How does Crypto Exchange work? Complete Guide 2024

Among other things, cryptocurrencies Crypto Exchange and other digital assets are designed to enable peer-to-peer value exchange just like cash, but in the digital realm. This means you can trade crypto assets for anything you want, and you can do so without using intermediaries like banks or payment apps. For example, if someone paints your house, you could potentially negotiate to send the person an agreed amount of crypto as payment. This would be effectively no different than handing over cash in exchange for the house-painting service.

Conversely, if you’re looking to buy crypto, you could offer the seller an agreed amount of cash (or any other good or service) in exchange for the agreed amount of crypto.

Read more -> How to send and receive crypto.

Of course, since most people don’t use crypto as a medium of exchange in their daily lives (at least not yet!), it’s generally harder to find peer-to-peer sellers/buyers than it is to, for example, trade in local currency. This brings us to the concept of ‘liquidity.’

Understanding Crypto Exchange

Crypto exchanges are essentially online marketplaces where you can buy, sell, and trade cryptocurrencies. They act as intermediaries between buyers and sellers, bringing them together to facilitate crypto transactions. Here’s a breakdown of some key things to understand about crypto exchanges:

Types of Crypto Exchanges:

• Centralized Exchanges (CEXs): These are the most common type of crypto exchange. They operate like traditional stock exchanges, with a company managing the platform and setting the rules. CEXs are generally user-friendly and offer a wide variety of cryptocurrencies and features. However, they often have higher fees and require users to surrender control of their crypto by holding it on the exchange’s wallet.
• Decentralized Exchanges (DEXs): DEXs operate on a peer-to-peer (P2P) basis, meaning there’s no central authority controlling the exchange. Transactions happen directly between users through smart contracts on the blockchain. DEXs offer more security and privacy since users retain control of their crypto in their own wallets. However, they can be more complex to use and may have lower liquidity (fewer users buying and selling), which can impact exchange rates.

Things to Consider When Choosing a Crypto Exchange:

• Security: Look for a reputable exchange with a strong security track record, including secure login procedures and measures to protect user funds.
• Fees: Transaction fees, withdrawal fees, and any other applicable charges can vary between exchanges. Consider your trading volume and choose an exchange with fees that suit your needs.
• Payment Methods: Some exchanges allow deposits and withdrawals in fiat currency (like US dollars) using debit cards, credit cards, or bank transfers. Others may only deal in cryptocurrency.
• Supported Cryptocurrencies: Different exchanges offer support for a varying range of cryptocurrencies. Ensure the exchange lists the cryptos you’re interested in buying or selling.
• Regulation: The regulatory landscape surrounding cryptocurrencies is still evolving. Some countries have stricter regulations than others. Consider any regulations that might impact your choice of exchange.
• Ease of Use: If you’re a beginner, a user-friendly interface with clear instructions is crucial. More advanced users might prioritize features and functionalities.

Remember: Crypto exchanges can be a valuable tool for buying, selling, and trading cryptocurrencies. However, it’s important to choose a reputable exchange that aligns with your needs and to prioritize security by potentially storing your crypto in your own wallet.

What is liquidity?

Liquidity refers to the ease with which you can trade in and out of an asset – and it depends largely on the number of buyers and sellers (market participants) there are for an asset. Cash is typically considered the most liquid asset, as it’s almost universally accepted. In other words, it’s easy to exchange cash for practically anything you want. A car, by contrast, is generally a less liquid asset than cash, since it requires some effort to find a buyer. A high-end collector’s car, meanwhile, would be an even less liquid asset, since the pool of potential buyers is smaller.

Bitcoin is the most liquid of all cryptocurrencies as it combines the highest number of market participants with the greatest volume of exchange. The daily exchange of bitcoin is measured in the tens of billions of dollars! Still, compared to cash, it’s not liquid, particularly when it comes to using it to buy something in the real world — and other cryptoassets are less liquid than Bitcoin.

What’s a crypto exchange?

A crypto exchange is any service that matches buyers of crypto assets with sellers.

When most people speak of crypto exchanges, they’re referring to centralized ‘custodial’ platforms like Coinbase, Kraken, and Binance. These platforms facilitate the trade of crypto assets. Similar to platforms for trading stocks like Robinhood and Charles Schwab, crypto exchanges match buyers and sellers.

Critically, by definition, a centralized crypto exchange takes custody of your crypto assets. This has a number of implications relating to security, but also relating to the freedom you have to use your crypto as you wish.

How do centralized crypto exchanges work?

From a user’s perspective, the typical flow is as follows:

1. Sign up to the exchange and present identity documents.
2. Fund your newly created account with cryptoassets such as Bitcoin or Ethereum. If the exchange allows it, you can also use a local currency.
3. Make a trade by setting a ‘buy order.’

Buy and sell orders are aggregated into an ‘order book’ which is maintained by the exchange for the purpose of efficiently and automatically matching buyers and sellers. Most exchanges allow you to set both ‘market buy’ orders and ‘limit buy’ orders.

