Let’s say you have a cryptocurrency like Ethereum (ETH), and you want to exchange it for another digital asset, such as Litecoin (LTC). How do you do that?
Well, the most popular method is to use a centralized crypto exchange, like Binance, to sell your digital asset and buy the other with your proceeds. But that’s not necessarily the easiest or the most convenient method since you have to pay transaction fees to the exchange for both transactions.
Instead, you can utilize a peer-to-peer exchange between the two coin networks through an atomic swap. Atomic swaps let you trade one digital currency for another without intermediation from third-party facilitators. That means you don’t have to pay expensive transaction fees, and you can quickly trade cryptos from your wallet app without moving your cryptocurrency to crypto exchange wallets.
In this article, we’ll explain how atomic swaps work and discuss their benefits and downsides. Let’s go!
How to Exchange One Cryptocurrency for Another
As we said before, the most common way to exchange one cryptocurrency for another is to use a centralized exchange to buy and sell cryptos. These exchanges also offer popular crypto pairings and let you buy and sell one digital asset for another.
For example, most exchange platforms offer Bitcoin (BTC)/Ethereum (ETH) markets that let you exchange one for the other. However, if you want to exchange your cryptocurrency for a less popular altcoin that isn’t paired with the crypto you own, you have to sell your digital asset on the platform and buy the other asset with your proceeds.
That’s why high-liquidity crypto exchanges with many altcoin offerings are so popular in the crypto ecosystem. They facilitate trades and make crypto transactions quite easy.
Of course, that’s not the only way to exchange currencies. You can also use peer-to-peer markets and decentralized exchanges (DEXs).
Peer-to-peer markets allow you to list your crypto offers on the platform, and people can reach out and accept the offers they want. The platform usually employs an escrow service to make sure the transaction goes smoothly. Of course, that means the platform works as a third party to the transactions, and it usually gets a cut of the trade as a transaction fee.
Decentralized exchanges work a little differently. These exchanges use smart contracts to pull off crypto trades, and everything is accomplished rather automatically.
A smart contract is essentially a program that facilitates transactions between two parties as long as the necessary conditions have been met. Decentralized exchanges employ smart contracts to allow users to swap one cryptocurrency for another without third-party intermediation. They’ve no control over your digital assets and are mostly impervious to hacking attempts. Finally, their transaction fees are also cheaper compared to centralized exchanges.
What Are Atomic Swaps?
As you probably already know, most cryptocurrencies utilize blockchain technology to conduct trades. When buying or selling Bitcoin, your transaction is recorded on the Bitcoin blockchain to complete the transaction. It’s the same way when you’re trading an Ethereum-based token for another Ethereum-based token: the transaction happens on the Ethereum blockchain.
But how do you trade between the Ethereum and Bitcoin blockchains? Well, you make a cross-chain atomic swap.
Sergio Lerner first described atomic cross-chain trading as a peer-to-peer method for exchanging cryptocurrencies (he called it P2PTradeX). Tier Nolan developed the concept further, and Litecoin and Decred developers successfully implemented the technology to complete the first on-chain atomic swap in crypto history in 2017. Litecoin founder Charlie Lee soon announced a successful swap between Bitcoin and Litecoin.
However, on-chain atomic swaps require immense effort since validators have to download both blockchains and verify transactions to complete trades.
In order to make cross-chain trading easier, developers begin to experiment with atomic swap protocols. Komodo managed to develop an off-chain swap protocol that made trading across blockchains easier. They implemented a layer 2 solution, similar to Bitcoin’s lightning network, that allows the trade to take place off the blockchains through external payment channels.
These days many DEXes and apps facilitate off-chain atomic swaps to facilitate crypto trades.
How Do Atomic Swaps Work?
Let’s think about how crypto exchanges for a second. Normally, when two people want to exchange an asset, they move their respective funds to a third party that can mediate the process. The third party can be an exchange platform or an escrow service, but the logic is the same: the funds aren’t released to the other party before conditions are fulfilled (before the buyer makes a payment). That way, traders can evade counterparty risk, where one of the parties refuses to pay their part despite receiving coins.
An atomic swap ensures both parties receive what they agree on, but in a trustless manner that doesn’t depend on third-party mediation. Instead, they utilize a smart contract algorithm and Hashed Timelock Contracts (HTLC) to execute transactions.
Let’s say you want to trade some ETH for your friend’s BTC. In practice, the process looks like this:
- You send ETH to a contract address and receive a special key.
- Using that key, you generate a hash of the key and share it with your friend.
- Your friend can check the hash to verify you have deposited the funds. They use this hash to create another contract address and transfer their BTC there.
- Now both parties are locked in a smart contract.
- You use your key to access your friend’s BTC. Once you claim your funds, the key is also revealed to your friend, who can also receive their ETH.
- Both parties must claim their funds in a given time frame, or the transaction will be void.
Advantages of Atomic Swaps
Atomic swaps make cross-chain trades relatively simple. You don’t have to pay high transaction fees to swap one coin for another, and you can complete the whole trade in a trustless manner without endangering your funds.
When you use exchange platforms, you have to either store your assets on the platform or frequently move them on and off the exchange for security. Keeping digital assets on exchange platforms isn’t recommended, especially if you own a large amount of crypto. These platforms are constantly targeted by hackers, and you can lose your investment if a hacker manages to get past exchange security.
On the other hand, if you store your crypto someplace else, you’ll have to deposit the assets back into the exchange every time you make a trade and then withdraw them back again. Given most exchanges charge deposit and withdrawal fees in addition to transaction fees (and regular blockchain fees), you have to pay a hefty sum for the privilege of trading.
When you make an atomic swap, you only pay the associated blockchain fees, so it’s a cheaper option. Some DEXs also charge minimal transaction fees, but it’s still less than what centralized exchanges charge.
That way, you can easily buy different cryptocurrencies with your assets and invest in altcoins without having to cash out your assets first.
Limitations of Atomic Swaps
While atomic swaps are quite useful, they are also a little limited in some ways. You can only trade cryptocurrencies that use the same hashing algorithm and similar blockchain networks through an atomic swap. For example, Litecoin and Bitcoin use similar hash algorithms, which allows seamless swaps between the two.
Atomic swaps aren’t as common as the other trading options yet, so there aren’t as many atomic swap apps as the other options.
Finally, you can’t trade digital currencies with fiat money through atomic swaps. You’ll have to use more traditional options when you want to cash out your assets.
A Few Words Before You Go….
Atomic swap technology allows interoperability between different blockchains. To put it simply, atomic swaps are a way of exchanging one digital currency for another in a trustless manner. The swap process is handled by a smart contract, and you don’t need a third party, such as an exchange or an escrow service, to keep an eye on things for the trade to go smoothly.