The atomic swap protocol allows for the exchange of cryptocurrencies on different blockchains without the need to trust a third-party. However, market participants who desire to hold derivative assets such as options or futures would also benefit from trustless exchange. They propose the atomic swaption, which extends the atomic swap to allow for such exchanges. Crucially, atomic swaptions do not require the use of oracles. They introduce the margin contract, which provides the ability to create leveraged and short positions. Atomic swaptions may be routed on the Lightning Network.
Cryptocurrencies such as Bitcoin rely on cryptographic protocols for security. However, as originally designed, there was no mechanism for different blockchains to communicate securely with each other. Thus, trading cryptocurrencies was (and is) done ”off-chain”, or outside of the scope of the blockchains involved. Two users who wished to trade would have to deposit their funds in a trusted third party, typically taking the form of a centralized cryptocurrency exchange.
The need to trust centralized exchanges has long been an uncomfortable reality within the cryptocurrency community. Exchange participants often fear that their funds may be frozen, seized or stolen, and history has shown that such fears are well-founded. Conversely, exchanges with good reputations have monopolistic power over potential new users/investors of a given cryptocurrency, allowing them to extract rents and exercise undue influence over cryptocurrency development in general. For instance, they can choose which new altcoins to
support on their exchange, perhaps charging a listing fee. Creators of new altcoins must cede to their demands or take their chances by working with less reputable exchanges. These frictions make it difficult for new participants to first acquire coins, posing an impediment to the adoption of cryptocurrencies.
Atomic swap allows users to avoid the risks and disadvantages inherent to centralized exchanges when trading. Atomic swaps use Hashed Time Lock Contracts (HTLCs), a form of cryptographic escrow; the blockchains themselves act as the trusted third party. Viewed another way, atomic swaps utilize cryptographic secrets to allow users to prove on one blockchain that certain events occurred on a different blockchain.
The functionality of atomic swaps can be further extended to allow the creation of option contracts, which is termed atomic swaptions. Parties can deposit only a fractional margin instead of the full principal. This, in turn, allows for a meaningful notion of a futures contract, enabling users to take leveraged or short positions on one cryptocurrency against another.
Previous approaches to decentralized derivatives have focused on trading ERC20 tokens on the Ethereum blockchain and/or use oracles (trusted providers of external data) to determine contract outcomes. This approach can be used between different blockchains, with only the requirement that they can support the creation of HTLCs with the same hash function. Namely, the blockchains don’t need to be Turing-complete like Ethereum. In addition, atomic swaptions don’t require oracles, eliminating an unnecessary element of trust from the process.
The design and adoption of new blockchains is an ongoing process, and it remains an open question what operations a blockchain should support to best facilitate the development of applications on top of it. A wide class of inter-blockchain derivatives can be implemented with only the features required to implement an atomic swap. The atomic swaption thus provides a practical path to derivatives trading on existing cryptocurrencies, and removes the need for designers of future blockchains to create specialized derivatives applications.