[role="pagenumrestart"]
[[ch03_How_Lightning_Works]]
== How the Lightning Network Works
After you have had your first hand experiences with the Lightning Network and learnt about its most important properties we now want to give you a high level overview of the components that are used to build the Lightning Network.
This overview will not contain all the technical details.
Our goal is rather to help you to become aware of the most important concepts and building blocks.
If you have a lot of experience in computer science, cryptography, Bitcoin and protocol development this chapter should probably 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 overview so that after reading it you will most likely have a much easier time reading through the rather formal protocol specification which is known as BOLTs (Basics of Lightning Technology).
In case you are a beginner this chapter shall help you to get a better access to the more technical chapters of the book.
That being said we are aware of the fact that some readers might have a hard time following high level descriptions without explaining all the details.
If you are one of those you might very well want to skip this chapter.

Let us start with a one sentence definition of what the Lightning Network (LN) is and break this down in the remainder of this chapter.
Please do not get frustrated if this one sentence does not make sense to you right away or if it seems either too sophisiticated or too trivial.

**The Lightning Network (LN) is a network of payment channels on top of the Bitcoin protocol together with a communication protocol that defines how participants set up and execute the smart contracts that enable the Lightning Network**

We will see that payment channels are nothing else than a 2 out of 2 multisignature address on the Bitcoin Network for which you hold a key and your channel partner holds the other key.
This multisignature address comes together with a cryptographic protocol that is established by creating a sequence of transactions that spend from this address.
Those transactions will be negotiated between you and your partner in secret and are attempts to double spend from that multisignature address.
The latest transaction of that sequence encodes the balance of your channel and defines how the funds of the multisignature address are to be divided between you and your partner.
The transactions in this sequence make use of the scripting language in Bitcoin.
The design will discourage you and your channel partner from publishing an old (outdated) state about your channel.
Thus collaboratively adding a new transaction to this sequence is equivalent to moving ownership of funds without the Bitcoin network being aware of it.
Since this construction or protocol is an agreement between you and your partner you could call it a contract.
As it is a rather smart construction people might call it a smart contract.

[NOTE]
====
When someone says they own bitcoin they would usually mean that they know the private key of a bitcoin address that has some unspent transaction outputs (UTXOs).
The private key allows the owner to produce a signature for a transaction that spends the bitcoin by sending it to a different address.
Thus one can define ownership of bitcoin as the ability to spend them.
If you have an unpublished but signed transaction from a 2-2 multisignature address where some outputs are send to an address that you control and additionally you own one of the private keys of the 2-2 multisignature address you effectively own the bitcoin of that output.
Without your help no other transaction from the 2-2 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 2-2 multisignature address.
====

Additionally these contracts have the option to connect channels in a way that one can forward payments from one channel to another.
So Alice can send money to Bob if Alice had a channel with Mallory and Mallory had a channel with Bob.
Surprisingly, 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 a 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!

The aforementioned innovations are certainly the major breakthrough that lead to the the LN protocol.
However the LN is so much more than the cryptographic protocols on top of the Bitcoin scripting language.
It is a full communication protocol which consists of a peer protocol that defines how peers communicate with each other via Lightning messages to achieve the transfer of bitcoin.
The communication protocol also defines how Lightning messages are being encrypted and exchanged.
A Gossip protocol is part of the specification that is used to share public information about the topology of the network with the other participants.
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 via Mallory to Bob.

Last but not least it is important to understand that the LN is nothing else than Bitcoin.
We emphasize this as you might find people who will try to spread misinformation and create an artificial barrier between the "real" Bitcoin and the Lightning Network or even use terms like the Lightning Network coin.
We hope that as soon as you have studied the remainder of this book you do not need to believe what we just mentioned.
We rather hope that this book enables you to critically do your own research so that you are able to understand and verify the following (instead of trusting us):
Besides all the technical primitives, the LN protocol is a creative way to get most use 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.

