Payment and state channels

Before getting into state channels, we need to know what payment channels are. A payment channel is a feature that allows us to combine more than two transactions of sending ether to another account into two transactions. Here is how it works. Suppose X is the owner of a video streaming website, and Y is a user. X charges one ether for every minute. Now X wants Y to pay after every minute while watching the video. Of course, Y can broadcast a transaction every minute, but there are few issues here, such as X has to wait for confirmation, so the video will be paused for sometime, and so on. This is the problem payment channels solve. Using payment channels, Y can lock some ether (maybe 100 ether) for a period of time (maybe 24 hours) for X by broadcasting a lock transaction. Now after watching a 1 minute video, Y will send a signed record indicating that the lock can be unlocked and one ether will go to X's account and the rest to Y's account. After another minute, Y will send a signed record indicating that the lock can be unlocked, and two ether will go to X's account, and the rest will go to Y's account. This process will keep going as Y watches the video on X's website. Now once Y has watched 100 hours of video or 24 hours of time is about to be reached, X will broadcast the final signed record to the network to withdraw funds to his account. If X fails to withdraw in 24 hours, the complete refund is made to Y. So in the blockchain, we will see only two transactions: lock and unlock.

Payment channel is for transactions related to sending ether. Similarly, a state channel allows us to combine transactions related to smart contracts.