outputs in the commitment transactions used for routing payments and for updating the channel balance.
When new participants join the Lightning Network they will be able to download the information propagated via the gossip protocol from their peers.
Peers can only omit messages but as every message is signed by the node that originally sent out the message the information on the gossip protocol cannot be modified to trick other participants.
The main goal of people using the Lightning Network is to keep their channels open as long as possible.
Opening and closing payment channels will result in bitcoin fees and in transactions that need to be stored in the Bitcoin Blockchain.
An open channel on the other side allows you to make an arbitrary amount of payments on the Lightning Network (as long as you have funds and they are liquid).
However sometimes there is the necessity that you have to close a channel. For example:
* After analyzing your routing statistics, as well as the network topology, you might have come to the conclusion that it might be better to close some channels and open some new ones.
The good news for you is that your Lightning Network software will most likely automatically select the best closing mechanism that can currently be used if you ask the software to close the channel or if the software discovers an issue with your channel partner and follows the protocol specification which in most of such cases state that the channel shall be closed.
The on-chain transaction fees of the shutdown transaction for closing the channel in a mutual way are being paid by the party who opened the channel and not as many people think by the person who initiated the closing procedure.
In case your node cannot engage in a mutual close (most likely because your channel partner is either offline or not responding) you will have to do a force close.
As discussed before the Bitcoin network has no way of knowing if this was the most recent commitment transaction or an old one which you might have published for a financial gain.
* The most obvious reason is that when the commitment transaction was negotiated you and your channel partner didn't know how high the on-chain fees might be at the time the force close is taking place.
As the fees cannot be changed without reasigning outputs of the commitment transaction which needs two signatures and as the force close usually should happen in an urgent situation the protocol developers decided to be very generous with the fee rate for the commitment transactions. It can be up to 5 times higher than the fee estimators would suggest at the time the commitment transaction is negotiated.
* In particular those routing attempts will have to be resolved on-chain by additional spends. These additional spends don't have to overestimate the fees but it still adds to the bill.
Your funds will be locked for a longer time and the person who opened the channel will have to pay higher fees. Also you might have to pay on-chain fees to abort or settle routing attempts - even if you haven't opened the channel.
In case your channel partner tries to cheat you - whether deliberate or not - by publishing an outdated commitment transaction, you will be able to use the timelock to catch this cheating attempt and collect on the outputs by using the revocation secret you had previously received to negotiate a newer state of the channel.
First if you catch your partner in time you will claim their funds. In that case the closing will be rather fast. Also you will have to pay the on-chain fees which could be really high if there is a lot of demand for transactions at that time.
In that case the fees of the commitment transaction are again paid by the partner who opened the channel and the fees for collecting the outputs are paid by the person controlling the output that is being collected.
While this method could be fully executed faster than the good and the bad way to close the channel, it is obviously never recommended to engage in this channel closing protocol.
The payment will either be transferred successfully through the path of nodes or will not be delivered.
There are no such things as a partial payment or a half successful payment.
While Lightning Nodes usually use the encrypted communication channels over the peer to peer network to exchange information, invoices are being transferred via a second communication channel.
The payment process of the Lightning Network is only secure if `r` is chosen completely randomly and is not predictable and as long as the Hash function cannot be inverted.
We note that this is not an additional security assumption for Bitcoin as the security of the Hash function is currently what Bitcoin mining is built upon.
These hints can also be used for public channels to point to those channels on which the payee has enough inbound liquidity to actually receive the amount.
We would however always recommend to open a new payment channel instead of doing an on-chain transaction that does not add an additional payment channel.
You have already learnt that payments start with the payee creating an invoice which includes a Payment Hash to make sure that payments are atomic and that no one on the path of payment channels can withhold the transferred money to their benefit.
In this section we will dive into the ideas and methods that are being used to deliver a payment over the Lightning Network and utilize everything that we have used so far.
Every peer can validate the information from the `channel_announcement` message and verify that the funding transaction was indeed confirmed by the Bitcoin network.
These messages will only be forwarded about 4 times per day for every channel to prevent spam.
The gossip protocol also comes with a variety of queries and tools to initially synchronize a node with the view of the network or to update the nodes view after being offline for a while.
A major challenge for the participants of the Lightning Network is that the topology information that is being shared by the gossip protocol is only partial.
1. To protect the privacy of the users and not shout out every financial transaction and payment that is being conducted.
