Atomic swaps are peer-to-peer exchanges of crypto assets across separate blockchain networks without the need for centralised intermediaries, such as exchanges. Instead, smart contracts facilitate this decentralised cross-chain crypto asset trading.
“Atomicity” or “atomic state” is a software term that refers to database transactions that execute fully or not at all, with no intermediate states.
When applied to atomic swaps, it means transactions between two parties trading different blockchain coins are either complete entirely or not at all. There are no in-betweens or alternatives.
Therefore, atomic swap protocols either receive the agreed token deposits from both parties ( usually before a timer runs out) and perform the swap or return all deposited tokens to their original owners.
This way counterparty risks are eliminated and users can securely move liquidity across multiple chains.
Let’s dive in:
Understanding Atomic Swaps
A significant risk in peer-to-peer (P2P) transactions is that one party may fail to fulfil their side of the trade.
Atomic swaps mitigate this risk by using smart contracts that only release funds once both parties deposit a predetermined amount of cryptocurrency. This ensures that the transaction is either completed fully or not at all.
Traditionally, users exchange one token for another by trading cryptocurrency pairs on centralised exchanges (CEX). However, this method has limitations, such as the unavailability of certain token pairs.
Atomic swaps offer a solution by allowing users to maintain high levels of decentralisation while securely moving assets across different blockchain networks.
How Atomic Swaps Works
To facilitate and automate cross-chain token swaps, atomic swaps use Hash Timelock Contract (HTLC).
HTLC act as time-bound virtual accounts or cryptographic escrow accounts between the involved parties. These contracts generate private keys and hash functions to control access to the funds, ensuring user funds are safe.
The swap only executes when both parties deposit the correct amount of tokens into the contract and acknowledge receipt of the tokens within the specified timeframe. If the users meet all the swap agreements, the transaction is finalized. If not, the tokens revert to their original owners.
An HTLC has two main components, they are:
- Hashlock Cryptographic Key: is the cryptographic key generated by the users initiating the transaction. The users involved in the swap must submit cryptographic proofs to verify that they have fulfilled their side of the contract. This mechanism ensures that the transfer is executed only when both parties acknowledge receipt of the desired tokens.
- Timelock: This defines the time limit for the exchange. If the proofs are not submitted within the specified time, the contract aborts the transaction and returns the deposited coins to their owners.
Benefits of Atomic Swaps
Eliminate Counterparty Risks: Assets are not entrusted to a centralised third party to facilitate the transaction. Instead, the process is decentralised, allowing users to control their assets completely.
No Fiat Currency or Stablecoins Involved: Users can trade or exchange crypto assets directly without needing to first sell to fiat currency or swap to a stablecoin. This allows them to avoid making multiple transactions and perform direct asset-to-asset swaps.
Lower Costs and Faster Speeds: The absence of a centralised third-party administrator, combined with the peer-to-peer nature of atomic swaps, generally reduces transaction costs. Additionally, since smart contracts facilitate the process, transactions are swift.
Cross-Chain Interoperability: Atomic swaps enable users to seamlessly transfer and exchange assets from one blockchain to another.
Guaranteed Outcome: Users are assured that either their trade will execute completely, or they will receive their assets back.
Limitations and Challenges of Atomic Swaps
Technical and Process Complexities: Atomic swaps require exchanging hashed cryptographic information and fulfilling the agreement before the specified time limit elapses. This process is very different from trading pairs on centralised exchanges (CEXs) and may be too complex for beginners who lack the necessary technical knowledge.
Compatibility: Atomic swaps are not possible on all blockchains they are only possible between blockchains that use the same cryptographic hashing algorithm.
No Fiat-to-Crypto or Crypto-to-Fiat On-Ramp and Off-Ramp: Atomic swaps do not facilitate exchanges between cryptocurrency and fiat currency. If a user wishes to liquidate cryptocurrency to fiat or purchase cryptocurrency with fiat, they must use alternative methods.
Security Concerns: Although atomic swap protocols aim for high security, smart contracts still carry inherent risks. Vulnerabilities in HTLC implementations or bugs in the underlying code can be exploited by malicious actors.
To mitigate these risks, it is crucial for protocols to undergo third-party audits, and for users to be well-versed in self-custody practices and proper setup to prevent unintended losses.
Atomic Swaps vs Cross-chain Bridges
Although both atomic swaps and cross-chain bridges enhance blockchain interoperability, they function through different mechanisms and serve distinct purposes.
Atomic Swaps allow for the direct peer-to-peer exchange of tokens between separate blockchains. This process relies on smart contracts to ensure that both parties involved in the transaction receive their respective tokens simultaneously, thereby reducing the risk of fraud and eliminating the need for intermediaries.
In contrast, Cross-Chain Bridges operate by creating wrapped tokens on one blockchain, which represent an equivalent amount of the original asset on another blockchain. For instance, a Bitcoin can be wrapped into an ERC-20 token on the Ethereum blockchain, enabling its use within Ethereum’s ecosystem. Beyond token transfers, cross-chain bridges can also facilitate the movement of other digital assets, including data between different blockchain networks
See more: The Importance of Blockchain Security and Auditing in Web3 Bridges
Closing Thoughts
In essence, atomic swaps are a decentralised version of P2P trading that uses smart contracts to eliminate all the counterparty risks involved in traditional P2P trading thus enhancing interoperability and making liquidity flow across multiple chains.
[Author’s Note: This article does not represent financial advice, everything written here is strictly for educational and informational purposes. Please do your own research before investing.]
Author: Godwin Okhaifo
Also read: Introduction to Blockchain Explorers: What They Are and Their Uses
