Back when the first cryptocurrency, Bitcoin, was introduced, there were only two ways to get your hands on it. Either by mining it yourself or by buying it directly from someone who already has it. Since this was obviously a restriction, crypto exchanges jumped into the picture. They connect a network of buyers and sellers to make the transfer of assets easy and accessible.
Today, crypto exchanges facilitate billions of dollars in crypto transactions every day. Not to mention that they’ve made adopting crypto significantly easier for a wide variety of investors. And you have used one too! But do you know how these crypto exchanges work? Let’s take a look.
What Is a Cryptocurrency Exchange?
A cryptocurrency exchange is where buyers and sellers trade a cryptocurrency for another or for fiat money ($). Unlike stock exchanges, these are privately owned entities. The reason behind this is crypto is still a developing market, and regulations around it in many countries aren’t clearly laid out.
However, that shouldn’t stop you from exploring this new asset class. Millions of people across the globe have invested billions of dollars in cryptos. Not just that, even institutions like MicroStrategy, Tesla, etc, have gotten their feet wet in the crypto market. It’s natural for any new asset class to go through a phase like this. And if you are looking to dip your toes in cryptocurrencies, Mudrex’s Coin Sets would be a great choice!
Coming back, there are three different kinds of cryptocurrency exchanges – centralized, decentralized, and hybrid.
Different Types of Cryptocurrency Exchanges?
1. Centralized cryptocurrency exchanges
A Centralized Exchange (CEX) acts as a third party that facilitates transactions between a buyer and a seller. It makes sure these transactions go through as intended. CEXs are almost like brokerages in that sense.
You’re probably thinking, “Aren’t cryptocurrencies supposed to be decentralized? Isn’t that the entire point?”. Yes, but centralized exchanges make it easier for retail investors to put their money in cryptocurrencies. They are more trustworthy in the public eye as the government licenses them.
But they aren’t without their risks– centralized exchanges are held by a single entity, which makes them more vulnerable to cyber-attacks.
Examples of CEXs are Binance, Kraken, etc.
2. Decentralized cryptocurrency exchanges
Decentralized exchanges (DEX), as the name implies, are the alternative to centralized exchanges– they have no single entity in charge of the exchange. Transactions are automated with the help of smart contracts.
A DEX is more secure than a centralized exchange in theory because it has no single central point of failure. They also process transactions faster, and the transaction fees are lower while offering complete anonymity to their users.
However, the downsides are that DEXs do not allow you to trade using fiat currencies. And liquidity on these platforms can be thin, making it hard to execute large orders. Besides, they are not as user-friendly as CEXs. Uniswap, Sushiswap, and PancakeSwap are a few popular DEXs.
3. Hybrid cryptocurrency exchanges
This one’s pretty obvious. Hybrid crypto exchanges aim to bring the best of both worlds to the table. The end product is an attempt at giving users the convenience of centralized exchanges while not compromising on security and freedom, like decentralized exchanges.
They haven’t really seen the level of adoption that the other two kinds have, but they could be an option that satisfies both the average consumer and the crypto enthusiasts.
Centralized Vs. Decentralized Cryptocurrency Exchange
Now that we understand what centralized and decentralized exchanges are, comparisons are obviously inevitable.
Most retail investors will prefer centralized exchanges as they are familiar, offering similar experiences as traditional trading platforms. On the other hand, crypto enthusiasts get excited about the unique advantages that decentralized exchanges offer. So how do centralized exchanges stack up against decentralized ones?
1. Cost to user
DEXs remove the need for intermediaries in the transaction between buyer and seller. This reduces and sometimes even eliminates transaction fees while also allowing transactions to go through faster. On the other hand, CEXs act as the middleman in transactions and charge a fee for their part in carrying out these transactions safely and efficiently.
2. KYC
CEXs being a centralized organization, require users to go through several identity verification steps to comply with regulations. DEXs embody the spirit of the blockchain; users can remain anonymous while trading on the platform.
3. Liquidity
Centralized exchanges are leagues ahead of decentralized exchanges when it comes to liquidity levels. DEXs are working on overcoming this drawback with a new liquidity mechanism called Automated Market Makers (AMM). This is simply because the masses prefer CEXs over DEXs, and by the sheer presence of mass buyers and sellers on the centralized platforms, they are liquid.
4. Listed asset diversity
To list cryptocurrencies on DEXs is a lot easier than it is to list on centralized exchanges. CEXs require listed assets to meet certain criteria, which results in a limited number of coins being available to trade. Hence, it’s easier for users to get early access to new and in-demand crypto assets on DEXs.
5. Accessibility
CEXs are highly user-friendly, being similar to traditional trading platforms. Most of them also offer round-the-clock customer support to handle any and all customer queries. DEXs do not have a central authority in charge of the platform that handles custody of funds and transactions. Users need to be responsible for their wallets and private keys. The app interface might also be complicated for the average user.
learn more about the difference between CEX & Dex here.
How Do Crypto Exchanges Work?
