Scaling up the Chain with Atomic Cross-chain Swaps
Our recent paper “Atomic Cross-chain Swaps: Development, Trajectory and Potential of Non-monetary Digital Token Swap Facilities” investigates the operation and market development of cross-chain swap facilities for cryptocurrencies and other coloured tokens.
In spite of the fact that many applications based on blockchain, such as cryptocurrencies, have proven to be disruptive, there are two major drawbacks inherent in the technology that impede its application: limited interoperability between chains and limited scalability due to high transaction latency.
Capped transaction throughput, resulting from the decentralised consensus approach and other network and algorithmic limitations, remains at the centre of all concerns associated with scalability of Blockchain based applications, especially for cryptocurrencies such as Bitcoin and Ethereum. To date, Bitcoin’s transaction capacity is 7 per second on average while that of Ethereum is 15 per second; Ripple’s capacity in this regard is much higher, 1500 transactions per second, compared to the others. On the contrary, Visa can process 24,000 transactions per second on average. That being said, an individual “unconfirmed” transaction might take between 10 minutes to several days to get “confirmed” in Bitcoin network. The queue time in Ethereum is also exponentially increasing due to mushrooming amounts of ICO’s (Initial Coin Offering), DAOs (Decentralised Autonomous Organization) and DApps (Decentralised Apps) running on the Ethereum network.
While it is extremely important to scale up the Blockchain ecosystems to reduce transaction queue, lack of interoperability - especially for cross-chain swap of cryptocurrencies and other coloured coins such as deeds, stocks, bonds and intellectual properties - is another key problem that needs to be addressed to achieve the potential benefit from this technology. At this moment, there is no easy way to exchange coloured coins or cryptocurrencies such as Bitcoin (BTC) for Ripple (XRP). Dependence on legacy exchanges is a necessity. Obscurity of the coin might add an extra layer of difficulty, leading to use of multiple exchanges, i.e. via several intermediary cryptocurrencies before converting into the desired one and thus generating high transaction costs for conversion.
These problems could have been eliminated if interoperability amongst various blockchains - enabling cross-chain swaps - was not an issue. This is where Atomic Swaps comes into the picture. As the name implies, Atomic Swaps, also known as atomic cross-chain swaps or atomic cross-chain trades, are tête-à-tête peer-to-peer (P2P) exchanges of one crypto asset for another between two counterparties (peers) by direct and automatic interaction of two separate blockchains at the binary level of their basic coding without the use of centralised intermediaries such as an exchange. They are mainly conceived as functioning between parties that actually need the currency rather than as between a protection provider and a protection buyer in a traditional currency swap contract.
The term “atomic” has been borrowed from database systems terminology, where atomicity or an atomic transaction is limited to a set of binary outputs: guaranteed to occur either completely or not at all. Depending on where the interim transactions are being conducted, atomic swaps can be of two major types:
On-chain Atomic Swap, or
Off-chain Atomic Swap.
The technology is in its infancy at this moment and the number of atomic swaps taking place is extremely small. However, such swaps are likely someday to become a fluid “background process”. Interoperability between blockchains will increase the liquidity of the currencies arising in these blockchains and atomic swaps could serve as a link to take assets formulated in one chain into assets formulated in another, multiplying versatility without losing the smart function of the blockchain. This could include securities settlement systems.
Atomic swaps could also play an important role in bringing the direct holding of securities back to organized markets, providing higher transparency and better corporate governance. In such a direct system, securities holders could even be empowered to trade securities directly without the need for broker-dealers or agents. Another important aspect is enabling cross-listing facilities for blockchain based securities exchanges. Current models for cross listing of securities lets one company list its securities on more than one exchange; atomic swaps could allow a similar function to take place via a smart protocol in the respective blockchains of future securities settlement systems.
From the perspective of private law, the governance of such swaps would be no more difficult than what is currently done through framework agreements governing international swap transactions. Choice of law and forum, as well as interpretation and default provisions could be written into the respective coding. From a regulatory perspective, however, atomic swaps could cross borders and legal systems, making them more difficult to monitor and regulate by the governments and their supervisory agencies. In off-chain atomic swaps, the transactions take places in a private channel while the netted result is broadcasted to the network of miners. Thus, apart from the participating merchants, no one actually knows the transaction details. This can lead to the growth of illicit markets. Although not every function of legacy exchanges are regulated by governments, eliminating the legacy exchanges by atomic swap, either off-chain or on-chain, would take away the central focus of regulatory oversight and could make regulation even harder (unless inspection of chain coding is found to be sufficient). The future of cryptocurrency and thus atomic swaps may well hang from how legal and regulatory provisions are adjusted around the globe.
The full paper provides a detailed explanation of how the atomic swap works, along with its current state and future trends as well as possible applications, especially in the domain of coloured coins such as securities settlement.
Mahdi H. Miraz, Centre for Financial Regulations and Economic Development (CFRED), The Chinese University of Hong Kong, Hong Kong
David C. Donald, Faculty of Law and CFRED, The Chinese University of Hong Kong, Hong Kong