What is an atomic swap and how does it work?

Understanding atomic swaps

Atomic swaps remove middlemen and centralized control, making cryptocurrency exchanges more decentralized.

Atomic swaps enable peer-to-peer (P2P) transactions between individuals holding different cryptocurrencies on two separate blockchains, eliminating the need for an intermediary (such as a centralized exchange). Atomic swaps allow users to exchange digital assets according to self-executing smart contracts.

Centralized exchanges (CEXs) provide a trading experience similar to traditional stock and fiat trading – ensuring asset liquidity, managing trading pairs and order books, ensuring fair market prices, and connecting buyers and sellers on a platform. They are custodians and exercise centralized control as they have access to the user’s private keys.

CEXs are popular with high trading volumes, but they run counter to the decentralized ethos of cryptocurrency and blockchain. This is where decentralized exchanges (DEXs) try to embody a non-custodial infrastructure. Atomic swaps allow for greater interoperability between different blockchain networks. They enable a decentralized multichain cryptocurrency exchange that promotes a truly decentralized finance (DeFi) ethos.

Related: Why cross-chain interoperability is important for DeFi

The importance of atomic swaps

Atomic swaps enable DeFi and solve the inefficiencies associated with exchanging cryptocurrencies within centralized finance (CeFi).

To exchange Ether (ETH) on the Ethereum network and Bitcoin (BTC) on the Bitcoin network, one can follow the steps below when using a CEX, such as Coinbase or Binance:

• Register an account on a centralized exchange platform that supports the ETH/BTC trading pair. This may require a sign-up process and a KYC mandate, as per CEX policy.
• transferring ETH to the centralized exchange.
• Converting ETH to BTC, which can involve transaction fees and sometimes a long wait.
• Withdrawing the acquired BTC to a Bitcoin wallet, which may incur additional fees.
• Finally, patiently await the processing of the exchange and the final arrival of funds.

This typical CEX exchange presents a series of steps, uneconomic costs, and multiple potential complications. In addition, CEXs may present unexpected security risks related to asset custody. CEXs store user funds in custodial wallets and the exchange retains control of the private keys. In the event of a security breach, hack or freeze by the regulatory authorities, the user’s cryptocurrency may be exposed to potential threats.

To solve these problems, DeFi and DEXs enable atomic swaps, eliminating the need for middlemen in trading, streamlining the process and significantly reducing numerous potential security risks for cryptocurrency users.

Related: How to mitigate the security risks of crypto payments

History of Atomic Swaps

Atomic swaps, also known as cross-chain atomic swaps, were theorized in 2013, but became practical after 2017.

In July 2012, Sergio Demián Lerner, a developer, produced the first version of a reliable exchange protocol. However, in 2013 a full working paper was given by Tier Nolan, who is widely recognized as the pioneer of atomic swaps for his extensive description of the atomic swap procedure.

In 2017, the concept was first realized when Charlie Lee, founder of Litecoin, tweeted the historic moment of the completion of the first successful atomic swap. He successfully performed a cross-chain atomic swap involving LTC/BTC, exchanging Litecoin (LTC) for BTC.

Since this milestone, countless DEXs and swaps have used this technology to create new cryptocurrency trading solutions. Popular DEXs and networks that support atomic swap trading include AtomicDEX, the Lightning Network, Liquality, and others.

How do atomic swaps work?

Atomic swaps work by using smart contracts and hashlock cryptographic techniques to secure the exchange of digital assets.

“Atomic” is a term used to describe processes that either shut down successfully or don’t start at all – there’s no other alternative. An atomic swap for crypto trading implies only two possible outcomes: the transaction is executed successfully or no action takes place.

In simpler terms, an atomic swap creates a mechanism where both sides of the cryptocurrency trade must meet all predetermined conditions before the transaction can be completed. This is achieved through the implementation of smart contracts, which are self-executing programs designed to enforce the terms necessary for a transaction to be successful.

Atomic swaps use hashed time lock contracts (HTLCs), which are a form of smart contract, to enable secure and reliable exchanges of cryptocurrencies. HTCLs essentially “lock in” a transaction and require both parties to verify the information before the exchange can proceed.