2. To be able to scale the amount of payments that can be conducted with the Lightning Network. Remember the Lightning Network was created in the first place because notifying every participant about every payment does not scale well. Thus for simple technical reasons the Lightning Network cannot be designed in a way that the current balance updates of channels are being shared among participants.
Payments on the Lightning Network are forwarded along a path of channels from one participant to another.
Thus, a path of payment channels has to be selected.
If we knew the exact channel balances of every channel we could easily compute a payment path using any of the standard path finding algorithms taught in any computer science program.
With only partial information about the network topology available this is a real challenge and active research is still being conducted into optimizing this part of the Lightning Network implementations.
The fact that the path finding problem is not fully solved for the case of the Lightning Network is a major point of criticism towards the technology.
The path finding strategy currently implemented in Lightning nodes is to probe paths until one is found that has enough liquidity to forward the payment.
While this is not optimal and certainly can be improved, it should be noted that even this simplistic strategy works well.
This probing is done by the Lightning node or wallet and is not directly seen by the user of the software.
The user might only realize that probing is taking place if the payment is not going though instantly.
The algorithm currently also does not necessarily result in the path with the lowest fees.
While the TCP/IP protocol stack allows reliable communication by resending packages that are not acknowledged this mechanism could not be reused directly in the Lightning Network.
A payment that is not being forwarded would effectively mean that the money was stolen by a router and the sender cannot just send out another payment.
While the routing protocol together with the Border Gateway Protocol which are used for data and information transport on the internet have the nice property of allowing the internet hosts to collaboratively find a path for the information flow through the internet, we cannot reuse and adopt this protocol for forwarding payments on the Lightning Network.
This includes currently known public payment channels, known nodes, known topology (how known nodes are connected), known channel capacities, and known fee policies set by the node owners.
If the sending node of a payment has selected a path that is supposed to be used to make the payment, the Lightning Network uses an onion routing scheme similar to the famous TOR-network.
1. The most important property is that a routing node can only see on which channels it received an onion and on which channel to set up an HTLCs and thus to which peer to forward the onion. This means that no routing node can know who initiated the payment and for whom the payment is supposed to be. The exception of course would be if the node is the recipient. In that case it would know that it was the final destination.
2. The onions are small enough to fit into a single TCP/IP package and actually even a link layer frame. This will make traffic analysis for intruding the privacy of the payments almost impossible.
4. Onions can have up to 20 hops included allowing for sufficiently long paths.
5. The encryption of the onion for every hop uses different ephemeral encryption keys with every single onion. Should a key (in particular the private key of the public node key) leak at some point in time an attacker who collected onions cannot decrypt the other onions that have been stored.
6. Errors can be sent back from the erring node in an encrypted way to the original sender. This is particularly useful as we have seen that Lightning nodes who initiate the onions select a path without knowing whether every node has enough liquidity along their channels to forward the payment.
As mentioned we will discuss the details of the Onion Format later but we note already that the `Payment Hash`, while needed to set up the HTLCs for the payment, is not transported within the onions.
The `Payment Hash` is rather included in the Lightning Message that also transports the onion.
Most importantly communication is needed to open and close payment channels, to send and receive onions, to set up and settle or fail HTLCs and for exchanging gossip information.
On the other hand, this makes development more difficult as one cannot easily monitor one's own traffic on a tool like Wireshark for debugging. footnote:[Luckily tools exist to make developers' lives easier: https://github.com/nayutaco/lightning-dissector]
As long as a person follows the protocol and has their node secured, there is no principle risk of losing funds when participating in the Lightning Network.
In our case the reward is that she can send and receive payments of bitcoin on the Lightning Network at any time and that she can earn bitcoin by forwarding other payments.
While the Lightning Network is built on top of Bitcoin, and inherits many of its features and properties, there are important differences that users of both need to be aware of.
For instance, a user making a payment of 1 BTC can use a single output with value 1 BTC, two outputs with value 0.25 BTC and 0.75 BTC, or four outputs with value 0.25 BTC each.
==== Change Outputs on Bitcoin vs No Change on Lightning
In order to make a payment on the Bitcoin network, a sender needs to consume one or more Unspent Transaction Outputs (UTXOs).
The entire UTXO needs to be spent, so if a user wishes to spend 0.8 BTC, but only has a 1 BTC UTXO, then they need to send 0.8 BTC to the receiver, and 0.2 BTC back to themselves.
On Lightning, the UTXO is consumed during the Funding Transaction, which leads to the creation of a channel.
