What Is a Cryptocurrency Exchange and How Do Exchanges Work?

Cryptocurrency exchanges are digital trading platforms, where holders of all types of cryptocurrencies can swap assets, trading on shifting crypto prices to make profits.

Crypto exchanges can handle trade requests from millions of traders simultaneously. In addition, many exchanges also offer additional financial services such as passive income programs, like staking, and financial advisory facilities.

Exchanges Explained

Cryptocurrency exchanges allow cryptocurrency holders to create trade requests and get matched by a willing buyer or seller. The exchange platform acts as a centralized or decentralized intermediary between buyers and sellers.

Exchanges pair assets. Paired assets include a quote and a base asset. Quote assets are used to purchase the base asset and vice versa. Exchanges support diverse trading models; spot trading and derivative trading. Spot trading is a relatively simple form of asset trading and always involves a real exchange of cryptocurrencies. Derivative trading includes futures, perpetual, and margin trading, some of which might not involve the exchange of assets but only a wager on their price development.

The Role of Exchanges in the Crypto Ecosystem

Direct Trading of Cryptocurrencies

Exchanges enable investors and traders to swap their assets for other cryptocurrencies. They ensure the continuity of cryptocurrency projects by creating a platform that satisfies the demand of other investors. Thanks to exchanges, crypto assets can easily maintain a steady flow of buyers and sellers and stay financially viable.

Institutional Financial Services H4

Cryptocurrency exchanges serve individuals and organizations. They can offer enterprise-grade services including serving trade requests for huge amounts of trades and providing institutions with data on the general outlook of the crypto market. Exchanges enable mainstream and crypto-native institutions to participate in the crypto market easily – a tedious task if done through crude P2P trading. Some exchanges also offer over-the-counter cryptocurrency trades. This makes it easier for institutions to acquire crypto assets without purchasing them directly from the order book and to avoid slippage due to low liquidity.

Connecting the Crypto Market with the Traditional Finance Sector

Cryptocurrency exchanges offer services like on-ramp crypto trading, fiat pairing, and P2P fiat-crypto trading, which connect the crypto ecosystem with the traditional finance sector, and allow investors to purchase and sell cryptocurrency. Investors can buy crypto using the traditional banking system and trade their cryptocurrency for fiat. Some crypto exchanges support transactions in USD, GBP, EUR, and other fiat currencies.

Market Insights

Crypto exchanges enable a fair valuation for cryptocurrencies through an inclusive market for buyers and sellers. They also provide a transparent view of the supply and demand for a crypto asset. In addition to these, they provide charting tools for traders. Experienced traders can make more informed trading decisions using the data obtained from cryptocurrency markets and price development charts from these platforms.

Here are some of the most popular exchanges:

1. Binance: A custodial cryptocurrency trading platform, available in over 150 countries, Binance is the largest cryptocurrency exchange by daily trading volume, serving over 200 million users and handling over $10 billion worth of trade requests daily.
2. Coinbase: This centralized cryptocurrency exchange, based in the US, supports crypto spot, derivative, and on-ramp trading. Coinbase also offers a wallet, institutional financial services, and passive income programs.
3. Uniswap: A decentralized exchange first deployed on the Ethereum blockchain, Uniswap is an AMM-powered exchange. It uses the liquidity pool to create a store of crypto assets from which it serves swap requests.
4. Changelly: This instant swap centralized exchange allows users to perform a one-way exchange of cryptocurrencies. Changelly connects to other centralized exchanges through an API and serves trade requests through a third-party connection.

Exchanges are software applications that handle the temporal custody of cryptocurrencies. They create a platform for users to compute sale or purchase requests. They handle these requests concurrently while computing new balances after successful trades. Exchanges create asset pairs and allow traders to exchange the paired assets.

The basic functions of exchanges are asset and account management, and the computation of users’ balances.

For centralized exchanges, the exchange creates a hot wallet where users deposit the funds meant for trading. User deposits are identified using unique wallet addresses. A representation of the deposited fund is reflected on the user’s account while the real funds are held in a collective wallet. Users can now trade these funds freely with other paired assets while the software computes the final balances at the end of each trade.

Centralized exchanges operate an order book system, which places users’ orders in a transparent record system usually displayed on the platform. The liquidity on a centralized exchange is a summation of the orders in the order book and the spread between each order level. Trade requests are served from the order book.

Decentralized exchanges function differently. Most decentralized exchanges serve trade requests via a pool of paired assets, known as a liquidity pool. Liquidity pools hold assets contributed by other users and serve the requested amount of assets from the pool through an Automated Market Maker (AMM) algorithm. After each successful trade, the AMM algorithm updates the value of each pool asset according to the changing ratio on the pool. Decentralized exchanges do not hold traders’ funds, unlike centralized exchanges.

Centralized exchanges are custodial and permissioned platforms for trading cryptocurrencies. They hold funds on behalf of their users, providing an interface to enable them to trade their capital against other assets listed on the platform. Users will be required to create an account on the platform and complete basic identification processes before they can trade on the platform. Withdrawals must also go through an application and review process before being transferred to the requested recipient.

Exchanges use the order book system to create a record of users’ trade requests and serve requests that correspond to an order. The order book features a sell-side which records requested sale transactions and a buy-side which records the requested purchase transaction, these are quoted in relation to the base currency. Users set their orders, which are completed when/if they meet the presiding market conditions.

Advantages of a CEX 

Fiat-crypto pairs: Centralized exchanges supporting fiat-crypto pairs enable traders to exchange their cryptocurrencies for fiat, with the fiat currency as either the base or quote currency. Users can deposit their fiat directly or using third-party deposit options.

Easy Trading Against Other Assets: Centralized exchanges provide a one-point platform for trading cryptocurrencies against several other assets. Users can easily swap, across different pairs, for a fee.

Challenges of a CEX 

Asset Custody: Users’ funds on centralized exchanges are held in a collective wallet. In the case of exchange mismanagement of users’ funds, users run the risk of losing a portion, or all the funds held on the exchange.

User privacy: Users must provide ID to create accounts, which are stored by the exchange. The platform holds a record of every user and can easily track users’ transactions. Also, in a data breach, an attacker can obtain financial records of users on the exchange.

Liquidity: The liquidity on centralized exchanges fluctuates. Since they are not locked users can easily pull their orders and widen the spread across order levels.

Extra transaction charges: In addition to the trading fees, exchanges also charge for withdrawals and deposits in some cases. Crypto withdrawal fees charged by centralized exchanges are usually higher than the network fees.

Decentralized Exchanges are non-custodial trading platforms. They allow users to retain full custody of their assets while using the platform. Decentralized exchanges are on-chain. They are deployed on blockchain networks and use smart contracts to automate the transfer of funds at the users’ approval.

Advantages of a DEX 

Self-custody: Transacting on decentralized exchanges, users do not give away personal information. Their funds stay in their wallets during most of the transaction. Each transaction is computed on the network, making it a more secure way of exchanging cryptocurrencies.

Low fees: Users on decentralized exchanges are only required to pay the liquidity provider fee and network fee which is always cheaper than the withdrawal fee charged on centralized exchanges.

Permissionless: Anyone can list an asset on decentralized exchange and trade assets. Users are not required to create an account or go through a review process to list, trade, or withdraw crypto assets.

Challenges of Using a DEX

Complex technology: Decentralized exchanges involve advanced computing operations, like creating a liquidity pool, signing transactions, and selecting trading routes. Unfortunately, errors in any of these processes may lead to irrecoverable loss of funds

Fluctuating charges: Charges on blockchain networks are determined by the presiding network conditions. This can change over time and charges can become sizable.

How Decentralized Exchanges Work

Decentralized exchanges use different technologies to create a liquidity and exchange medium and for users.

One type is an on-chain order book, which is similar to the order book system used by centralized exchanges. Decentralized exchanges that use this system use smart contracts to manage the custody of users’ assets on the order book. Users can place orders just like on centralized exchanges.

Another type is AMM-powered decentralized exchanges. More popular than order book DEXes, they use liquidity pools to create a store of crypto assets from which they serve trade requests and update asset prices using the AMM algorithm. Examples of such exchanges include Uniswap, Raydium and PancakeSwap.

Hybrid exchanges aim to fuse the positive features of centralized and decentralized exchanges while addressing the challenges of both. They are an emerging kind of cryptocurrency exchange that uses a centralized order book system to ensure instant execution and cheaper fees. During the trading process, users maintain custody of their assets as seen on decentralized exchanges. Compared to liquidity pools and AMMs, order books are faster and more transparent. The self-custody of funds provides a level of security almost matching decentralized exchanges.

Key Features and Considerations

The goal of hybrid exchanges is simply to develop an interface and user experience similar to that of centralized exchanges and also achieve the level of security and privacy seen on decentralized exchanges.

Hybrid exchanges combine centralized and decentralized technologies and while this might work on paper, there are chances of dysfunction due to the inability to create an efficient connection between both systems. The consequences could be poor UX and security insufficiencies. This is an emerging technology and should be used with caution.

Setting Up an Account H3
After choosing a crypto exchange, follow these instructions:

• Visit the official website of your desired crypto exchange to create a user account.
• Complete the basic KYC process as stipulated by the exchange to enable you to trade cryptocurrencies on the platform.

Depositing Funds

• To deposit crypto to your trading account, copy the wallet address of the asset you wish to deposit from your trading account and send your capital to the asset.
• To deposit Fiat, follow the guidelines for Fiat and on-ramp purchases for the platform

Trading on an Exchange

After creating your account and crediting your trading account, you are now ready to start trading cryptocurrencies. Here is how to buy a cryptocurrency

To place a buy order.

1. Visit the exchange where you have created a trading account.
2. Navigate to the market section and find the crypto asset you wish to buy.
3. On the asset’s page, you can see the presiding price and the order book.
4. In the Buy section, set the price at which you wish to buy the asset, enter the amount you wish to purchase, and click on the BUY button to complete your order.

Check the order summary area to see the completion progress for your orders.

Withdrawing Funds

To Withdraw funds

1. Go to your account area and click the Withdraw button
2. Select the asset you wish to withdraw.
3. Enter the withdrawal details, including the recipient’s address and amount.
4. Follow the platform’s confirmation process to complete your withdrawal request.

If approvedby th platform, your withdrawal will be completed once it’s confirmed on the network.

Trading fees: Cryptocurrency exchanges charge a fee for each successful trade. On centralized exchanges, this is split into maker and taker fees. Maker fees are paid for initiating a sell transaction while taker fees are paid by buyers. This applies to spot and derivatives trading as well.

Withdrawal fees: This is the fee charged by the exchange platform to process your fund withdrawal request. For crypto withdrawals, the withdrawal fees cover the network fees and the platform fees.

Deposit fees: Some exchanges charge fees for crypto deposits, however, deposit fees are usually associated with fiat deposits. This is the amount charged by the platform to cover the charges for the fiat deposits.

Liquidity provider fee: This is usually associated with decentralized exchanges and is equivalent to trading fees on centralized exchanges. However, some decentralized exchanges include liquidity provider fees as part of the total trading fee. These fees are distributed among holders who commit their assets to the liquidity pool.

Network fee: While trading on decentralized exchanges, you will be required to pay a fee for transaction verification on the blockchain. This is not charged by the exchange platform but by the blockchain network where your assets are held.

Cryptocurrency wallets enable investors to manage their cryptocurrencies. They are primarily meant for asset custody and P2P transactions, web3 wallets enable users to connect to smart contract applications. On the other hand, cryptocurrency exchanges allow investors to trade their assets against other assets. They allow different exchange models like instant swaps, derivate trading, and limit orders. Exchanges only keep custody of users’ assets for trading purposes.

Our CoinHint analysts believe that cryptocurrency exchanges will stay relevant as long as cryptocurrencies remain viable financial assets but will continue to evolve along with broader changes in the cryptocurrency market. Exchanges could adjust to comply more with financial regulations which means stricter KYC policies and anti-money laundry precautions. Also, decentralized exchanges could dominate, in the future, as investors are increasingly drawn to their privacy and security advantages.

Cryptocurrency exchanges are the lifeblood of the cryptocurrency business and critical to the mass-adoption of digital assets. They bring buyers and sellers together using a unified platform and design these platforms to simplify the trading of assets. This lowers the barrier to participation, allowing anyone to buy and sell cryptocurrencies, while the integration of fiat currencies also introduces investors in the traditional finance sector to cryptocurrency.