Crypto exchanges facilitate trade using cryptocurrency or fiat money. This is done using a live order book in case of centralized exchanges. A live order book shows all buy and sell orders for a cryptocurrency. This directly influences cryptocurrency prices on that platform. More buy orders and fewer sell orders lead to higher prices and vice versa.
The only job of a cryptocurrency exchange is to match orders between buyers and sellers and make the trade happen. In an order book, all the buy orders (prices at which people are willing to buy that crypto) are listed from the highest to lowest order. You can sell your cryptos to them at this price if you want.
While the sell orders (placed by people willing to sell that crypto) are listed from lowest to highest. You can buy cryptos at that price if you want.
Since everybody in the market wants to buy at the lowest price and sell at the highest price possible, there exists a difference between the buy and sell prices. It is also called the bid-ask spread. The top orders in the order book are the best prices at which you can buy/sell your assets. More liquidity can reduce this spread.
- Liquidity is an important factor for crypto exchanges. It determines how easy/difficult it would be for someone to convert their cryptos. More people on a platform equals more orders and, thus, more liquidity.
- Another important aspect of crypto exchanges is market depth. Market depth refers to the ability of the platform to absorb large market orders without disturbing the price of assets much. This is also a function of liquidity.
How is a crypto exchange different from a stock exchange?
One aspect where crypto exchanges differ dramatically from traditional stock exchanges is the prices seen across different exchanges for the same asset. On the stock market, there is one common liquidity pool held by the Securities and Exchange Board of India (SEBI). This means that the price for a particular stock is uniform across exchanges, or at least there is not much difference.
Crypto exchanges, on the other hand, are privately owned and have their own liquidity pools. This affects asset prices across exchanges. Exchanges with more users usually show prices that are closer to the token’s real value. This is because each exchange calculates prices based on its own trading volume. Volume affects prices because when new investments come in, this increases liquidity. And this, in turn, results in prices appreciating. The opposite is true when there’s an outflow of liquidity– prices fall.
Another aspect where crypto exchanges differ from traditional exchanges is the working hours. Crypto exchanges work 24/7, unlike traditional stock exchanges, which have predefined trading hours.
How Do Exchanges Make Money?
Most exchanges turn to commissions as a revenue stream. They charge a fee for every trade that takes place on their platform. This commission is usually fixed, between 0 and 0.25%, in most Indian crypto exchanges.
New exchanges face issues with thin liquidity during consolidating markets. Thin liquidity is seen when there are very few buyers and sellers on the market. And a consolidating market is one in which an asset’s price moves within a well-defined range. Consolidation ends when the price moves either above or below this range.
Now, how do these exchanges generate revenue when liquidity is low? By facilitating initial coin offerings on their exchange and taking a portion of the revenue.
Conclusion
Both centralized and decentralized exchanges bring something valuable to the table. While centralized exchanges are more user-friendly and are currently more common, decentralized exchanges are revolutionizing the finance space by removing intermediaries. They are giving back power to the users. They have the potential to become the industry standard.
CEXs are a safe option because they comply with government requirements. DEXs can be highly rewarding in the long run if they do become mainstream. But it’s important to remember that with higher potential rewards comes higher risk. So take some time to DYOR– Do Your Own Research, and decide what works for you and your risk appetite.
FAQs
1. What are the fees associated with crypto exchanges?
Crypto exchanges typically take commissions for every transaction on the platform, which usually ranges between 0 – 0.25%. Another way they generate revenue is by charging a fee for coins to be listed on their platform. They may also facilitate IEOs or initial exchange offerings.
2. What are the different types of orders on a crypto exchange?
The two most widely used types of orders are limit orders and market orders. Limit orders tell the exchange to trade with your money at a predetermined price or better. While this ensures you get the desired price, if no one’s willing to sell at the set price, the order will not be executed. Market orders execute trades at the best available market prices for a predefined asset quantity.
3. What are the benefits of using a crypto exchange?
Usually, the first time people interact with crypto assets is on a crypto exchange because of the convenience they offer:
- They allow users to buy and sell cryptos on a government-licensed platform.
- They are user-friendly and pretty easy to navigate.
- Some of them even provide users with tax forms, thus making it easier to calculate taxes.
4. What are the risks of using a crypto exchange?
Crypto exchanges are great, but they aren’t exactly a bed of roses. They do come with their faults.
- Users can be left stranded with no access to their funds or assets if the exchange goes down.
- Users using the exchange’s custodial wallet don’t hold the private keys to them.
5. What is KYC, and why is it required by some exchanges?
KYC, also known as Know Your Customer is a mandatory process for centralized exchanges to verify the identity of their customers. Users usually have to go through multiple steps of verification to complete the process. This is done because exchanges that are regulated are monitored heavily by the regulators, and KYC is an important part of compliance.
6. How can I find a reputable crypto exchange?
Before choosing an exchange to put your funds in, here are five factors to consider.
- If the exchange is allowed to do business in your country
- If the exchange has a high number of users and high trade volume
- If the crypto asset you want to trade is listed on the exchange
- If the transaction fees are low enough
- If the exchange offers high security