When you create a market buy order, you only need to indicate how much crypto you’d like to buy (you don’t set the price). The exchange will automatically match you with the seller(s) currently offering the lowest price, and execute your trade. Market orders are, by and large, instantly completed, meaning the moment you submit the order, you’ll receive the cryptocurrency you’re trading into.

When you create a limit buy order, you’re indicating how much crypto you’d like to buy and the price you’re willing to pay for it. If and when there are sellers willing to accept the price you’ve set (your ‘limit’), your order will complete, meaning your cryptoasset will show up in your exchange wallet and your money (or other cryptoasset) will disappear.

What’s a banked exchange?

Crypto exchanges that allow you to transfer local currency to and from them are known as ‘banked exchanges.’ Some exchanges allow you to transfer local currency to start buying (typically in the form of credit card or payment app like PayPal), but don’t allow you to withdraw local currency back to your credit card or payment app. These are known as ‘partially banked’ exchanges. A fully-banked exchange will allow to you fund your account via bank transfer and send local currency back to your bank account.

Is Crypto exchanges Safe?

The safety of crypto exchanges is a complex issue. Here’s a breakdown of the risks and some steps you can take to mitigate them:

Risks:

• Hacks: Crypto exchanges are unfortunately targets for hackers. If an exchange is hacked, your crypto holdings could be stolen.
• Security breaches: Even without a full-on hack, security weaknesses on the exchange could expose your personal information or make your account vulnerable.
• Rug pulls: Not all projects listed on exchanges are legitimate. Some might be scams designed to steal your crypto after listing.
• Exchange closure/bankruptcy: If a crypto exchange goes bankrupt, your crypto holdings might be inaccessible or even lost.

Steps to Mitigate Risks:

• Choose a reputable exchange: Research the exchange’s security practices, track record, and user reviews. Look for established exchanges with a strong commitment to security.
• Enable two-factor authentication (2FA): This adds an extra layer of security to your account login process.
• Use strong and unique passwords: Don’t reuse passwords across different platforms. Consider a password manager to generate and store strong passwords.
• Don’t keep all your crypto on the exchange: If you’re holding a significant amount of crypto, consider storing it in a secure wallet that you control the private keys for. This is often referred to as “self-custody” and offers more security but also comes with its own responsibilities.
• Stay informed: Keep up-to-date on crypto scams and security vulnerabilities. Be wary of unsolicited investment advice or offers that seem too good to be true.

Overall:

Crypto exchanges can be safe if you use them with caution. By following the tips above, you can minimize your risk of falling victim to scams or security breaches. However, it’s important to remember that cryptocurrencies and crypto exchanges are still a relatively new and evolving space. There will always be some inherent risk involved.

What are makers and takers?

Generally speaking, the more users an exchange has, the greater ‘market depth’ it is able to provide. Market depth refers to the size of the exchange’s order books. People who place buy and sell orders on exchanges are known as market makers.

The more orders there are on the book, the easier it is for people to buy and sell large amounts of crypto at closer to the global market rate. In markets, takers are those who reduce liquidity by taking orders that are already on the books. When you place a market order, you’re a taker. You can also be a taker when you place a limit order if your order happens to match with another person’s order that’s already on the books.

In the world of crypto exchanges, makers and takers refer to different roles traders play in providing liquidity to the order book. Here’s a breakdown:

Makers:

• Who they are: Makers are traders who add liquidity to the order book by placing limit orders. Limit orders specify a certain price at which a trader is willing to buy or sell a cryptocurrency.
• How they contribute: By placing limit orders, makers create a standing offer to buy or sell at a specific price. This helps create a more orderly market because other traders can see these orders and take them if they match their desired price.
• Benefits: Makers typically enjoy lower fees on crypto exchanges compared to takers. This is because exchanges incentivize adding liquidity to the order book, which benefits everyone by making it easier to buy and sell crypto.

Takers:

• Who they are: Takers are traders who remove liquidity from the order book by placing market orders. Market orders instruct the exchange to buy or sell a cryptocurrency at the best available market price.
• How they take advantage: Takers benefit from the liquidity provided by makers by getting their trades executed quickly and easily. They don’t need to wait for a specific price to be met.
• Costs: Takers typically pay higher fees on crypto exchanges compared to makers. This is because they’re not contributing to the order book’s liquidity but rather taking advantage of it.

The Maker-Taker Model:

The maker-taker model is a fee structure used by most crypto exchanges to incentivize adding liquidity (makers) and ensure there are enough takers to fulfill those orders. This creates a healthy balance within the order book.

Analogy:

Imagine a marketplace. Makers are like vendors who set up shop with specific prices for their goods. Takers are the customers who come and buy those goods at the listed prices. The marketplace (exchange) charges a lower fee to the vendors (makers) for setting up shop and attracting customers (takers), but charges a higher fee to the customers (takers) for the convenience of immediate purchase.

How do centralized crypto exchanges make money?