Once the bitcoin is locked within that channel, portions of it can be sent back and forth within the channel, without the need to create any change.
This is because the channel partners simply update the channel balance, and only create a new UTXO when the channel is eventually closed using the Bitcoin network.
These fees are paid to the miners who mine that particular block, and are based on the _size_ of the transaction in _bytes_ that the transaction is using in a block, as well as how quickly the user wants that transaction mined.
As miners will typically mine the most profitable transactions first, a user who wants their transaction mined immediately will pay a _higher_ fee-per-byte, while a user who is not in a hurry will pay a _lower_ fee-per-byte.
On the Lightning Network, users pay fees to other users to route payments through their channels.
In order to route a payment, a routing user will have to move the funds in two or more channels they own, as well as transmit the data for the sender's payment.
Typically, the routing user will charge the sender based on the _value_ of the payment, as well as setting their own fees they require to route the payment.
Higher value payments will thus cost more to route, and a market for capacity will exist, where different users will charge different fees for routing through their channels.
==== Varying Fees Depending Traffic vs Announced Fees
On the Bitcoin network, miners are profit-seeking, and so will typically include as many transactions in a block as possible, while staying within the block size limit (actually, a modified form called the block weight limit).
If there are more transactions in the queue (called the mempool) than can fit in a block, they will begin by mining the transactions that pay the highest fees per byte (highest fee per weight).
Thus, if there are many transactions in the queue, users will have to pay a higher fee to be included in the next block, or they will have to wait until there are fewer transactions in the queue.
This naturally leads to the concept of 'traffic' and the creation of a fee market where users pay based on how urgently they need their transaction included in the next block.
On the Lightning Network, traffic does not exist since users are not competing for block space outside of the Funding or Closing transactions.
Instead, they are paying fees to the users routing their payments, and different routers will charge different fees for routing through their channels.
Naturally, routers who are charging lower fees for the same capacity will be more attractive to route through.
Thus a fee market exists where routers are in competition with each other over the fees they charge to route payments through their channels.
==== Public Transactions on the Blockchain vs Secret payments
While the addresses involved are pseudonymous and are not typically tied to identity, they will still be collected and validated by every other user on the network.
Typically only the sender and the receiver will be fully aware of the source, destination, and amount of bitcoin transacted in a particular transaction.
On the Lightning Network, confirmation only matters for opening and closing channels.
Once a Funding Transaction has reached a suitable number of confirmations (e.g. 3), the channel partners consider the channel open.
As the bitcoin in the channel is secured by the smart contract that manages that channel, payments settle instantly once received by the receiver and are not reversible.
When the channel is closed, a transaction will be made on the Bitcoin network and, only once that transaction is confirmed will the channel be considered closed.
==== Sending arbitrary amounts vs capacity restrictions
On the Bitcoin network, a user can send any amount of bitcoin that they own to another user, without capacity restrictions.
On the Lightning Network, a user can only send as much bitcoin as currently exists on their side of a particular channel.
For instance, if a user owns one channel with 0.4 BTC on their side, and another channel with 0.2 BTC on their side, then the maximum they can send with one payment is 0.4 BTC.
At the time of writing, Atomic Multi-Path Payments (AMPs) are in development, which, in the above example, would allow the user to combine their 0.4 BTC and 0.2 BTC channels to be able to send a maximum of 0.6 BTC with one payment.
Once a transaction is included in the blockchain it is final.
Thus no disputes can arise and it is unambiguous how much bitcoin is controlled by a particular address at a particular point in the blockchain.
(The only possible dispute is if the blockchain forks into two or more different blockchains)
On the Lightning Network, the balance in a channel at a particular time is known only to the two channel partners, and is only made visible to the rest of the network when the channel is closed.
When the channel is closed, the final balance of the channel is submitted to the Bitcoin blockchain, and each partner receives their share of the bitcoin in that channel.
For instance: if the opening balance was 1 BTC to Alice, and Alice made a payment of 0.3 BTC to Bob, then the final balance of the channel is 0.7 BTC to Alice and 0.3 BTC to Bob.
If Alice tries to cheat by submitting the opening state of the channel to the Bitcoin blockchain, with 1 BTC to Alice and 0 BTC to Bob, then Bob can retaliate by submitting the true final state of the channel, as well as penalty transaction that gives him all Bitcoin in the channel.
In this context, the Bitcoin blockchain acts as a court system; recording the initial and final balances of each channel, and approving penalties if one of the parties tries to cheat.
