Atomic swaps facilitate a peer-to-peer (P2P) exchange of two cryptocurrencies on different blockchains. By using smart contract technology, thereby eliminating the need for centralized intermediaries, atomic swaps can be conducted both on-chain or outside the distributed network.
In 2017, the first Bitcoin (BTC) and Litecoin (LTC) were successfully swapped off-chain, driving public interest into the potential of this new technology. Some of the crypto-focused startups that have since embraced atomic swap technology include Komodo and Lightning Labs.
How Atomic Swaps Solve Traders’ Problems
Centralized exchanges have a lot of shortcomings that can be addressed by atomic swaps. Their ability to function without centralized platforms brings a lot of benefits to traders.
- Some of the shortcomings of centralized exchanges include heightened vulnerability due to pooling digital assets in a single place. This provides incentives for malicious attackers to breach the platforms' security.
- Centralized exchanges are operated by individuals who are bound to make mistakes or even abscond with funds, such as with the unfortunate QuadrigaCX affair. In other cases, developers unintentionally alter key network parameters, leading to a permanent locking of user funds.
- Furthermore, many of these platforms have yet to receive widespread recognition from regulators. Although some of them (such as Coinbase) are regulated, governing agencies across the globe have yet to reach a consensus on how to handle digital currencies. And regulated platforms follow government-provided rules, which may sometimes not be ideal for users.
- Another problem faced by cryptocurrency exchanges is scalability. Although most popular trading platforms can keep up with high trading activities, there are many instances of crashes when trading volume spikes.
- Furthermore, exchanges have differing costs related to deposits, trading and withdrawals. Therefore, atomic swaps are able to guard traders against these rather high operational costs.
How Does an Atomic Swap Work?
Here's an example to display the process of an atomic swap:
John wants to swap his ETH with Joyce, who owns LTC. John sends his ETH to a smart contract and is assigned a unique key. He then sends Joyce the key's cryptographic representation. Since Joyce doesn't have the key itself, she is unable to access John's ETH.
Joyce uses the hashed key to create a contract address that holds her LTC. Using his private key, John claims Joyce's LTC. When John claims his share, Joyce is also able to claim hers as well.
All things considered, atomic swaps eliminate fractional settling of trades; either all the coins are swapped or none at all. Apart from its atomic nature, the technology is powered by a smart contract that enforces hash and time-locking functionalities. These contracts are commonly called hash timelock contracts (HTLC).
Therefore, a swap is confined inside a hash and time. Within the hash, a swap can only occur by generating and revealing transaction-specific data such as private keys or their representations. A time lock defines the contract's execution time. Moreover, the two locks prevent either party from duping the other.
Advantages of Atomic Swaps
- An atomic swap’s key advantages revolve around its distributed nature. For instance, it enables inter-chain interactions without the need for third-parties like centralized cryptocurrency exchanges.
- Furthermore, without trusting third-parties with the custody of funds, atomic swaps enhance user security during a trade.
- P2P trading eliminates or significantly reduces the transaction costs compared to trading coins on an exchange.
- In some cases, an exchange lacks a trader's coin of choice, forcing them to conduct intermediary trades in order to get to their preferred cryptocurrency. Fortunately, atomic swaps enable the fast trading of lesser-known altcoins with added interoperability features.
Disadvantages of Atomic Swaps
- An atomic swap’s results can be hampered by the underlying technology inherent to its participating crypto assets. For a successful atomic swap, the cryptocurrencies involved have to be powered by decentralized networks utilizing similar hashing algorithms. For instance, to swap Bitcoin (BTC) atomically, the other coin's blockchain has to use Bitcoin's SHA-256 hash algorithm.
- The blockchains involved in a swap must be HTLC-compatible and accommodate extra programming features.
- From hashing to HTLC compatibilities, atomic swaps raise privacy concerns. Blockchain-based interchanges are also easily trackable, and coins on one side of the swap can be connected to their corresponding entry in the other blockchain.
- The current generation of atomic swaps is yet to be tested with large data volumes.
Atomic Swaps: A Conclusion
Despite having some drawbacks, atomic swaps present an opportunity to enhance privacy and security when trading cryptocurrencies. Consequently, they foster inter-chain operability, which is increasingly important as there are already over 7,800 cryptocurrencies today and a lot of them exist in silos. Atomic swaps, along with other blockchain connectors, should continue to play an important part in the evolution of the nascent crypto industry.