Atomic swaps are automated, self-enforcing cryptocurrency exchange contracts that allow cryptocurrencies to be traded peer-to-peer without the need for a trusted third party.
As of 2017, cryptocurrencies could only be traded and bought through platforms such as Coinbase, Kraken, Coinsquare, and more. Trade execution was anonymous, and not peer-to-peer until an atomic swap between litecoin and bitcoin was announced.
The Development of Atomic Swaps
The idea of peer-to-peer swaps without third-party intervention was invented by Tier Nolan in 2013 when he laid the basic foundation for how to make cryptocurrency exchanges using various blockchain technologies.
The atomic swap technology was brought to life in 2017 by Charlie Lee, who founded Litecoin, when he tweeted about how he “did a cross-chain atomic swap with LTC/BTC” and exchanged 10 LTC (Litecoin units) for 0.1167 BTC (Bitcoin units). Since then, many decentralized exchange platforms, as well as independent traders, are using the technology to trade cryptocurrencies.
Today, atomic swaps offer the potential to change how cryptocurrencies are traded and exchanged. Cryptocurrency exchange platforms, like those mentioned above, do not allow users and investors to exercise complete control over their wallets.
So, the users are always at risk and dependent on the exchange platform when it comes to the security of their assets. Atomic swaps mitigate such risks and add value by giving traders more flexibility at lower costs.
How Do Atomic Swaps Work?
Atomic swaps make use of the hash timelock contract technology (HTCL), which is a smart contract that “locks” the transaction and requires verification from both parties for the exchange to be completed.
The contract generated using HTCL technology includes two security features:
The HashLock technology allows the contract to be locked with a special key that only the currency depositor is able to access. The deposited currency can only be unlocked with the special key (i.e., a unique piece of data).
The TimeLock mechanism ensures that the transaction occurs within a given timeframe and returns funds to the depositor if it is not completed. It secures the transaction through time constraints. Even if someone’s currency is deposited and the trade is not completed immediately, they are assured that the funds are safe and will be returned.
Suppose Lara and Mark wish to exchange cryptocurrencies using an atomic swap.
Lara deposits her cryptocurrency into an HTCL address, which acts like a virtual safe and can only be unlocked with a special key that she can access.
Lara shares a cryptographic hash of the special key with Mark, who deposits his cryptocurrency into an address created using the same cryptographic hash.
Once Mark has deposited the cryptocurrency, Lara can use the currency by “unlocking” the transaction with the special key obtained from her initial deposit.
After Lara has used the key to “unlock” the transaction, Mark can get access to his share of the exchange.
Once both parties have access to their respective funds, the atomic swap is completed.
Advantages of Atomic Swaps
1. Decentralized nature
Cryptocurrency traders tend to advocate for a decentralized financial world but still need to trade using centralized exchanges, such as Coinbase. By being independent of exchange platforms and allowing for direct, wallet-to-wallet transactions, atomic swaps offer traders complete control over their accounts and exchanges.
2. Increased security
The HashLock and TimeLock technologies in HTCL contracts employed by atomic swaps offer greater security and assurance to traders – since they have the guarantee of getting their currency back in case of delays or conflicts and have complete control over the transaction.
3. Peer-to-peer trading and lower costs
In addition to allowing people to trade with each other independently, atomic swaps reduce operational costs and trading fees that are associated with using centralized exchange platforms.
4. Increased altcoin trading flexibility
Exchange platforms, such as Coinbase, do not allow traders to exchange all types of altcoins, e.g., Ripple (XRP), cannot be traded directly for Litecoin on Coinbase. It must be turned into Bitcoin, and then it can be exchanged for Litecoin. Atomic swaps solve such a problem by allowing almost all types of altcoins to be traded.
Disadvantages of Atomic Swaps
1. Complexity and conditions
Since they offer higher security, atomic swaps come with trade conditions that are more stringent than those imposed by exchange platforms, and they require parties to interact without means of direct communication. For example, platforms may execute trades with the click of a button, whereas atomic swaps require the exchange of data and information, along with hashed cryptographs.
2. Privacy issues
Atomic swaps can take time to execute (depending on the timeframe of the TimeLock). As a result, the transaction is active on the blockchain network for longer times, giving hackers more time to interrupt the process and gather private information about traders.
Since one of the most important characteristics of cryptocurrency trading is the legal anonymity of transactions, it is an issue that needs to be addressed.
3. Lack of a centralized platform
Despite all the disadvantages associated with using centralized platforms, atomic swaps do not offer the same amount of convenience that trading platforms do – especially when it comes to exchanging fiat currency for cryptocurrency – which cannot be done through atomic swaps.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: