When you want to trade a crypto asset on another blockchain, you use your centralized exchange, CEX, to handle the transaction. As a result, you have no ultimate control over the trading process, and your asset is held for the duration of the procedure.
Fortunately, traders may now swap cryptocurrencies without using centralized platforms because of how blockchain technology has evolved. Thus, decentralized exchanges (DEX) use a one-of-a-kind exchange procedure that allows users to trade cryptocurrency without giving up their assets to a custodian or leaving their private wallet's security. This procedure is called an Atomic Swap.
What is Atomic Swap?
Atomic swaps are exchange contracts that automatically allow two parties to trade tokens from two distinct blockchains. When specified rules are met with fee-free trading, an atomic swap produces automated, self-enforcing contracts that execute the particular actions. This type of technology, also known as atomic cross-chain trading, eliminates the requirement for centralized third-party entities to complete trades.
In other words, an Atomic swap can be called a "peer-to-peer swap" or "atomic cross-chain trading" because it entails a trade between two users of various cryptocurrencies on different blockchains. The transaction is completed and executed through smart contracts and does not involve the use of an intermediary or custodial entity.
How Does Atomic Swap Work
Atomic swaps allow crypto asset holders to trade coins directly between blockchains (i.e., an exchange between an Ethereum blockchain and a Bitcoin blockchain). Atomic swaps carry out its transaction through the use of smart contracts, which are meant to execute transactions only when all of the trade's conditions are met.
A smart contract is fundamental to an atomic swap. This smart contract ensures that the token owners consent to the trade and follows the transaction's success requirements. The blockchain records the transaction after the smart contract is executed. The exchange cannot be undone at this point; the parties must agree to another transaction if their initial tokens are to be returned.
Therefore, when a request to commence a swap is received, it is immediately sent to a smart contract, which then executes it in real-time according to the terms and conditions agreed upon by the exchange in question and the participants who wish to carry out the swapping process. However, you don't need to set up a separate wallet for this operation since you may trade these tokens directly from your portfolio by connecting them to the specialized smart contract service. Also, you don't have to worry about creating these smart contracts because they can be created after submitting a swap request.
Atomic swaps employ hash timelock contract technology (HTCL). This smart contract "locks'' the transaction and needs proof from both parties for the exchange to be executed. However, two unique elements are needed in the contract created with HTCL technology to unlock the tokens:
HashLock
The HashLock secures the contract with a unique key that only the participant (asset depositor) can access. This means only the key can unlock the deposited currency. Hence, when both parties have signed off on their transactions, this key will only release swapped cryptocurrency.
TimeLock
The TimeLock ensures that the transaction is completed within the timeframe specified and if otherwise, refunds assets to the depositor if it is not. The mechanism of Timelock is to protect the transaction by imposing timing limits. Hence, the key acts as a safety feature, returning swapped cryptocurrency if a trade does not execute within the duration set.
Here is a practical procedure of how atomic swap operates;
Typically, two parties are searching for swaps (peer-to-peer); for example, party A has Ethereum in their possession and would like to exchange it for some Bitcoin. Another party, B, now possesses Bitcoin and would like to exchange it for Ethereum.
Party A first deposits Ethereum into an HTCL address, which operates as a safe and can only be opened by a unique key they can access. Following that, Party A sends a cryptographic hash of the unique key to Party B, which deposits Bitcoin into an address generated with the identical cryptographic hash. A can utilize the currency because B likewise deposited Bitcoin by "unlocking" the transaction with the unique key gained from their initial deposit. B can access their portion of the exchange when A has used the key to "unlock" the transaction. The atomic swap is complete once both parties have access to their respective assets.
Additionally, HTLCs can produce on-chain –on-chain swaps that necessitate the adoption of the same hashing algorithm by both blockchains– or off-chain –off-chain channels using a multi-signature wallet to enable both parties to send and receive payments– interactions. This makes the relationships between the participants in an HTLC significantly faster and less expensive.
Advantages of Atomic Swap
Decentralized
With a centralized exchange, you can't have a genuinely decentralized trade because the exchange keeps your funds for the duration of the trade. This invalidates one of decentralized finance's most distinguishing characteristics. However, atomic swaps provide traders complete control over their accounts and exchanges by being independent of exchange platforms and allowing direct wallet-to-wallet transfers.
Peer-to-peer
Atomic swaps eliminate the requirement for centralized authority and allow transactions to be completed conditionally. The ability to complete the transaction without using an intermediary or a third-party payment provider is the most significant advantage of the atomic swap. As a result, the system is entirely peer-to-peer.
Transparency and Interoperability
Atomic swaps enable a more transparent and personalized trading experience. This is possible because third-party engagement in the process is not required. Furthermore, they enable interoperability between several cryptocurrencies. Users can interact much more quickly and immediately as a result of this.
Better Security
The two unique technologies, HashLock and TimeLock in HTCL contracts used by atomic swaps, provide more security and assurance to traders because they are guaranteed to receive their currency in the event of disagreement or delay. Fund theft is also tricky because funds are held in users' wallets rather than the atomic swap service.
Anonymity
Atomic exchanges allow you to remain completely anonymous. You can purchase, stake, and trade cryptocurrencies without disclosing your identity. This means that no KYC (know your customer) is required, as with centralized exchanges.
Final Takeaway
Because atomic swaps are highly decentralized and do not require any third parties to facilitate a transaction, trades may be limited by liquidity. As a result, this is the major limitation of the swap process. The term "atomic" refers to the fact that these transactions either take place entirely or not at all. If any parties involved fail to meet the conditions, the contract is terminated, and the money is promptly returned to the owners.
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