In the physical world, a bank is a financial institution licensed to receive deposits, transfer funds, and store money for its clients. Banks can legally offer the right to exchange one fiat currency for another to its customers.
In the digital world, a cryptocurrency exchange provides services similar to banking to their clients; additionally, exchanges function as similar to a stock exchange.
Why use crypto exchanges?
Crypto exchanges are the financial intermediaries needed to link together different cryptocurrencies while offering clients a web-based centralized gateway to manage funds. There are hundreds currently operating, each with varying degrees of liquidity and security. New exchanges continue to emerge while others end up shutting down.
But what is a cryptocurrency exchange?
Cryptocurrency exchanges are secure online marketplaces in which users can exchange one kind of digital asset for another based on the market value of the given assets. A few exchanges even allow trading of fiat currencies such as the Euro for cryptocurrencies. Crypto exchanges have the added benefit of functioning digital currency wallets. Users can send cryptocurrency to the exchange’s wallet or store the tokens on the wallet provided by the exchange.
Cryptocurrency exchanges function in two ways:
- Peer-to-peer (P2P) trading where the seller sets the price.
- Brokers similar to currency exchanges where the platform sets the price, which is market price plus a small premium
Cryptocurrency exchanges can be centralized or decentralized peer-to-peer. The concept of a centralized exchange is comparable to a traditional stock exchange e.g. trusted middlemen who handle user funds and facilitate trades. The design is that one entity manages closed liquidity pools holding large amounts of tokens and fiat currency. Centralized exchanges are far more accessible, common, and easier to use.
The non-custodial idea of a decentralized exchange is based on smart contracts and a trading interface. P2P exchanges allow people to share data, information, or digital assets in a trustless manner. More specifically, P2P exchanges allow traders to buy and sell cryptocurrencies directly without needing a central intermediary. Unlike centralized exchanges, P2P exchanges do not compel users to deposit their funds into an exchange. Decentralized exchanges are entirely run by software.
How can I trade cryptocurrencies?
Due to know-your-client (KYC) and anti-money-laundering (AML) regulation, many centralized exchanges require verified identification for account setup. The process will usually include a photo of your official ID, and occasionally, a proof of address. Once the user has set up an account on a cryptocurrency exchange, you will need to fund your exchange account to start trading.
You can transfer Bitcoin and other cryptocurrencies, from your cryptocurrency wallet to the corresponding cryptocurrency address on your trading account.
Alternatively, the exchange can purchase the corresponding amount of bitcoin on your behalf, deposit the tokens in an automatically generated wallet on the exchange where the payment has been received.
Most exchanges accept payment via credit card, bank transfer, and some even work with Paypal. The transfer can take minutes or sometimes hours, due to network bottlenecks. Ou must also consider that most exchanges charge fees on top of the mining network fee, as sort of a broker fee for the transaction.
While some exchanges charge a single flat fee, other exchanges split their trading fees into two separate fees: the maker fee and the taker fee. The maker fees can be higher than the taker because the maker adds liquidity to the market, so the exchange “rewards” the trader.
Now that the account has coins to trade, users can exchange them with another cryptocurrency. Most exchanges work by matching people who want to buy with those who want to sell. Traders can either set a special price they are willing to pay, and the exchange will make the trade when someone matches that price. They can do a ‘buy now’ style transaction that lets them buy at the best price available at that time.
Similarly, traders can opt to sell cryptocurrency by inputting a market order or a limit order. When a market order is picked, the trader is authorizing the exchange to trade his tokens for the best available price in the online marketplace. When a limit order is set, the trader tells the platform to exchange tokens for a price below the current ask or above the current bid.
Once the trader decides to withdraw money from the account, they can do so using the options provided by his exchange. These options could include a bank transfer, PayPal transfer, check mailing, cash delivery, or bank wire.
What are the risks of using crypto exchanges?
Different crypto exchange platforms offer various types of cryptocurrencies and have different terms, policies, payment methods, and fees. Exchanges also vary in aspects such as security, user-friendliness, functionality, and design. These factors can all play a significant part when choosing the most suitable exchange.
The majority of crypto exchanges are only lightly regulated, enabling for sometimes shady or abusive price manipulations. While looking for a cryptocurrency trading platform, users need to consider a multitude of concerns.
Questions to Ask Yourself Before Choosing a Crypto Exchange
- Is the platform reputable? Are there a sufficient number of good reviews in the relevant cryptocurrency online forums?
- Is it user friendly? This is particularly crucial if you are a new user or don’t have sufficient technical familiarity with cryptocurrencies.
- What are the features and services offered? Do they have wallets, different trading options, and more?
- Which cryptocurrencies are listed?
- Which payment methods are supported?
- What is the KYC policy?
- Does the exchange work in my location?
- Are the exchange rates clear and reasonable?
Cryptocurrency exchanges require custody of your digital assets to make trades. Leaving money in centralized exchanges is risky because hacks and breaches have occurred in the past.
Digital exchanges are so vulnerable to hacks because they centralize the risk. Also, the exchange’s servers are subject to maintenance downtime. Once the trade is completed, it is recommended to withdraw the funds to an off-exchange Bitcoin wallet immediately.
Bitcoin trading isn’t child’s play and its important to know the ins and outs of cryptocurrency exchange and even blockchain mining. Here’s a quick guide to smart contracts to help you become a Bitcoin master.