State channels are a Layer 2 scaling solution that allows participants to conduct any number of off-chain transactions securely and for free. Transactions and only pay gas fees when opening and closing channels. Therefore, state channels can support greater transaction throughput with the lowest possible gas fees.

What is Layer 2? What does it do for blockchain? Please refer to the entry "What is Layer 2 Network".

The principle of state channel

Let’s imagine a situation like this:

Bob has to ask him every day My friend Alice made more than 10 payments worth $0.5 in ETH for a month. However, this is not only very time-consuming, but also wastes a lot of gas fees. Most of the time, the amount of each transaction does not even cover the gas fee Bob needs to pay for it.

What is gas fee? How is it generated and how is it calculated? Please refer to the entry "What is Gas Fee".

So they came up with a pretty clever way. They could open their own accounts in an accounting APP, and Bob had to deposit some money (let's say $100) in advance. Enter a safe to gain Alice's trust. After that, for each transaction, they only need to update their account balance without immediate settlement.

A month later, when all transactions between them have concluded, the accounting app clearly shows that Bob owes Alice $80. At this point, the $100 locked in the safe will be redistributed between them. This is an intuitive way to understand state channels, except that all storage and calculations will be managed by smart contracts.

Mechanism of state channel

Technically speaking, to join a state channel, a group of participants need to jointly sign a multi-signature smart contract. Depositing and locking their funds into it forms an initial blockchain "state". This locked "state" can be a certain number of ERC-20 tokens, or even NFTs, ENS domain names, etc.

Participants within the same channel are then free to conduct off-chain transactions without immediately returning the transaction to Layer 1 for settlement. Every off-chain transaction needs to be signed by all participants to be considered a valid "status update".

Finally, when the transaction is completed, all participants should submit the final status recognized by all participants to Layer 1 by signing a smart contract. The smart contract, after verifying that all off-chain transactions ("status updates") are valid, will eventually close the channel and settle the deposit balance for each participant. Participants can then withdraw the remaining balance of their deposits.

Advantages and Disadvantages of State Channels

The above characteristics of state channels make them very good at handling extremely high transaction throughput while keeping gas fees low for users, especially Suitable for long-term, repeated and small-amount payments. However, it also has other shortcomings, such as only allowing transactions between participants in the same channel, but not allowing the channel to add or delete participants during the process, which will greatly increase the limitations of its application.

The most famous example of using state channel technology is the payment channel in the Bitcoin Lightning Network, which allows off-chain payment transactions to be conducted directly between two parties without paying fees. Another famous example is Celer Network. Its product Layer.2 finance allows users to access all existing DeFi protocols at extremely low fees through state channel technology.