Payment Channel

A payment channel is a Layer 2 scaling technique that enables unlimited instant transactions between two parties by locking funds in an on-chain smart contract and exchanging signed off-chain messages that update the balance distribution without touching the blockchain until final settlement.

The mechanics: Alice and Bob each deposit funds into a multi-signature contract controlling a shared balance. ' Each new message supersedes previous ones. These updates happen instantly, cost nothing, and require no blockchain confirmation. The channel can remain open indefinitely, handling thousands of transactions.

When parties want to close, they submit the latest mutually-signed balance state to the contract, which distributes funds accordingly. Dispute resolution handles uncooperative closures: if Bob tries to submit an outdated favorable state, Alice can submit a more recent state plus proof of recency. The contract enforces a challenge period during which counterparties can contest.

Payment channel networks like Lightning (Bitcoin) and Raiden (Ethereum) connect individual channels into a mesh: Alice pays Carol through Bob if Alice-Bob and Bob-Carol channels exist, using hash time-locked contracts to guarantee atomic multi-hop payments.

This network effect greatly extends payment channel utility beyond bilateral relationships, enabling payments to anyone connected to the network.