5. And what are those payment channels?

It’s like a safety deposit box where two people deposit equal amounts of money and each put a lock on it.

This action of depositing equal amounts of money in a common box is recorded on the Blockchain in the form of an ‘Opening Transaction’ and thereafter a payment channel is open between those two people.

The idea behind locking money in such a box is that no one person can spend the money in the box without the other. The money in this box is then used to transact between each other.

Imagine, Xan and Yelena pool in 10 BTC each in the common box. And now, if Xan wants to send 2 BTC to Yelena, how would he do that?

To do that, he would transfer a promise of ownership for two of his Bitcoins in the common box to Yelena. After this transfer of promise, if the box is unlocked, Xan will be able to take 8 BTC from it and Yelena will be able to claim 12 BTC.

But they will not open the box because they want to continue transacting between themselves. That’s the beauty of this arrangement.

Now, if the next day, Yelena has to send 1 BTC to Xan, she would do the same - transfer a promise of ownership for one of her Bitcoins to Xan. After these two transactions, if the box is opened, Xan can claim 9 BTC and Yelena can get 11 BTC.

To imagine how off-chain transactions look like, consider this:

To sum it up, payment channel is nothing but a combination of pooling some money together and then transferring the promise of ownership of the pooled-in money in the agreed upon manner. If ever either of Xan or Yelena wants to close the channel, they can.

Closing a channel would simply mean opening up the box and taking the money inside. This opening of the box happens on the Blockchain and the who owns how much from the box is recorded forever.

That’s how payment channels work. But that doesn’t even come close to defining their true potential. Their true power is unleashed when two or more payment channels work together to form a network - The Lightning Network.