What Is an Atomic Swap?

An atomic swap is an exchange of cryptocurrencies from separate blockchains. The swap is conducted between two entities without a third party’s involvement. The idea is to remove centralized intermediaries like regulated exchanges and give token owners total control.

The term atomic derives from the term “atomic state” in which a state has no substates; it either happens or it doesn’t—there is no other alternative. This refers to the state of the cryptocurrency transaction; it happens or it doesn’t.

Most atomic swap-enabled wallets and blockchains use smart contracts. Smart contracts are programs within blockchains that execute when certain conditions are met. In this case, the conditions are that each party agrees to the transaction before a timer runs out. Using a smart contract in the trade prevents either party from stealing a cryptocurrency from the other.

Atomic swaps are also called cross-chain atomic swaps.

Understanding Atomic Swaps

Each cryptocurrency is supported by a blockchain, designed only to accept transactions in specific tokens. For example, Bitcoin (BTC) has a blockchain, and ETH (ether) has another. You cannot easily exchange BTC and ETH without first converting to fiat currency then buying the other; another technique is to convert between cryptocurrencies and exchanges multiple times to get the one you want. Atomic swaps allow you to exchange tokens from different blockchains in one trade.

Decentralized exchanges can conduct atomic swaps for you. A decentralized exchange (DEX) has no central authority regulating it; it is a platform you can trade on without third parties. You can also choose from cross-chain swap providers, where you transfer your digital assets into another wallet, conduct the swap, and transfer them back out.

History of Atomic Swaps

The concept was conceived shortly after altcoins—cryptocurrencies other than Bitcoin—materialized. The creation of altcoins meant some cryptocurrency owners became interested in moving capital between coins. This type of token swap first appeared in September 2017, when an atomic swap between Decred and Litecoin was conducted.

Since then, startups and decentralized exchanges have implemented swaps and allowed users the same facility. For example, Lightning Labs, a startup that uses Bitcoin’s lightning network for transactions, has conducted off-chain swaps utilizing the technology.

Special cryptocurrency wallets have also been developed that are capable of cross-chain atomic swaps—Liquality has developed a wallet that will swap Bitcoin, ETH, and more.

Atomic Swap Process

In an atomic swap, two token owners agree to exchange their tokens for any amount they agree on. The smart contract program sees that they both agreed to it, so it executes the trade for them. The transaction is recorded in the blockchain and validated by the network nodes, and then a new block is opened for another transaction.

The transaction cannot be reversed. Both parties must agree to another transaction to exchange the tokens again if they would like them back.

Atomic swaps use Hash Timelock Contracts (HTLC) to automate the exchange of tokens. As its name denotes, HTLC is a time-bound smart contract between parties that involves generating one cryptographic hash on each end.

HTLC requires both parties to acknowledge receipt of funds within a specified timeframe. If one party fails to confirm the transaction within the timeframe, then the entire transaction is voided, and funds are returned. This eliminates counterparty risk, or the risk that one party will accept the offered coins and decline the transfer of their coins.

For instance, suppose Jane wants to convert 1 BTC to an equivalent number of Litecoins with John. She submits the transaction through an atomic swap-capable wallet. A cryptographic hash function generates a hex number to encrypt the transaction during this process. The process is repeated at John’s end.

Both Jane and John unlock their respective funds using their encrypted numbers. They have to do this within a specified timeframe, or the transfer will not occur. The HTLC within the blockchains then executes the trade.

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What Is an Asset Swap?

An asset swap is similar in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.

All swaps are derivative contracts through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount agreed upon by both parties. As the name suggests, asset swaps involve an actual asset exchange instead of just cash flows.

Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts between businesses or financial institutions.

Understanding an Asset Swap

Asset swaps can be used to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are used to transform cash flow characteristics of underlying assets and transforming them to hedge the asset’s risks, whether related to currency, credit, and/or interest rates.

Typically, an asset swap involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold them the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based floating coupon.

It is widely used by banks to convert their long-term fixed rate assets to a floating rate in order to match their short-term liabilities (depositor accounts).

Another use is to insure against loss due to credit risk, such as default or bankruptcy, of the bond’s issuer. Here, the swap buyer is also buying protection.

The Process of an Asset Swap 

Whether the swap is to hedge interest rate risk or default risk, there are two separate trades that occur.

First, the swap buyer purchases a bond from the swap seller in return for a full price of par plus accrued interest (called the dirty price).

Next, the two parties create a contract where the buyer agrees to pay fixed coupons to the swap seller equal to the fixed rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR plus (or minus) an agreed-upon fixed spread. The maturity of this swap is the same as the maturity of the asset.

The mechanics are the same for the swap buyer wishing to hedge default or some other event risk. Here, the swap buyer is essentially buying protection and the swap seller is also selling that protection.

As before, the swap seller (protection seller) will agree to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the cash flows of the risky bond (the bond itself does not change hands). In the event of default, the swap buyer will continue to receive LIBOR plus (or minus) the spread from the swap seller. In this way, the swap buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure.

How Is the Spread of an Asset Swap Calculated?

There are two components used in calculating the spread for an asset swap. The first one is the value of coupons of underlying assets minus par swap rates. The second component is a comparison between bond prices and par values to determine the price that the investor has to pay over the lifetime of the swap. The difference between these two components is the asset swap spread paid by the protection seller to the swap buyer.

Example of an Asset Swap

Suppose an investor buys a bond at a dirty price of 110% and wants to hedge the risk of a default by the bond issuer. She contacts a bank for an asset swap. The bond’s fixed coupons are 6% of par value. The swap rate is 5%. Assume that the investor has to pay 0.5% price premium during the swap’s lifetime. Then the asset swap spread is 0.5% (6 – 5 – 0.5). Hence the bank pays the investor LIBOR rates plus 0.5% during the swap’s lifetime.

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