Atomic swap smart contracts have two essential components:

hash lock

The hashlock mechanism allows the contract to be locked with a unique cryptographic key that can only be generated by the cryptocurrency depositor. This key, a unique piece of data, ensures that the exchange only becomes final when both parties approve the transaction.

Time slot

The timelock mechanism is like a deadline for the trade. It ensures that the transaction is completed within a specified time, and in the event that this does not happen, the depositor’s funds are returned. Timelock essentially helps secure the transaction. Both parties must approve the exchange within the specified time limit, otherwise the transaction will be aborted and the crypto returned to their respective owners.

Advantages of atomic swaps

Atomic swaps improve blockchain interoperability and reduce risk while offering traders more flexibility at a lower cost.

Atomic swap benefits include:

Fully decentralized character

Atomic swaps offer traders the advantage of decentralization. Peer-to-peer trading grants autonomy over one’s funds and independence from CEX platforms or a centralized pool of liquidity.

Enhanced security

The hashlock and timelock mechanisms in the self-executing smart contracts used by atomic swaps provide traders with a higher level of security. Traders have the assurance that their cryptocurrency will be returned in the event of delays or conflicts.

Interoperability and altcoin trading flexibility

Atomic swaps enable the swap for users on different blockchains. Many CEXs do not allow traders to exchange all kinds of altcoins. Atomic swaps solve this problem by allowing virtually all forms of altcoins to be swapped.

Disadvantages of atomic swaps

Atomic swaps can be technologically complex, with higher blockchain latencies resulting in slower adoption rates.

Atomic swap disadvantages include:

Complexity with trade swap

Atomic swaps require the exchange of data, information and hashed cryptographs. This can be daunting for novice traders.

Lack of fiat-crypto ramp

For traders looking to liquidate to fiat, this can be challenging as fiat-to-crypto and crypto-to-fiat exchanges are not possible on atomic swap DEXs.

Currently, few platforms support atomic swaps. In addition, you may need specific programming skills and hash knowledge to use atomic swaps. Nevertheless, cryptocurrency wallets are likely to integrate this technology into their software in the future.

Can atomic swaps be tracked?

Atomic swaps are designed to ensure user anonymity so that their identity is not revealed.

Unlike CEXs, atomic swaps do not require KYC. Atomic swaps themselves are designed to be trustworthy and private, meaning they ensure that transaction details and participants’ identities are not directly revealed.

However, it is important to note that the underlying blockchains used in atomic swaps, such as Bitcoin and Litecoin, are public ledgers where transactions are recorded and visible to everyone. While the atomic swap transaction itself may not be easily distinguishable from other transactions on the blockchain, the individual transactions involved in the swap can still be tracked on their respective blockchains.

To further enhance privacy, participants can use additional techniques such as mixing coins or privacy-focused cryptocurrencies. Coin mixing obfuscates transaction history by combining multiple transactions to make it more difficult to trace the funds. Privacy-focused cryptocurrencies, such as Monero (XMR) or Zcash (ZEC), offer built-in privacy features that can be used in conjunction with atomic swaps to improve anonymity.

Atomic swap vs bridge

Atomic swaps enable P2P exchange, while cross-chain bridges provide a connection between blockchains for the transfer of assets through tokenized representations.

While both cross-chain bridges and atomic swaps improve blockchain interoperability and serve the purpose of transferring cryptocurrencies across different blockchains, they work in different ways. Cross-chain bridges serve as a connection or link between multiple blockchain networks. They act as intermediaries that facilitate the transfer of assets between these networks.

Cross-chain bridges require burning or locking a token before it is available on another blockchain. A wrapped token is created and an equivalent amount is made available within a liquidity pool on the target chain. These wrapped tokens can then be transferred, traded on the target blockchain, or exchanged for the original assets on the source blockchain.

Cross-chain bridges are gaining popularity due to their ease of use and good user interface and are seen as a modern, accessible way to exchange cryptocurrencies on separate blockchains.