In Part I, we demonstrated Poon-Dryja channels; a generalized channel structure which used revocable transactions to ensure that old transactions wouldn’t be reused.

A channel from me<->you would allow me to efficiently send you 1c, but that doesn’t scale since it takes at least one on-blockchain transaction to set up each channel. The solution to this is to route funds via intermediaries; in this example we’ll use the fictitious “MtBox”.

If I already have a channel with MtBox’s Payment Node, and so do you, that lets me reliably send 1c to MtBox without (usually) needing the blockchain, and it lets MtBox send you 1c with similar efficiency.

But it doesn’t give me a way to force them to send it to you; I have to trust them. We can do better.

Bonding Unrelated Transactions using Riddles

For simplicity, let’s ignore channels for the moment. Here’s the “trust MtBox” solution:

What if we could bond these transactions together somehow, so that when you spend the output from the MtBox transaction, that automatically allows MtBox to spend the output from my transaction?

Here’s one way. You send me a riddle question to which nobody else knows the answer: eg. “What’s brown and sticky?”. I then promise MtBox the 1c if they answer that riddle correctly, and tell MtBox that you know.

MtBox doesn’t know the answer, so it turns around and promises to pay you 1c if you answer “What’s brown and sticky?”. When you answer “A stick”, MtBox can pay you 1c knowing that it can collect the 1c off me.

The bitcoin blockchain is really good at riddles; in particular “what value hashes to this one?” is easy to express in the scripting language. So you pick a random secret value R, then hash it to get H, then send me H. My transaction’s 1c output requires MtBox’s signature, and a value which hashes to H (ie. R). MtBox adds the same requirement to its transaction output, so if you spend it, it can get its money back from me:

Handling Failure Using Timeouts

This example is too simplistic; when MtBox’s PHP script stops processing transactions, I won’t be able to get my 1c back if I’ve already published my transaction. So we use a familiar trick from Part I, a timeout transaction which after (say) 2 days, returns the funds to me. This output needs both my and MtBox’s signatures, and MtBox supplies me with the refund transaction containing the timeout:

MtBox similarly needs a timeout in case you disappear. And it needs to make sure it gets the answer to the riddle from you within that 2 days, otherwise I might use my timeout transaction and it can’t get its money back. To give plenty of margin, it uses a 1 day timeout:

Chaining Together

It’s fairly clear to see that longer paths are possible, using the same “timelocked” transactions. The paper uses 1 day per hop, so if you were 5 hops away (say, me <-> MtBox <-> Carol <-> David <-> Evie <-> you) I would use a 5 day timeout to MtBox, MtBox a 4 day to Carol, etc. A routing protocol is required, but if some routing doesn’t work two nodes can always cancel by mutual agreement (by creating timeout transaction with no locktime).

The paper refers to each set of transactions as contracts, with the following terms:

If you can produce to MtBox an unknown 20-byte random input data R from a known H, within two days, then MtBox will settle the contract by paying you 1c.

If two days have elapsed, then the above clause is null and void and the clearing process is invalidated.

Either party may (and should) pay out according to the terms of this contract in any method of the participants choosing and close out this contract early so long as both participants in this contract agree.

The hashing and timelock properties of the transactions are what allow them to be chained across a network, hence the term Hashed Timelock Contracts.

Next: Using Channels With Hashed Timelock Contracts.

The hashed riddle construct is cute, but as detailed above every transaction would need to be published on the blockchain, which makes it pretty pointless. So the next step is to embed them into a Poon-Dryja channel, so that (in the normal, cooperative case) they don’t need to reach the blockchain at all.