Hashed Timelock Contract (HTLC): Overview and Examplesin Crypto

What Is a Hashed Timelock Contract (HTLC)?

A hashed timelock contract (HTLC) is a type of smart contract used in blockchain applications. It reduces counterparty risk by creating a time-based escrow that requires a cryptographic passphrase for unlocking.

In practical terms, this means that the person receiving the funds in a transaction has to perform two actions to access the funds: enter the correct passphrase and claim payment within a specific timeframe. If they enter an incorrect passphrase or do not claim the funds within the timeframe, they lose access to the payment.

Understanding Hashed Timelock Contracts (HTLCs)

A Hashed Timelock Contract (HTLC) uses several elements from existing cryptocurrency transactions. For example, HTLC transactions use multiple signatures consisting of a private and public key to verify and validate transactions. However, two elements distinguish HTLC from standard cryptocurrency transactions with smart contracts—the hashlock and the time contract.

Hashlock

The first element is the hashlock. A hashlock is a hashed—or cryptographically scrambled—version of a public key generated by the person that initiated the transaction. The associated private key is then used to unlock the original hash.

In HTLC, the initiating party generates a key and hashes it. The hash is stored in a pre-image, which is revealed during the final transaction. HTLCs are programmed to expire after a certain period passes or a specific number of blocks are generated, creating a known termination date and time.

Timelock

The second important element of HTLC is a timelock. Two different timelocks are used to set time constraints on contracts generated using HTLC. The first one is CheckLockTimeVerify (CLTV). It uses a time base to lock and release cryptocurrency. This means that time constraints are hardcoded, and coins are released only at a specific time and date or a specific height of block size.

Atomic swaps—cross-chain trading between cryptocurrencies— are often achieved using HTLCs. Additionally, Bitcoin’s lightning network (LN) also employs HTLCs.

The second one is CheckSequenceVerify (CSV). It is not dependent on time; instead, it uses the number of blocks generated as a tracking measure to determine when to finalize a transaction.

The Process in a Hashed Timelock Contract

Suppose Alice wants to exchange her Bitcoin for Litecoin from Bob. A typical HTLC transaction between them takes place as follows:

1. Alice generates a hash from her Litecoin private key and sends it to Bob. She also generates a pre-image of the hash by creating a nominal transaction. This pre-image will help her validate and finalize the transaction.
2. Bob also generates a hash from his key and sends it to Alice. In addition to this, he creates a pre-image by conducting a nominal transaction (in Litecoin). 
3. Once Alice receives Bob’s Litecoin transaction, she signs it using the original key that is already available with her in the pre-image. Bob does likewise on his end, using his private key to unlock Alice’s transaction.
4. Once Alice and Bob enter their keys and agree to the transaction, the smart contract executes it. Neither can change the transaction once it executes, which removes the possibility that one could trick the other by quickly canceling the exchange.

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