First thing’s first – what is an atomic swap? In its most basic sense, an atomic swap is the exchange of one cryptocurrency for another cryptocurrency. These days, this would normally be executed on a trading platform (third-party), but with the implementation of atomic swaps, you would be able to cut out the third-party and trade directly with your counterparty.
In the traditional finance world, a swap is a derivative contract through which two parties exchange financial instruments. Usually the instruments command different types of cash flows (an interest rate swap involves a fixed rate cash flow and a floating rate cash flow). An atomic swap is the crypto-version of this.
One of the main functions of cryptocurrencies is to create a trustless, and therefore more scalable, financial system. Until now, it has been necessary to use third-parties to perform cross-chain trading, because there was no dependable way to perform the transaction securely.
However, with the invention and implementation of the lightning network, an atomic swap became possible. They use something called a hash time-locked contract (HTLC) to ensure the fulfillment of both party’s requirements in the trade. Both parties must acknowledge receipt of their funds by generating a proof of payment, otherwise the funds are returned back to the senders.
The Effects of Atomic Swaps on the Market
At the most basic level, atomic swaps seem to be good for the entire cryptocurrency community. They reduce friction by cutting down on transaction costs, and make it possible to seamlessly transfer money between cryptocurrencies.
On a security level, technologists are still trying to assess whether this would compromise any protocols. People are just getting comfortable with the lightning network, so it may take time before the trust is there for HTLCs.
Thinking about things more philosophically, atomic swaps help to unify cryptocurrencies and create an interconnected set of networks. This network of networks has endless possibilities and a real chance at attaining continual evolution.
Somewhat more controversially, it helps cut out third parties and enables cross-chain transactions. This can be said to be in the spirit of blockchain, since it was originally designed as a way of combating the deficiencies of the global banking and financial network.
The next level of effects is where the difficulty comes in. First of all, by cutting out the exchanges, the amount of liquidity on the market decreases. This means that cryptocurrency isn’t as available to new buyers, and it slows down the speed that money can flow to cryptocurrencies from fiat.
But far more importantly, it creates a world where utility tokens no longer need to be held. If you can quickly transfer your crypto into another cryptocurrency before making a purchase, why would you risk holding it in anything but the currencies you trust?
Cryptoeconomics dictates that the market capitalization of a cryptocurrency is equal to the goods transacted in a day multiplied by the average holding period. So with a low holding period, it is possible atomic swaps could kill utility tokens by destroying their market capitalizations.
However, there are some cryptocurrencies which are designed to withstand this problem. Coins that depend on proof-of-stake reward the holders of currencies for their investment. In the future, we will probably see a lot more information flowing around the best ways to inoculate utility tokens from being wiped out by atomic swaps.