How Do State Channels Handle Disputes If Participants Disagree on the State of an Off-Chain Derivative Contract?

State channels have a built-in dispute resolution mechanism that relies on the underlying Layer 1 blockchain. If participants disagree, any one of them can submit the last mutually signed state to the main chain's smart contract.

This initiates a challenge period. If the other party has a more recent, validly signed state, they can submit it to overwrite the older one.

If they fail to respond within the challenge period, the submitted state is considered final, and the contract settles the derivative based on that state. This threat of on-chain settlement incentivizes honest off-chain behavior.