=== Payment channels

As you have seen in the last chapter, in order to use the LN you had to ask your wallet software to establish a payment channel with at least one other participant of the network.
From a computer science perspective a payment channel is a cryptographic communication protocol between you and your channel partner.
It allows the both of you to send funds back and forth as often as you wish.
The channel is only limited by two things:
First, the time it takes for the internet to transfer the few bytes of data that the protocol requires to make a payment between you and your partner.
Second, the capacity of the channel, which is the term for the funds that have been assigned to the channel.
Payment channels have a couple of very interesting and useful properties.

* 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 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 on 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 agreed previously agreed upon.
* The capacity of the channel will be split between you and your partner. In that sense at that level you will have already gained more privacy as in comparison to the Bitcoin Network where every transaction is public. Within payment channels the amount and values of payments are secretely kept between 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 the payment channel is closed.
* As the time to update the channel is the only bound, making a payment within a payment channel is almost instant.

Bitcoin had to be about 5 years old until talented developers figured out how payment channels could be constructed and by now there are at least 3 different constructions known.
This chapter will only focus on the "Poon, Dryja" - Construction since it is actually being used in the Lightning Network and was first described in the Lightning Network whitepaper.
The other two constructions are the Duplex Micropayment channels which have been introduced by Christian Decker around the same time as the "Poon, Dryja" - channels and the "eltoo" - channels which have been introduced in 2018 by Christian Decker, Rusty Russel and our co-author Olaoluwa Osuntokun.
The later seem much easier to implement and to have a couple of nicer properties.
However they need a new OP_CODE to the Bitcoin scripting language and can currently not be implemented on top of the bitcoin mainnet.

==== Multisig addresses
Payment channels are smart contracts that build on top of 2-2 multisignature addresses which will be spent by Segwit transactions.
By knowing the properties of multisignature addresses you will be able to understand the exact construction of payment channels.
Thus at this point we will not review all the technical details about multisignature addresses and Segwit but just stick to the properties.
If you know Bitcoin so well that you are familiar with those topics feel free to skip this section.

[TIP]
====
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 general form of a locking script setting an M-of-N multisignature condition is:

----
M <Public Key 1> <Public Key 2> ... <Public Key N> N CHECKMULTISIG
----

where N is the total number of listed public keys and M is the threshold of required signatures to spend the output.

A special case which is particularly interesting for us is a locking script setting a 2-of-2 multisignature condition.
It would look like this:

----
2 <Public Key A> <Public Key B> 2 CHECKMULTISIG
----

The preceding locking script can be satisfied with an unlocking script containing pairs of signatures:

----
0 <Signature A> <Signature B>
----
The two scripts together would form the combined validation script:

----
0 <Signature A> <Signature B> 2 <Public Key A> <Public Key B> 2 CHECKMULTISIG
----

==== Funding Transaction
You already learnt that one of the most important building blocks of a payment channel is a 2-2 multisignature address.
To open a payment channel one must send bitcoin to that address.
The Bitcoin transaction - which will be included to the Bitcoin Blockchain - that sends the bitcoin to that 2-2 multisignature address is called the funding transaction.
While there is the possibility for 2 participants of the Lightning Network to open a private payment channel, this transaction will always be publicly visible to the Bitcoin network.
The amount of bitcoin sent to the multisignature address is called the capacity of the channel.
Two channel partners will never be able to conduct larger payments on that channel than the channel capacity.
What cannot publicly be seen from the funding transaction is how the funds in that open channel are being distributed between the two channel partners.


