Recent developments in the crypto space allow the exchange of cryptocurrencies without centralised platforms. Using decentralised exchanges (DEX), traders can exchange crypto without the tokens having to leave their private wallets using an exchange method known as the atomic swap. This article will help understand “atomic swaps” in further detail. We will explore what atomic swap is, how it works, and its pros and cons.
What Are atomic Swaps?
An atomic swap is used to create self-enforcing, automated contracts, which execute specific processes once the pre-programmed conditions are met. Atomic swaps allow cryptocurrency trading without requiring a fee. Atomic swaps can either be executed between different cryptocurrency blockchain platforms or be conducted off-chain, away from the blockchain.
The History of Atomic Swaps
Atomic swaps were initially introduced on the BitcoinTalk forums in 2013 by Tier Nolan. Nolan outlined the use of atomic swap smart contract technology to enable the trading of a digital asset without a central intermediary such as a trading exchange or platform. Atomic swaps highlight the basic principles for cross-chain cryptocurrency swaps by using simple cryptocurrency trades across multiple blockchain platforms.
Atomic swaps garnered significant attention from the cryptocurrency community in 2017, when Charlie Lee, founder of Litecoin (LTC), successfully executed an atomic swap between Decred (DCR) and LTC.
How Do Atomic Swaps Work?
Atomic swaps leverage a smart contract that “locks” the transactions and needs both transacting parties to verify to mark the transaction as complete. The smart contract used by atomic swap is specialised and referred to as hash timelock contract technology (HTCL). The HTLC contract is like a “virtual lockbox” consisting of two security features – TimeLock and HashLock.
TimeLock is a safety mechanism that can return cryptocurrencies that have been traced back to the traders if a trade is not completed within a stipulated time frame. Thus, TimeLock secures the transactions through time constraints to ensure that every transaction is settled within a specific timeframe, and if not, the depositor receives the funds back. TimeLock assures the safety of funds in the event of a failed transaction.
HashLock ensures that traded cryptocurrencies are distributed provided all parties have confirmed their respective transactions. HashLock technology locks the contract with a special key that the currency’s depositor can only access.
To start an atomic swap, one party needs to generate an HTCL address and deposit the cryptocurrency. A secret passcode is generated for the cryptocurrency, called a preimage. Preimage is hashed, so it gets “locked”.
The initiator can then forward the preimage to the counterparty, verifying that the cryptocurrency has been deposited. Upon verification, the second party has to deposit their share of the trade capital into a new address created using the same hash. The first party will need to unlock the initial amount of capital deposited by the second party. This is performed using secret passcode that was used to deposit the initial trade capital. Once completed, the second party will be able to unlock the original sum of funds that were deposited by the first party to complete the atomic swap process.
Let’s consider a simple example of an atomic swap between Bob and Alice. Let’s assume that Bob is a trader interested in converting 50 Litecoins to equivalent bitcoins with Alice. Bob submits his transaction to the Litecoin blockchain and generates a cryptographic hash function to encrypt the transaction. Alice repeats the same process by submitting her transaction to the bitcoin blockchain. Both parties unlock their funds within a pre-defined period to avoid the transfer from being canceled.
What are the benefits and Limitations of atomic swaps?
Atomic swaps are analogous to the barter system in the real world, with the additional layer of a smart contract that can be regarded as an overseer. The smart contract ensures timely and unbiased swap. Though atomic swaps have several advantages, they are still in their nascent stage and cannot be considered perfect. Let’s review some of the advantages and disadvantages of atomic swaps.
- Flexibility in trading altcoins – Exchange platforms do not permit trading of all altcoins; for instance, Coinbase doesn’t allow LTC to be traded for Ripple (XRP) directly. Thus, traders need to convert LTC to BTC and then exchange the BTC for XRP. However, instant cryptocurrency services that use atomic swaps allow users to trade directly between altcoins.
- Decentralized – Though cryptocurrency has advocated decentralization, traders are compelled to rely on centralized exchanges, like Kraken and Coinbase, for a majority of the trading activities. Atomic swaps make trading independent of exchange platforms by permitting direct, wallet-to-wallet transactions. Thus, traders have complete control over their trades and accounts.
- Security – The TimeLock and HashLock technologies used in HTCL contracts offer better security to traders. Atomic swaps guarantee traders would get their currency back if there is a conflict or delay in the transaction.
- Lower costs – Atomic swaps allow people to trade with each other independently, in a peer-to-peer fashion. Thus, atomic swaps reduce the trading fee and operational costs associated with using centralized exchange platforms.
- Relatively new – Since the atomic swap is still in its early stages, very few cryptocurrencies are available for atomic swaps. Moreover, most cryptocurrencies are paired with Litecoin or bitcoin, as the ecosystem is still under development.
- Complexity – Atomic swaps require a high-level understanding of blockchain protocols and software programming as it lacks proper GUI that can provide easy access. The impact of greater security in atomic swaps can result in more stringent trading conditions than those used on exchange platforms. While exchange platforms can execute trades with the click of a button, atomic swaps require a complex exchange of information in the form of hashed cryptographs.
- Lack of testing – Since atomic swaps have a limited history, they haven’t been tested rigorously. Thus, multiple things can go wrong during an atomic swap. The addresses of the receiver and sender can get compromised via attacks. Moreover, new exploits can come up once atomic swaps reach mainstream adoption. The ideal way of overcoming these issues is through testing the protocol thoroughly.
- Privacy – Atomic swaps can result in a delay in transaction, contingent on the TimeLock’s timeframe. Thus, the transaction would stay active on the blockchain network for a long time, which gives hackers time to interrupt and garner traders’ private information.
- Lack of support for fiat currency – While decentralized platforms have several advantages, atomic swaps lack the convenience that centralized platforms offer because atomic swaps cannot be used for fiat currency.
Frequently Asked Questions
Can Atomic Swaps Be Traced?
The possibility of atomic swaps being anonymous is minimal. Although atomic swaps use smart contracts, there is a high risk of tracing and tracking a transaction via the blockchain explorer, making it easier to link the address. Atomic swaps are also prone to privacy leakage, bringing up concerns regarding a user’s privacy. A workaround for this problem would be to use a more privacy-based cryptocurrency that can minimize the exposure.
Are Atomic Swaps Safe?
Yes, atomic swaps are safe. However, the security of the transaction is time-bound. As it uses HTLC, it consists of a Hashlock key to ensure trades are finalized when both parties have completed their transactions. Atomic swap also uses a Timelock key as a safety measure to set the deadline and return the coins to the swap owner if the transaction is incomplete within a certain pre-determined time frame.
Are Atomic Swaps Taxable?
Yes and no, because atomic swaps do not directly lead to taxation; however, it is vital to record all the transactions to calculate the capital profits and losses while disposing of the coins. Most swaps are taxable, but the payment of taxes is avoided until the coins are sold for cash. Only one tax is paid as a long-term capital gain. Thus, simply put – atomic swaps do not have a direct tax code; however, it is a reasonable assumption that the guidelines applied on stock splits are valid for atomic swaps as well.