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What Is a Cryptocurrency Exchange and How Does It Work?

When you want to start investing in bitcoin and other cryptocurrencies, one of the key factors you have to decide on is choosing where to make your first crypto purchase. Most often than not, a cryptocurrency exchange is your first option.

Crypto tracking site CoinGecko lists over 350 cryptocurrency exchanges that fall under the categories of spot trading, derivatives, and decentralized exchange (DEX).

In this guide, we will learn what a crypto exchange is, how does it work, what to consider when selecting your preference, and how to set up an account. Moreover, we will provide the best crypto trading tips you can follow when dealing with crypto exchanges.

What is a cryptocurrency exchange?

A crypto exchange is a marketplace where multiple cryptocurrency coins and tokens can be sold, bought, traded, and stored (if the exchange offers wallet support). Per exchange, people can view information like a coin’s market cap and prices of cryptocurrencies.

If in NYSE, you can trade options and equities and in FOREX, you can trade commodities and foreign exchanges, in numerous digital asset exchanges, you can enter the markets of your preferred crypto and start trading.

Cryptocurrency exchanges are online websites where you can buy, sell, or exchange cryptocurrencies for another digital currency or fiat currencies like US dollars or Euro. Unlike stock exchanges with specific trading hours, crypto exchanges are active 24/7.

How do crypto exchanges work

Basically, crypto exchanges allow the conversion of one crypto to another and the buying and selling of cryptocurrencies. These platforms set the price of digital assets, both coins and tokens, based on trading activities.

It is important to note that crypto exchanges are not connected to one another. This means that crypto prices in the market vary depending on the buy and sell activity (order) on each of the exchanges.

Each crypto exchange has its own options and functions for users. In order to profit, traders use the trading pairs of their owned assets.

Every exchange calculates the price of Bitcoin, Ethereum, and other crypto-assets based on its own volume of trades as well as the supply and demand of its users. This means that the bigger the exchange, the more relevant the price you get.

But due to the unpredictable nature of crypto, there is no such thing as a ‘stable’ or ‘fair’ price for Bitcoin or any other asset — it’s always determined by the market movement at a specific timeframe.

In reality, there is no single and official price for any asset. CoinMarketCap, Coingecko, and other crypto information websites display the aggregated value from numerous exchanges.

Buyers and sellers

Initially, a buyer must first fund their exchange account. They may use their local currency or another cryptocurrency. Nowadays, most crypto exchanges accept bank transfer or debit/credit card as a payment method.

After, the user can then place a ‘buy’ order on the exchange, requesting to buy BTC or other assets, at anything below a maximum price. On the other hand, a seller places a ‘sell’ order, offering to sell a certain amount of crypto for above a minimum price.

When someone successfully places a buy or sell order, the exchange adds this to its ‘order book,’ which shows the list of the amounts traders want to sell, and the prices they’re looking for to purchase.

The crypto exchange acts as a matchmaking service between buyers and sellers.

To enumerate, here are some of the common functions you will see in exchanges:

  • Limit Order: allows you to buy or sell with the desired price and amount.
  • Market Order: allows you to directly buy the highest sell order or sell to the lowest buy order.
  • Stop-Limit Order: allows you to set a stop price, which when reached can trigger the submission of a limit order
  • Units: the amount of cryptocurrency that you would like to buy/sell
  • Bid/Ask: the price that you would like to create your order

If the buyer and seller match their demands, then a sale can happen. Otherwise, each one of them has to look for their desired orders.

Types of cryptocurrency exchanges

 

Source: Statista
Source: Statista

10,000 respondents revealed the leading types of crypto exchange platforms globally. These are namely CEX, DEX, and hybrid.

The majority of cryptocurrency trading occurs on centralized exchanges aka CEX. These exchanges are privately-owned and serve as your custodians when conducting trades and storing assets on their built-in wallets.

Issues of custody and centralization have been primary issues when using CEX but due to user-friendliness, convenience, and high volume and liquidity, a lot of investors rely on these exchanges on a regular basis.

In response to the above-mentioned concerns, decentralized exchanges aka DEX have emerged. Unlike CEX that operates under private servers, DEX has no central point of control.

A DEX never takes custody of user funds. In general, there is an order matching protocol followed within this platform, and funds are transferred between individual wallets using smart contracts, executing trades automatically.

Bridging the gap between a centralized and decentralized is the third type of exchange — hybrid. It is based on the security and confidentiality of DEX as well as the liquidity and functionality of CEX.

How do crypto exchanges make money?

Similar to how traditional money remittance centers and exchanges generate profits, crypto exchanges are also a valuable money-making business. A crypto exchange revenue model considers the following:

  • Listing Fees
    Exchanges charge a listing fee to any project who wants their coin or token to be supported and traded on their platform. These listing fees are payable in cryptocurrency or the project’s native tokens, within a range of 1 to 10 BTC. Competition for token and coin listing has become fierce in the crypto world. Small-scale crypto exchanges are often less strict and affordable than popular ones. Typically, an evaluation process is done and the probability of getting listed depends on meeting the specified factors.
  • Commissions
    Exchanges charge a trading fee within their platforms. Therefore, the more traders there are in their markets, the more revenue can be accumulated. Currently, commissions of as low as 0.01% are being asked per transaction. This is a strategy that could lead to a relatively large daily trading volume. Top exchanges in the cryptocurrency industry boast daily trading volumes in the range of billions of dollars, generating 8-figure commissions and more.
  • Market Making
    Exchanges can also yield profits while providing liquidity to its users. This strategy consists of having market makers that buy and sell digital assets at prices displayed in the exchange, with the goal of profiting on the bid-ask spread. Market makers must operate under an exchange’s bylaws and by the movement of the asset they are trading. They execute a similar strategy when introducing new trading pairs for a currently listed asset.
  • Token Sales
    Exchanges host various crowdsourced fundraising rounds for crypto projects, letting them receive a percentage of total proceeds as compensation. These include IEOs, STOs, and ICOs. Organizing token sales can drive significant revenue. When the hosting exchange collects funds on the behalf of the fundraising company,  it charges a percentage of total proceeds as a fee. Depending on the final amount raised, such percentage could yield a large payout for the platform.

