What is atomic swap and how does it work?

What is atomic swap and how does it work

Atomic swaps remove intermediaries and central control, thus making cryptocurrency exchanges more decentralized.

Atomic swaps enable peer-to-peer (P2P) transactions between individuals who own two separate cryptocurrencies on blockchains, eliminating the need for intermediation (like a centralized exchange). Atomic swaps enable users to exchange digital assets based on self-executing smart contracts.

Centralized exchanges (CEXs) offer a trading experience similar to traditional stocks and fiat trading—providing asset liquidity, managing trading pairs and order books, ensuring favorable market prices, and connecting buyers and sellers to one platform. They have access to user private keys because they have centralized control of storage and application.

CEXs are popular for their high trading volumes, but they go against the decentralized ethos of cryptocurrency and blockchain. This is where decentralized exchanges (DEXs) try to embody a non-custodial infrastructure. Atomic swaps provide greater interoperability across various blockchain networks. It enables decentralized omni-channel cryptocurrency exchange to promote a true decentralized finance (DeFi) ethos.

Atomic swaps enable DeFi and solve the inefficiencies associated with exchanging cryptocurrencies within centralized finance (CeFi).

When using the Ethereum network on Ether exchange (ETH) and the Bitcoin network on Bitcoin (BTC), you can follow the steps below when using a CEX such as Coinbase or Binance:

Registering an account on a centralized exchange platform that supports the ETH/BTC trading pair. This may require a registration process and a KYC authorization according to CEX policy.
Transfer of ETH to the central exchange.
Converting ETH to BTC may require transaction fees and sometimes a long waiting period.
Transferring acquired BTC to a Bitcoin wallet may involve additional fees.
Finally, patiently waiting for the exchange to trade and ultimately for the funds to arrive.
This typical CEX exchange presents a series of steps, uneconomical fees and many possible complications. Additionally, CEXs may introduce unexpected security risks related to asset custody. CEXs store user funds in custodial wallets and the exchange maintains control of the private keys. In the event of a security breach, attack, or legal withdrawal freeze, the user's cryptocurrency may be exposed to potential threats.

To solve these problems, DeFi and DEXs enable atomic swaps that eliminate the need for intermediaries in trading, streamlining the process and significantly reducing numerous potential security risk points for cryptocurrency users.
How do atomic swaps work?

Atomic swaps work by using smart contracts and hashing encryption techniques to secure digital asset exchanges.

“Atomic” is a term used to describe processes that either end successfully or do not start at all—there is no alternative. For crypto trading, an atomic swap means only two possible outcomes: The trade executes successfully or no transaction occurs.

In simpler terms, an atomic swap cryptocurrency trade must meet all predetermined conditions before the trade can be concluded. This is achieved through the implementation of smart contracts, which are self-executing programs designed to enforce the conditions necessary for a transaction to be successful.

Atomic swaps use hybrid time-lock contracts (HTLC), a type of smart contract, to enable the safe and reliable exchange of cryptocurrencies. HTCLs, in essence, “ lock a transaction and require both parties to verify the information before the exchange can proceed.

Atomic swap smart contracts have two key components:

Hashlock
The hashing mechanism is locked with a unique encryption key of the contract that can only be generated by the cryptocurrency depository. This key, a unique piece of data, ensures that the exchange is only finalized when both parties confirm the transaction.

timelock
The time lock mechanism is like a deadline for clearing. It ensures that the transaction is completed within a certain period of time and returns the depositor's funds in case of failure. The timeline essentially ensures the security of the transaction. Both parties must confirm the exchange within the specified time, otherwise the transaction will be canceled and the crypto returned to their respective owners.

What are the advantages of atomic swaps?

Atomic swaps improve blockchain interoperability and reduce risks while providing investors with greater flexibility at lower cost.

Atomic swap benefits include:

Completely decentralized nature
Atomic swaps offer investors the advantage of decentralization. Peer-to-peer trading, autonomy to one's funds and access from CEX platforms or centralized liquidity pool.

Advanced security
Hashing lock and timelock mechanisms in self-executing smart contracts used by atomic swaps provide investors with a higher level of security. Investors are assured that their cryptocurrencies will be returned in case of delays or conflicts.

Interoperability and altcoin trading flexibility
Atomic swaps enable swaps for users on different blockchains. Many CEXs do not allow traders to exchange altcoins of any kind. Atomic swaps solve this problem by allowing the exchange of almost any form of altcoin.

So what are the disadvantages of Atomic swaps?

Atomic swaps can be technologically complex, with higher blockchain waiting times resulting in slower adoption rates.

Atomic swap disadvantages include:

Complexities with trade exchange
Atomic swaps require the exchange of data, information, and hash cryptographers. This can be intimidating for beginners.

Lack of fiat-crypto on ramp
For investors looking to liquidate into fiat, this can be difficult because fiat-to-crypto and crypto-to-fiat exchanges are not possible on atomic swap DEXs.

Currently, several platforms support atomic swaps. Additionally, special programming skills and mixed knowledge may be required to use atomic swaps. Still, cryptocurrency wallets will integrate this technology into their software in the future.

While atomic swaps enable P2P exchange, cross-chain bridges provide a connection between blockchains for the transfer of assets through tokenized representations.

While both cross-chain bridges and atomic swaps increase blockchain interoperability and serve the purpose of transferring cryptocurrencies across various blockchains, they work in different ways. Cross-chain bridges act as a link or connection between multiple blockchain networks. They act as intermediaries that facilitate the transfer of assets between these networks.

Cross-chain bridges require a token to be burned or locked before it can be found on a different blockchain. A wrapped token is created and an equivalent amount is held in a liquidity pool on the target chain. These wrapped tokens can then be transferred, traded on the target blockchain, or redeemed for original assets on the source blockchain.

Cross-chain bridges are becoming popular thanks to their ease of use and good user interface, and are seen as a modern and accessible way to exchange cryptocurrencies on separate blockchains.