[Paper Review] Atomic Swaptions: Cryptocurrency Derivatives

James A. Liu|arXiv (Cornell University)|Jul 20, 2018

Blockchain Technology Applications and Security2 references3 citations

TL;DR

This paper introduces atomic swaptions, a trustless mechanism for trading cryptocurrency options across different blockchains without oracles or centralized exchanges. By extending atomic swaps with Hashed Timelock Contracts (HTLCs) and margin mechanisms, it enables leveraged and short positions while allowing cancellation of identical swaptions via cyclic rebalancing, particularly on the Lightning Network.

ABSTRACT

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. In this paper I propose the atomic swaption, which extends the atomic swap to allow for such exchanges. Crucially, atomic swaptions do not require the use of oracles. I also introduce the margin contract, which provides the ability to create leveraged and short positions. Lastly, I discuss how atomic swaptions may be routed on the Lightning Network.

Motivation & Objective

• To enable trustless, decentralized trading of cryptocurrency derivatives such as options and futures across different blockchains.
• To eliminate reliance on centralized exchanges and oracles, reducing counterparty and systemic risk.
• To support leveraged and short positions through a margin contract mechanism.
• To enable efficient routing and cancellation of swaption positions on the Lightning Network using cyclic rebalancing.
• To provide a practical, minimal-crypto-features solution for inter-blockchain derivatives using only HTLCs and time-locked transactions.

Proposed method

• Extends atomic swaps using Hashed Timelock Contracts (HTLCs) to support option-like settlement between different blockchains.
• Introduces a margin contract that allows users to post only a fraction of the principal, enabling leveraged and short positions.
• Uses identical secrets and timelocks to enable cancellation of paired swaptions through a circular fund flow, minimizing lockup and settlement costs.
• Applies the atomic swaption mechanism to the Lightning Network, enabling off-chain routing of long-term derivative contracts.
• Employs timestamp-based timelocks instead of block height to ensure predictable expiration ordering across heterogeneous blockchains.
• Designs the protocol to be compatible with non-Turing-complete blockchains, requiring only HTLC support and a common hash function.

Experimental results

Research questions

• RQ1 Can option contracts be created in a trustless, decentralized manner across different blockchains without relying on oracles?
• RQ2 How can margin and leverage be implemented in inter-blockchain derivatives while preserving trustlessness and minimizing counterparty risk?
• RQ3 What mechanisms enable efficient cancellation and rerouting of swaption positions on payment channel networks like the Lightning Network?
• RQ4 How do long-term inter-blockchain contracts affect network liquidity, settlement order, and economic incentives?
• RQ5 What are the risks and limitations of deploying atomic swaptions in practice, especially under protocol rule changes or market manipulation?

Key findings

• Atomic swaptions can be implemented using only HTLCs and time-locked transactions, without requiring Turing-complete blockchains or oracles.
• The use of identical secrets and timelocks enables the cancellation of paired swaptions through cyclic rebalancing, reducing fund lockup and settlement costs.
• Margin contracts allow for leveraged and short positions by requiring only a fractional deposit, enabling futures-like exposure.
• Routing atomic swaptions on the Lightning Network is feasible, but long paths increase counterparty risk and transaction costs due to cumulative time value and liquidity constraints.
• The protocol is vulnerable to manipulation if large numbers of margin-expiring swaptions are concentrated in time, potentially triggering short squeezes via coordinated intermediaries.
• Timestamp-based timelocks are preferred over block height for expiration ordering, as block timing is unpredictable across different blockchains.