[Note]
====
You will often hear that people complain about bitcoin being locked to the Lightning Network which can't move freely.
This is obviously a lie.
One can use the Bitcoin network to send bitcoin from a P2PKH address as well as sending bitcoin from a 2-2 multisignature address with a P2WSH transaction.
In both cases transfer of ownership might be expensive in bitcoin fees if there is a lot of demand from people to utilize the Bitcoin Network.
However once the bitcoin are used to open a payment channel they can freely flow within the Lightning Network from one participant to another one.
If a channel partner should not respond, one will always have the chance to fall back to the onchain transactions without the necessity for the channel partner to help to do so.
Due to the potentially high fees and confirmation times, bitcoin on the Bitcoin Network are way more rigid and harder to move than bitcoin on the Lightning Network.
====


===== Example of a poor channel opening procedure
Alice wants to open a payment channel with Mallory but she is not yet fully aware of the Lightning Network Protocol.
She creates a new private and corresponding public key and talks to Mallory who does the same and sends her public key to Alice.
Now Alice prepares a Bitcoin Transaction sending a few mBTC to the multisignature address that was created from Alice's and Mallory's key.
As Alice wasn't aware of the protocol to open the channel she now has to trust Mallory.
Mallory on the other side has the chance to execute a blackmail attack on Alice.
Alice needs a signature from Mallory to send Alice's funds from the multisignature address back to an address controlled by Alice.

In order to prevent Mallory from committing such an attack Alice will need to create a spend transaction from the funding transaction and have that transaction signed from Mallory before she broadcasts her funding transaction to the Bitcoin network.
The transaction protecting Alice is called Commitment transaction and we will study it now.

==== Commitment Transaction

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.
These such ingredients are the commitment transactions.
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.
The commitment transactions also encode the balance of the payment channel.
The balance of the payment channel is an agreement of the channel partners of how the capacity is split among the partners.
Let us assume Alice opens a channel with a capacity of 10 mBTC with Bob.
Naturally one would assume that Alice should still be in the possession of the 10 mBTC.
This can actually be easily achieved with the following construction:

. Alice creates a new private / public key pair and informs Bob that she wishes to open a channel.
. Bob also creates a new private / public key pair and agrees to Alice to accept a channel from Alice while sending his public key to Alice.
. 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.
. 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.
. Alice provides a signature for Bob's Commitment Transaction and Bob provides a signature for Alice's Commitment Transaction.
. Only after signatures have been exchanged Alice will broadcast the funding transaction to the bitcoin network.

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.
She will only have lost the fees for the two on chain transactions. As long as she follows the protocol and has her node secured this is her only risk when opening a channel.

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.

[Note]
====
In Mastering Bitcoin Andreas states it very elegantly:
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 souble-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. 
====

We will now see how such a penality mechanism can be included to the above construction of the commitment transactions.
Usually the commitment transaction has at least two outputs, one for each partner.
However a channel partner will encumber their own output with a timelock and a revocation secret.
The timelock prevents the owner of the output to spend it directly once the commitment transaction was included to 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 a 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.

Obviously for every new update of the channel balance new revocation secrets have to be created and the old ones all need to be saved.
Luckily the secrets are rather small and it is only the channel partners who need to do that, not the entire network.
Still managing the revocation secrets is one of the more tricky parts of Lightning nodes that hinders node operators to maintain backups.
Watchtower services or switching to the aforementioned eltoo channels might be future strategies to mitigate these problems.

==== Announcing the channel
Channel partners can agree to publicly announce the channel over the Gossip protocol that comes with the Lightning Network.
This is useful as other nodes will then be able to utilize this channel to route payments to other participants of the network.
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.
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.
We will later investigate HTLCs in more detail.
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.

==== Closing the channel
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:

* You have become aware of the fact that your computer got compromised and you want to secure your funds by sending them to cold storage.
* Your channel partner might be offline for too much time so that you cannot utilize the funds in that channel.
* 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.

There are 3 ways to close a payment channel:

* the good way - mutual close
* the bad way - force close
* the ugly way - protocol breach

Not all ways could be chosen for each of the above mentioned reasons.
For example if your channel partner is offline you will not be able to engage in the good way to do a mutual close.
The good news for you is that you 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.

