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There must be a way to incentivize peers to act honestly; this is where penalty transactions come into place.

A penalty transaction can be used by the cheated party to claim all the funds in the channel if the cheater publishes an old commitment transaction on-chain. This works because commitment transactions are represented by the HTLC contract, which enforces how the coins in a lightning channel can be spent.

In a scenario where Alice is paying Bob, the HTLC contract if written in English would say something along these lines:

1. Alice will pay Bob 0.5 BTC if Bob can reveal the secret of the hash he provided to Alice and provide a valid signature for his public key.
2. If Bob doesn’t reveal the secret in a 500-block period, Alice can get her 0.5 BTC back.
3. All the funds locked in the channel can be redeemed by whoever can provide a valid signature for the revocation public key present in this contract.

This third clause is what is used by the cheated party to create a penalty transaction. Let’s follow the lifetime of the channel in the images above and simulate a penalty transaction.

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