For many exchanges, the primary revenue source is fees. These may include some or all of the following:

• Withdrawal fees Most exchanges charge a fee to withdraw cryptoassets and local currencies. In most cases, the fee is on a per withdrawal basis (not a percentage of the withdrawal amount). The withdrawal fees charged by exchanges tend to change frequently, often without notice.
• Trading fees These are typically calculated as a percentage of the trade value and often depend on whether you’re the maker or the taker (see above for an explanation of makers and takers). In most cases, makers pay lower fees than takers. The rationale for the discrepancy is that makers provide liquidity (and should, therefore, receive a discount), while takers remove liquidity (and should, therefore, be charged extra).
• Interest/Borrowing/Liquidation Fees Some exchanges offer margin trading. This is where you borrow to increase your position, creating what’s known as leverage. Exchanges that offer margin trading typically charge additional fees based on the amount borrowed and an interest rate determined by the total supply of funds available to all traders. You’ll also likely be charged an additional fee if your position is liquidated.

In some cases, exchanges also act like banks in that they take your deposits and use them to generate yield, typically by lending them out to third parties. This introduces third-party risk, which is a key reason you should be wary of giving possession of your cryptoassets to these entities. Read more about the importance of retaining self-custody of your crypto holdings.

Why do I have to verify my ID to use a centralized crypto exchange?

Taking custody of customers’ cryptoassets, as centralized exchanges must do, has legal implications. Specifically, such exchanges are subject to the money transmitter laws in the jurisdiction in which they are legally registered.

For this reason, centralized crypto exchanges that wish to remain compliant will require you to complete a registration process in which you must verify your identity before you can use the platform. Regulators impose this requirement on exchanges ostensibly to prevent money laundering, terror financing, and tax evasion. Regulators also typically require exchanges to report customer information (including trading history) upon request.

In many cases, you’ll be allowed to begin using the exchange by verifying your email only. It’s important to note that this ‘lite verification’ typically comes with considerable restrictions including limited purchase amounts, limited withdrawals, and in some cases, no withdrawals at all. Before you fund a crypto exchange with your cryptoassets, be sure to check that you’ll be allowed to withdraw.

The next level of verification typically entails uploading nationally-issued identification like a passport or driver’s license. In some cases you’ll be asked to upload a photo of yourself holding your ID next to a piece of paper on which you’ve written, for example, the current date and a specific message as requested by the exchange.

Note that many exchanges exclude certain nationalities from using the exchange altogether.

How does peer-to-peer crypto exchange work?

A number of match-making platforms such as Peach Bitcoin have arisen to (1) help buyers and sellers of crypto assets find each other, and (2) facilitate trades (typically with the use of escrow) without actually taking custody of the traders’ crypto assets. These are known as peer-to-peer crypto exchange platforms.

Peer-to-peer crypto exchange platforms can be an effective way to buy and sell crypto assets, but since you must individually negotiate trades, they carry a certain level of inconvenience. For buyers, it can be difficult to quickly obtain the exact amount of a cryptocurrency they’d like to purchase, and to get it at competitive market rates. Sellers, meanwhile, may face legal implications depending on their jurisdiction and the volume of crypto involved. These factors combine to make most peer-to-peer crypto exchange platforms considerably less liquid than most centralized (custodial) cryptocurrency exchanges.

Summary of crypto exchanges

Crypto exchanges are online platforms where you can buy, sell, and trade cryptocurrencies. They act as middlemen, connecting buyers and sellers to facilitate crypto transactions.

Types of Exchanges:

• Centralized Exchanges (CEXs): Most common, user-friendly, with a wide range of cryptos and features. They control the platform and hold user funds (potentially less secure).
• Decentralized Exchanges (DEXs): No central authority, more secure (you hold your own crypto), but can be complex and have lower liquidity.

Choosing an Exchange:

• Security: Look for a reputable exchange with strong security measures.
• Fees: Consider transaction, withdrawal, and other applicable fees.
• Payment Methods: Choose an exchange that supports your preferred deposit/withdrawal methods.
• Supported Cryptos: Ensure the exchange offers the cryptos you’re interested in.
• Regulation: Consider regulations in your area that might impact your choice.
• Ease of Use: If you’re a beginner, prioritize a user-friendly interface.

Safety Considerations:

• Exchanges can be hacked, so choose a reputable one with a good track record.
• Enable 2FA and use strong, unique passwords for added security.
• Consider storing significant crypto holdings in a secure, self-custody wallet (you control private keys).
• Stay informed about crypto scams and security vulnerabilities.

Makers and Takers:

• Makers: Add liquidity by placing limit orders (specify price to buy/sell). They get lower fees for creating a more orderly market.
• Takers: Remove liquidity by placing market orders (buy/sell at best market price). They pay higher fees for the convenience of immediate execution.

Overall: Crypto exchanges are a valuable tool for crypto transactions, but choose them wisely and prioritize security measures to manage risks. Remember, the crypto space is still evolving.

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