What are Atomic Swaps and how do they work?
Many cryptocurrencies have emerged since 2008 when Bitcoin, the first cryptocurrency, was developed.
Trading of cryptocurrencies has become diversified, often requiring swaps between different cryptocurrencies.
This led to the development of atomic swaps where traders can swap two different cryptocurrencies directly from their wallets without a third-party intermediary, like in centralized exchanges.
This article explores the technology behind atomic swaps, how they work, benefits, limitations, and real-world applications.
What are Atomic Swaps
Atomic Swaps, also known as cross-chain Swaps, enable peer-to-peer exchange of cryptocurrencies on different blockchains without a centralized intermediary.
Atomic swap facilitates a trustless and non-custodial exchange of crypto tokens which involves only the two parties with tokens to be exchanged and no other party either as an intermediary or custodian.
Derived from the word ‘atomicity’, a computing term used to refer to the stages of a system in which either all stages are complete or none is complete, atomic swaps are exchanges that are either fully executed or not executed at all.
The first discussion on what can be referred to as ‘Atomic swaps’ was by Sergio Damien Lerner in an online post in which he proposed the idea of cross-coin peer-to-peer trading without a central point. He referred to this as the “holy grail” of altcoins where coins can be automatically traded against Bitcoin.
The first use of the words, ‘Atomic swap’ was by Tier Nolan in 2013 where he explained the underlying technology behind an atomic swap.
A practical usage of an atomic swap did not occur until 2017 by Charlie Lee, the founder of Litecoin who made a tweet of his cross-chain Atomic swap with Litecoin (LTC) and Bitcoin (BTC) where he swapped 10 LTC for 0.1137 BTC.
Atomic swaps were thereafter adopted across decentralized exchanges, wallets, and platforms.
How Do Atomic Swaps Work?
A. Underlying Technology
Atomic swaps utilize Hash Timelock Contract Technology (HTCL). HTCL is a smart contract that executes a transaction between parties only when the predetermined cryptographic conditions have been met and verified within a given time frame.
HTCL comprises of two aspects:
- Hash lock: The Hash lock function in Hash Timelock Contract Technology (HTCL) ensures that the deposited currency is locked until both parties submit cryptographic proof that verifies that the predetermined conditions of the swap such as the deposit of the agreed amount of tokens have been met.
- Time lock: This provides a time frame within which the transaction must be concluded, which is usually after the creation of a certain amount of block.
If the given time frame lapses before the swap transaction is concluded, the transaction is canceled automatically and the deposited funds are reverted to its owners.
These aspects of the Hash Timelock Contract Technology (HTCL) also serve as a preventive measure against counterparty risk and ensure the security of deposited funds.
B. Step-by-Step Breakdown (Using Bitcoin and Litecoin)
- A person wishes to initiate a 0.1 BTC swap with a responder for an equivalent amount of LTC.
- A HTCL contract is created between the initiator and the responder and the amount of tokens to be exchanged and the time frame for transaction is determined.
- A contract address is created where 0.1 BTC is deposited by the initiator and locked.
- A preimage which serves as the special key to unlock the funds is generated and is only accessible to the initiator.
- The initiator sends a hash of the pre-image to the responder to show that funds have been deposited.
- The responder verifies that 0.1 BTC has been deposited with the Hash but cannot access the funds.
- The responder uses the Hash to create an address to deposit the agreed amount of LTC tokens.
- The initiator can claim the LTC tokens since the address was created with the Hash of the pre-image generated.
- The initiator reveals the pre-image to the responder and the responder claims the BTC tokens.
- If either of the parties fails to acknowledge receipt of funds or claim tokens within the agreed time frame, the contract is automatically brought to an end at the end of the time frame and the deposited funds are returned to the owners.
- Similarly, where either of the parties defaults, for example, where the responder deposits an amount of LTC less than the equivalent of 0.1BTC as agreed, the initiator can refuse to continue with the transaction and use the refund function. The deposited funds will be refunded after the time frame has lapsed.
C. On-chain vs Off-chain Atomic Swaps
On-chain Atomic Swaps are executed directly on the blockchain using Hashed Timelock Contracts (HTCL).
The transactions are directly recorded on the blockchain and require that the two blockchains involved in the swap have compatible scripting features.
On-chain Atomic Swaps may take a longer time to be completely executed due to HTCL waiting time. This may also be further aggravated by network congestion on the blockchain thereby incurring higher transaction fees.
Off-chain Atomic Swaps are executed and recorded on second-layer solutions built on the blockchain and not directly on the blockchain.
Off-chain Atomic Swaps eliminate the use of HTCL. Instead, it leverages second-layer solutions to enable broader compatibility, faster transactions, and lower transaction fees.
Benefits of Atomic Swap
- Decentralization: Atomic swaps remove the need for a centralized authority and facilitate transactions just between users. Traders maintain complete control over assets.
- Security: Atomic swap enables the non-custodial exchange of tokens. Atomic swaps are therefore not susceptible to theft, hacks, or diversion of funds common in custodial exchanges.
The underlying technology behind Atomic Swaps, HTCL, also ensures the security of deposited funds by unlocking funds only after the terms of the contract have been met and the agreed time frame has elapsed.
