Decentralized exchanges have become a reliable way to exchange cryptocurrencies where people don’t have to utilize any exchange-based wallet. Instead, exchanging crypto is possible through a noncustodial wallet that only holds a private key. Decentralized exchanges (DEXs) use several trading mechanisms, such as order books and automated market makers (AMMs), to make transactions smooth and secure.
However, DEXs have gotten a boost in user adoption from developments such as atomic swaps, a peer-to-peer exchange method in which two or more parties can directly exchange cryptos through their personal wallets. One of the largest privacy-focused cryptocurrencies, Monero (XMR), has experienced a 20% price surge after implementing the atomic swap in its system. According to Monero project contributor ErCiccione, this brand-new concept allows investors to exchange BTC and XMR without involving any third-party exchanges.
Implementing atomic swap represents a big leap for the cryptocurrency industry as traders and investors now have more liquidity in the market. In the following sections, we’ll look at what are atomic swaps, provide easy examples and elaborate on the transaction process.
What Are Atomic Swaps?
Atomic swaps are a technique of quickly exchanging cryptocurrencies on different blockchain systems. This method is often known as atomic cross-chain trading, where the exchange happens through a smart contract between two personal crypto wallets. It is a peer-to-peer (P2P) transaction system using different blockchains.
Centralized exchanges (CEXs) have the biggest position in digital asset trading. They allow investors to experience traditional trading in crypto, such as forex, stocks and commodities. The exchanges are responsible for managing and funding the wallet, just as a bank would do. On the other hand, DEXs enable investors to trade their crypto coins without involving an exchange-based wallet. Traders can directly exchange and trade cryptocurrencies from their noncustodial wallets. DEXs, however, use several mechanisms to make trading more secure, with atomic swap being one of them.
Although the atomic swap is an innovative way to exchange cryptocurrencies, the idea of cross-chain trading came after many years of discussion. In 2013, Tier Nolan described the atomic swap system. Before that, Daniel Larimer presented the trustless exchange protocol P2PTradeX in 2012, and some people consider it to be the atomic swap prototype.
Since then, many crypto enthusiasts and developers have started experimenting with the atomic swap protocol, with the Bitcoin, Litecoin, Decred and Komodo communities playing an important role. The first P2P atomic swap took place in 2014, but it became publicly available in 2017 after a successful swap between Litecoin and Bitcoin. In addition to being used as part of CEXs, the atomic swap has a trustless and peer-to-peer nature. This is why traders consider it to be a true decentralized trading system.
How Do Atomic Swaps Work?
Now that you know what are atomic swaps, it’s time to explore how they function. The term atomic connotes processes that will either complete or not start at all. In other words, we can consider the atomic swap as a function which ensures all predetermined conditions are fulfilled before a trade occurs. Atomic swaps became possible with the utilization of the smart contract, an automated process to enforce conditions during a transaction.
The atomic swap uses a two-way virtual safe function, the hashed timelock contract (HTLC), which utilizes complex mathematical encryption known as hash function. Moreover, it implements a time constraint by which the transaction is reversed if any parties fail to fulfill conditions within a predetermined time.
For example, two parties may agree to set a one-hour time constraint for an atomic swap. If either of the parties doesn’t fulfill all of the trading conditions within one hour, the contract will send the crypto coins back to the original owner.
As a trustless trading system, the atomic swap uses HTLC with the following protocols:
- Hashlock key: The hashlock key ensures that the trade is finalized when both parties submit their cryptographic proofs from their sides of the transaction.
- Timelock key: The timelock key is a safety mechanism that sets a deadline for a particular transaction. As a result, it confirms that the deposited coins are returned to the traders in case the swap isn’t completed due to single or multiple reasons within the deadline.
There are two ways to process the atomic swap: on-chain and off-chain. With the on-chain method, the atomic swap takes place on a single blockchain network. On the other hand, in the off-chain atomic swap the transaction occurs via a secondary layer. This type of atomic swap uses bidirectional payment channels, which is a mechanism comparable to Lightning Network.
How to Initiate an Atomic Swap
Let’s break down the atomic swap system from start to finish:
- The first party generates an HTLC address and deposits their cryptocurrency there. Later on, a passcode known as preimage (pre-image) is generated and hashed, which subsequently locks the transaction.
- Next, the first party sends the preimage to the second party to verify that the cryptocurrency has been deposited.
- Now the second party can deposit their cryptocurrency into a new address with the same generated hash.
- Once the second party deposits the cryptocurrency, the first party can unlock the amount with a secret passcode used to initiate the first deposit.
- Lastly, the second party completes the atomic swap process by unlocking the deposit made by the first party.
Now, let’s look at an example of how an atomic swap would take place in the real market:
Let’s say Allison and Scott are friends who want to exchange cryptocurrencies through an atomic swap. First, Allison deposits Litecoin into a safe contract address. While creating the contract, Allison generates an access key and shares the cryptographic hash with Scott. Remember that Scott cannot access the deposited Litecoin yet, because he knows only the hash, not the access key.
Next, Scott creates another safe contract address using the hash provided by Allison and deposits his Bitcoin. To claim the deposited BTC, Allison needs the same access key that she created while depositing. As soon as she claims the BTC with the access key, the swap is completed.
The overall process is straightforward and neither party has to rely on a CEX that charges more.
Pros and Cons of Atomic Swaps
One detail which might catch investors’ attention is that the atomic swap has a decentralized nature, thereby obviating the need for a CEX or any other mediator. Two or more parties can easily execute a transaction with a cross-chain swap. In this way, the whole process runs through a high-security environment, and no party has to give their funds to a CEX or any other third party. On the other hand, some limitations might discourage people from using atomic swaps.
Let’s look at some of atomic swaps’ advantages and disadvantages..
- Atomic swaps play an important role in decentralized P2P exchanges. Right now, DEXs work only with a single blockchain. However, using the atomic swap, investors can easily swap cryptocurrencies between multiple blockchains.
- A Decentralise Exchange (DEX) is a crypto exchange platform that is built upon blockchain technology and negates the need ... with atomic swap functionality has an interface that’s easier to use than a CEX’s.
- The atomic swap is a P2P transaction, so people can send funds directly from their wallet without involving any third parties. Moreover, trading fees are lower. In some cases, atomic swaps don’t involve any cost at all.
- Atomic swaps have high transaction speeds. People can swap altcoins without directly using the BTC or ETH networks as intermediaries.
- There are some conditions that need to be met for an atomic swap to occur. For example, an atomic swap can happen only when two cryptocurrencies have the same hashing algorithm. Moreover, they should be compatible with HTLCs and other programming functions.
- Although an atomic swap is inexpensive and fast, there is a problem regarding users’ privacy. People can easily track any transaction using on-chain swaps from the blockchain explorer, where making a link to addresses is easy. On the other hand, it’s often hard to track transactions for atomic swaps. Nonetheless, many developers believe the digital signature used in atomic swaps is a more reliable solution.
- Complexity is another problem with atomic swaps. Users can traditionally exchange cryptos with just a click. On the other hand, an atomic swap consists of several steps.
- There is no way to exchange crypto to fiat, or fiat to crypto, with the atomic swap. Therefore, users sometimes find exchanges with atomic swap functionality to be an incomplete solution for their trading needs.
The Bottom Line
We hope that you now understand what are atomic swaps with this handy guide. Although there are some disadvantages to consider, the atomic swap has become a gateway for improved privacy and security in cryptocurrency trading. Its inter-chain operability allows users to swap more than 7,800 different cryptocurrencies. Therefore, the atomic swap, along with other blockchain connectors, will play an important role in the ongoing evolution of the crypto industry.