The scale of the crypto market is growing, as is the variety of crypto-asset types. According to the most recent data, the market contains over 17,000 assets traded on over 450 exchange services. Now, in order to organize and structure this booming business of crypto trading, there is the need for simple and frictionless asset management mechanisms. In this context, management of assets includes blockchain projects around storing, buying, investing, or using these assets.

Another term you often come across in the crypto space is ‘swapping’. This mechanism, also known as a token swap, has acquired significant momentum in a short period of time due to its ability to reduce the overhead cost and time required to exchange one asset for another. However, it is impossible to describe how swaps operate in a few lines. We must dive deeper.

In this article, you will learn what token swaps are, how to swap tokens, and what they mean for DeFi.

What are token swaps? 

Token swaps, at their core, are simple and secure methods of exchanging tokens with other network users. However, the term swap has various connotations in the crypto-verse. The first is an immediate exchange of one cryptocurrency for another desired token. In fact, when you exchange tokens is the core definition of a token swap.

In this first use case of the term token swap, you are often not required to leave your wallets in order to trade crypto tokens. This eases the process for network participants and foments trade. You can swap tokens in both your wallet (via a decentralized exchange, a DEX) or your custodial account (via a centralized exchange, a CEX) – and there are benefits in both options. 

Then, there is the second connotation for the term token swap. It refers to projects or platforms that are migrating from one blockchain to another. Nonetheless, this also requires coin swapping. However, this second scenario is more sophisticated than the first since it involves more than just a trader's desire to have his coin exchanged for another.

The latter connotation for token swapping comes to fruition when a project believes it should relocate its operations to a new network with distinct token requirements. While doing so, the project's development team should provide its network participants the opportunity of exchanging their holdings for another token that is compliant with the new blockchain network standards. 

For example, let's say you wish to exchange ETH, which is based on Ethereum, with an exchange from another network, such as the Solana native token SOL. In this context, you can token swap this pair. The same can be done for other pairs involving any token from Bitcoin (BTC) to a range of altcoins.

Regardless, in both cases, token swapping between two distinct token standards can imply exchanging fungible tokens for non-fungible tokens as well. One of the advantages of this can be paying for NFTs with fungible assets.

Advantages of swapping

Token swapping has many major advantages: it is simple, fast, cheap, and much more. But how come? To understand how token swapping offers these advantages, let’s break it down into two main sections.

Swapping vs. usual trading

Comparing the usual trading path with token swapping is a way to identify the advantages of the latter. So here is an example:

Assume you have some Solana (SOL) and wish to exchange them for Atom (Cosmos). When you explore cryptocurrency exchanges, you see that there are relatively few SOL-ATOM trading pairings. In this situation, the normal lengthy approach would be to first buy fiat currency with your SOL and then buy ATOM in exchange for them. Alternatively, you might buy popular crypto assets that are more likely to pair with ATOM. This context included pairs with new tokens or niche cryptocurrencies, which can be rarer. These two options would include two transactions, while token swapping would only need one.

Besides being more complex and time-consuming, these processes are also less cost-effective for token holders. You are completing two consecutive transactions and hence paying at least two fees. And the time it takes to conduct these transactions is sometimes long enough for the volatile cryptocurrency market to see major fluctuations in exchange prices. You may wind up paying more or receiving less than you would have if the transaction had been completed in a shorter period of time.

The token swap process brings a solution to these issues. With a swap, you exchange one token for another without having to take the roundabout route of going from crypto to fiat (traditional currencies), or another popular coin, and then buying another token with fiat (or with another popular coin). Token swapping is faster, simpler, and can be cheaper.

Token swap services

It is due to the advantages mentioned previously that token swap services gained mainnet traction. Quickly, exchanges, wallets, and other facilitation services realized the importance of instant swaps and started to add token swap features.

The user's role in these token swap services is quite easy. One must specify the desired amount to exchange as well as the trading pair they wish to swap tokens with. Then, the coin is instantaneously processed and converted by the service. The process is over and transaction fees are paid just once.

The Atomic Swap, for instance, leverages a hashed time-lock contract as a digital escrow service. Both parties submit their tokens from their wallet to the token swap service wallets. These tokens then get locked in a hashed time-lock contract, which is essentially a smart contract. Upon presenting proper secrets, the parties can claim the tokens. The time-lock or timeout feature ensures that a refund will be allowed if either party fails to accept the terms of the trade offer.

With these smart contracts in place, you no longer need a third-party settlement broker. The security features of these contracts ensure that none of the parties stands to lose their token due to fraudulent acts of the exchange counterparty. 

There are several benefits of this process. A user can leverage any token to buy tokens of any other kind. It increases liquidity. Since the process of token swap and transactions therein happens on-chain, there is nothing to fear about losing the data integrity of the swapped tokens. The absence of a third party ensures that the cost of the process remains low. Finally, the cross-chain token swaps strengthen the concept of interoperability in the respective blockchains’ ecosystems.

If your non-custodial wallet is robust, you might not need to transfer your coins to token swap platforms (like Uniswap, Airswap, etc.) or to a centralized exchange (like Binance, etc.) before accessing an instant crypto-to-crypto exchange feature. These wallets come with built-in crypto swapping exchanges utilizing smart contracts for users to convert their coins safely from their wallets. Some wallets that offer direct swaps are Metamask, Solflare, Phantom, and much more.

Overall, the benefits of the token swapping functionality stem from the fact that they are simple and seamless, fast, affordable, and secure.

Contribution to the market

The contribution of token swaps to the overall crypto economy is that it makes the market more inclusive. The entry barriers into the market have substantially reduced as you can get any coin for any other. It has also helped investors get more confidently into digital assets that might not be as popular as Bitcoin or Ethereum. On the other hand, these projects, which otherwise had brilliant growth potential, could not grow because of the lack of investors’ interest and liquidity, therefore. Token swap removed the hurdle for them, while investors did not feel hesitant anymore to buy them if required. 

It has also improved the crypto purchase experience. It is fast and direct. You can get wherever you want in exchange for whatever you currently hold in a single transaction at a lower cost. 

It has given the much-needed boost of efficiency, improved the market’s perceptions around speed, and helped it become more liquid and more immune from the risks of sharp swings and quick price fluctuations. 

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Please note that none of this is to be considered financial nor investment advice. We highly advise you to always do your own research (’DYOR’) before interacting with any of the projects or tools we write about. Crypto is a highly dynamic and fast paced environment with lots of moving parts that can quickly change.

Published on:
February 23, 2022