- Privacy: Unlike centralized exchanges, atomic swaps do not subject traders to Know-Your-Customer (KYC) procedures before swaps can be made.
Atomic swaps help to preserve the privacy of traders as personal information needs not be provided or verified before transactions can be carried out.
- Cost efficiency: Atomic Swaps eliminate intermediaries and the need to swap initially to a stablecoin before swapping to the desired token.
As a result, no additional transaction fees are incurred by the trader. The cost of an atomic fee is only limited to the transaction fees on the blockchain.
- Interoperability: Atomic swaps facilitate cross-chain transactions and swaps within the peers without relying on a third- party or intermediary.
Atomic swaps remove the barrier that exists within different blockchains and facilitate interoperability cross-chain.
Challenges and Limitations
- Limited Blockchain support: Atomic swap can only facilitate swaps between blockchains with similar scripting compatibility and hashing algorithms.
This has limited the use of Atomic swap across various blockchains and hindered its adoption overall.
- User Experience: Atomic swap requires traders to have some basic understanding of coding which is not the case in other decentralized or centralized exchanges.
Also, atomic swap is limited to certain supported wallets. These complexities negatively impact the user experience of a trader.
- Speed and scalability: Atomic swaps may experience certain delays in the execution of transactions, specifically on-chain Atomic swaps.
Thus, atomic swap may not be suitable for high-volume and frequency trading
- Smart Contract bugs: Atomic swaps employ the use of a hash timelock smart contract to execute transactions.
Where the smart contract is not properly deployed, there may be possibilities of vulnerabilities that could be exploited by bad actors or lead to improper execution.
- Threats to Privacy: In the process of an atomic swap, the transaction details which include the public address and details of the transaction are available on-chain ( for on-chain Atomic swaps).
Atomic swaps take a long time to complete execution depending on the time frame of the HCTL. This gives hackers ample time to gather information about the transaction and interrupt the transaction process.
Use Cases and Real - World Adoption
- Decentralized Exchanges (DEX) and Wallets: Some of the most common uses of atomic swaps are in Decentralized exchanges and wallet integration
Decentralized Exchanges facilitate the peer-to-peer exchange of cryptocurrency tokens using smart contracts.
However, most decentralized exchanges only enable the exchange of tokens on the same blockchain.
The use of atomic swaps in a decentralized exchange extends its application to cross-chain swaps.
An example of a decentralized exchange that used atomic swap is AtomicDEX by Komodo.
AtomicDEX serves as a multi-coin wallet and a decentralized trading platform that supports Bitcoin, Ethereum, and ERC-20 tokens.
Another example is Liquality, a multi-chain non-custodial wallet that leverages atomic swaps to facilitate cross-chain swaps. Liquidity supports BTC and ETH tokens and has integrated other tokens across various blockchains.
- Layer 2 Protocols: The execution of atomic swaps on layer 1 blockchains may take a long time due to congestion on-chain. This makes Layer 2 platforms a better alternative to carry out atomic swaps.
Subsequently, Layer 2 protocols are increasingly being developed with atomic swap capabilities. An example is the Lightning network.
Lightning network is a payment network built on top of the Bitcoin blockchain to facilitate faster and lower-cost Bitcoin transactions by executing the transactions off-chain through a payment channel.
Just like atomic swaps, the underlying technology behind the lightning network's payment mechanism is Hashed Timelock Contract Technology (HTCL).
Therefore, the lightning network leverages HTCL and its off-chain execution feature to enable quick and seamless execution of cross-chain swap transactions.
The Future of Atomic Swaps
There has been a growing interest in cross-chain interoperability in the cryptocurrency sphere.
Decentralized Exchanges and Protocols are beginning to adopt and implement tools that can support the execution of swap transactions across different blockchains.
Cross-chain interoperability plays an important role in increasing liquidity in the Decentralized Finance (DeFi) pool by enabling the flow of assets between blockchains.
The emergence of atomic swaps and cross-chain platforms removes the barriers between blockchains and fosters the adoption of Cryptocurrency and DeFi. It provides opportunities for traders to easily access deep liquidity and DeFi applications whilst retaining custody of their tokens across different blockchains.
Nonetheless, atomic swaps struggle with scalability, limiting its adoption on a broader scale. The development of layer 2 Protocols with atomic swap capabilities like lightning networks could effectively address these concerns.
The future of atomic swaps and cross-chain interoperability lies in the evolution and advancement of Layer 2 Protocols to enable scalable cross-chain transactions.
Conclusion
There are currently over 17,000 Cryptocurrencies in existence, and the need for atomic swaps that enable peer-to-peer cross-chain exchanges cannot be any more pressing.
Despite scalability concerns, atomic swaps preserve the security and privacy of assets, widening participation and improving access to liquidity within the Decentralized Finance (DeFi) market.
Atomic swaps play a significant role in enhancing a decentralized and trustless future of finance where traders can access a wide range of financial activities and tools whilst retaining full custody of assets.
Please be advised, that this article or any information on this site is not an investment advice, you shall act at your own risk and, if necessary, receive a professional advice before making any investment decisions.
Roman Klochko