===== Examining the mutual close
The preferred and good way to close a channel is the mutual close.
When you decide that you want to close the channel, your Lightning Network node will inform your channel partner about your intention.
Now the channel will be prepared for shutting down.
No new routing attempts will be accepted from either channel partner and the ongoing routing attempts will be settled or removed after they timed out.
Once no further routing attempts are pending, the closing transaction is prepared.
This transaction is similar to the commitment transaction.
It has the same balance as the commitment transaction but no outputs are encumbered with a time lock.
As the finish up of the routing attempts could take some time, a mutual close can also take some time.
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.
As both nodes sign the shutdown transaction they have the chance to pay small fees for the Bitcoin transaction by using their onchain fee estimator.
Even though there is is a potential waiting time this type of channel close is usually faster than the bad way.

===== Examining the force close
In case your node cannot engage to a mutual close (most likely because your channel partner is either offline or not responding) you will have to do a force close.
This is done by publishing the latest commitment transaction that your node has.
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.
Thus after that transaction was mined you will have to wait for the timelock of your output to expire until you can spend your own funds.
Also the onchain fees will be much higher for several reasons.
The most obvious reason is that when the commitment transaction was negotiated you and your channel partner would not 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 to signatures and as the force close usually should happen in an urgent situation the protocol developer decided to be very generouse 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.
There are more reasons for the more expensive fees.
The pending routing attempts in the commitment transaction are encoded as additional outputs which take up more space and will also hit the chain.
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.
In general you should not do a force close unless it is absolutely necessary.
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 onchain fees to abort or settle routing attempts - even if you haven't opened the channel.

===== Examining the ugly way to close a channel
In case you channel partner tries to cheat you - weather deliberate or not - by publishing an outdated state, you will be able 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.
This close can actually go in two ways.
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 going on at that time.
This should not bother you as you just gained the entire channel capacity.
Second if you did not catch the cheating attempt then your channel partner will be able to collect their outputs after the time lock expired.
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 who committed the closing operation.
Also all the routing attempts will have to be resolved just as in the force close.
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.


=== Invoices

An alternative structure for the subsections of the invoice section (while covering the same topics) could be: (creating, decoding, paying as 3 sub chapters)

* creating invoices
* decoding invoices
* bech32 encoding and human readable part of invoices

==== Payment Hash
* `pre_image` as proof of payment
* random numbers and selecting the pre_image

==== Meta Data
* Description
* routing hints
* fallback address
* expire time
* signature

=== Delivering the payment

* gossip protocol
* network of payment channels
* different scope of the network
** global path finding (entire knowledge of the network necessary)
** multihop routing (onion necessary only a subset of nodes involved)
** locally setting up and setteling htlcs (only peers involved)

==== Finding a path

* trivial case / channel partner as destination with enough funds in the channel
* topology information from the gossip protocol
* fees and pathfinding from destination to source

==== Onion routing

* construct an onion using
** SPHINX
** payment hash
** path

==== Payment Forwarding Algorithm

* receive an incoming HTLC
* forward an HTLC
* BOLT 02 channel update protocol
* sending back errors

=== Missing bits
* Noise_XK
* Lightning Messages

=== Thoughts about Trust
As long as a person follows the protocol and has their node secured, there is no principle risk of losing funds when participating with the Lightning Network.
However there is the risk of paying fees when opening a channel.
Any risk should come with a potential reward.
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.
Alice decides that the reward is enough for her to take on the fee risk.
Since Bob can directly close the channel, which costs fees paid by Alice, she will need to have a little trust in Bob.

=== Comparison with Bitcoin

* select outputs vs select payment channels / finding a path
* change outputs vs no change on lightning
* mining fees vs routing fees
* public transactions on the blockchain vs. secret payments
* waiting for confirmations vs instant settlement (if everything works smoothly)
* arbitrary amounts vs capacity restrictions
* variying fees depending on the traffic vs announced fees (might become dynamic too?)
* blockchain to save all transactions vs blockchain as a court system