What to consider when choosing a crypto exchange?

Source: Statista
Source: Statista

When crypto traders were asked what the biggest problems they see in currently-available exchanges are, security, lack of liquidity, customer support, lack of crypto pairs, inconvenient user interface, and high withdrawal fees were stated.

In line with this are the important factors you must consider when choosing which crypto exchange to trust:

  • Security
    Any trader should consider security before trusting any crypto exchange. Cybersecurity is one of the main concerns as one research found that cybercriminals looted $125 million in BTC, ETH, and other crypto assets from crypto exchange scams. As a wise trader, you need to do comprehensive research about the exchange. If they are known experts in the areas of privacy and security, your fund may be guaranteed to be safe compared to other exchanges.
  • Reputation
    Before putting any amount of funds on a crypto exchange, check out its reviews among professional crypto traders, app stores, or Reddit. You should know what can affect you and your asset’s safety.
  • Trading fees
    You will be obliged to pay a certain fee with every transaction you make (unless you have a coupon or staked crypto). Although such fees can vary among different platforms, keep in mind that they should not go beyond the market average (0.1- 0.5%).
  • Crypto trading pairs
    More supported trading pairs are practical for traders. They accommodate the needs of users who trade with high-liquidity assets as well as those who prefer to trade with other altcoins in the market.
  • Liquidity
    Easily liquidated assets result in higher trading volumes. The liquidity rate is naturally dependent on the daily transaction volume on the platform. If an exchange has high liquidity, the platform can handle seamless transactions without delay.
  • Payment options
    Some crypto exchanges are strictly for crypto-to-crypto trading and purchase only while some have more flexible payment methods such as direct bank account transfer and credit/debit cards. Be extra careful when providing your card details.
  • User-friendly
    Some platforms are very easy-to-navigate and use. This is a must especially if you are a novice trader. Check the availability of tools for technical support and market analytics and other supplementary information like guides and blogs to make you a smart trader.
  • Geographical Restrictions
    Some exchanges and their specific functions are only accessible from certain countries. Make sure that your preferred exchange allows full access to all platform tools and functions in the country you are currently residing in.
  • Exchange Rate
    Unsurprisingly, different crypto exchanges have different rates. You should take time to canvass around. As crypto is volatile, you can expect fluctuating rates of up to 10% and even higher.Once you have decided on the exchange you will use, it is also important to ensure that your assets are stored securely and efficiently. You can see the different storage methods in our cryptocurrency wallet guide article.

How to set up a crypto exchange account?

Though every cryptocurrency exchange has its own steps for account creation, there is a general registration process that tends to be rather similar at each platform.

You can expect the sign-up process to be like this:

  • Provide personal details such as your name and email address.
  • Complete the email verification
  • Add a payment method for your deposits and withdrawals.
  • Finish a more extensive KYC process that requires additional identity verification.
  • A copy of a utility bill sent to that address
  • Social security number
  • Driver’s license, passport, or any other government-issued ID
  • A selfie of you holding your government ID

Top crypto exchanges in 2020

Despite the hundreds of crypto exchanges in the industry, there are the major players that lead the digital asset landscape. Here are some of the top CEX and DEX in 2020:

Leading centralized exchanges

Binance206 coins683 trading pairs
Coinbase Pro29 coins78 trading pairs
Kraken38 coins176 trading pairs
Kucoin216 coins458 trading pairs
Gate.io246 coins467 trading pairs
Gemini9 coins25 trading pairs

Leading decentralized exchanges

Uniswap (v2)531 coins1,349 trading pairs
Curve Finance7 coins24 trading pairs
Balancer111 coins183 trading pairs
Aave16 coins18 trading pairs

To know about exchanges in detail, you can read our comprehensive exchange reviews here.

Best crypto trading tips

Either you are a professional trader who rides the volatile waves of the crypto market or a newbie one who is just testing the water, keeping in mind some tips is beneficial.

Before the actual trading, you might be intimidated at the sight of candlestick charts. That is why we particularly made a guide for dummies explaining the basics of bitcoin and crypto technical analysis.

Experts said that trading is mainly about managing your risks and understanding the price action. Koroush AK, a well-known crypto trader, and successful entrepreneur shared some of the deadly sins that should be avoided to avoid losing money when trading.

  • Have a clear mindset or specific purpose before entering any trade.
  • Establish a clear stop loss level.
  • Learn how to manage your risks and losses.
  • Check out the market cap value; not the price alone.
  • Conduct a background check before joining any token sales, airdrops, etc.
  • The higher the trading volume, the more suitable an asset is for long-term investments.
  • Diversify your financial portfolio.
  • Take it easy when trading; do not be an emotional trader.

Conclusion

By all means, anyone interested in owning a digital asset must understand initial concepts first. These include what blockchain technology is, how Bitcoin works, and how cryptocurrencies differ. (You probably encountered many crypto jargons in the process)

But that is just the beginning. Once you have a grasp of the industry, you now have to think carefully about where you can buy crypto for a good price. This is where crypto exchanges come in.

Pick the best cryptocurrency exchange platform that would be certainly suitable for your specific needs and remember to pay attention to the fees, reputation, security, and verification an exchange platform has to offer. Have a safe crypto trading journey!

CoinQuora Staff

CoinQuora is an online publication that aims to educate about news, exchanges, and markets in the cryptocurrency and blockchain industry

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