What is a cryptocurrency exchange and how does it work?
What is a cryptocurrency exchange?
In order to invest in any cryptocurrency, one should first find a suitable online exchange platform, which would allow them to buy and trade the desired cryptocurrencies. The main purpose of one crypto exchange is to provide an opportunity for efficient trading procedures regarding the cryptocurrency of choice. Therefore cryptocurrency exchanges are established to operate as digitally exclusive marketplaces, where users would be able to acquire and sell different crypto coins and tokens.
After you have settled on a certain crypto trading platform, you have to create an account in it, which would allow you to actively take advantage of what that exchange offers. This is the first step to becoming a crypto asset owner and consequently a trader, as long as you wish to make short-term investments. The crypto exchange is where not only you can experiment with investing in diverse crypto coins but is also the place where your current digital currencies are being stored. That means that the exchange account acts as a hot storage wallet, which is not always the safest place to keep your assets and while this is a great option for when you are just starting to invest, it is not recomandable to store large sums in the long run.
Types of cryptocurrency exchanges
As the popularity of the cryptocurrencies has increased tremendously over the years, there have been established a few different types of crypto exchanges and each of them distinguish themselves from one another with the exchange options they provide the crypto owners with and the way the entire process is handled.
A centralized cryptocurrency exchange (CEX) allows you to purchase crypto assets with fiat money and then to exchange the newly acquired crypto for other cryptocurrencies. In that case the exchange is the third party which conducts the trading process and enables a Peer-to-peer model to be exploited by the users.
These types of exchanges are centralized because they have the control over your private keys. All the funds that you have acquired through this exchange are being stored on it. Basically the CEX acts as a “middle man” who “clears” the trades between the users on the platform. The most used centarlized exchanges are Binance, Kraken and Coinbase Pro.
Unlike the centralized exchange, a DEX is not an intermediary and processes without a central authority which would govern everything on the platform, but instead they work with smart contracts. That means that all the deals within this online platform are completed through the pieces of code which make up one smart contract that allows people to enter an agreement. Here the user has control over their private keys and is responsible for their safety. Some of the more popular decentralized exchanges are Bisq, Gemini and BitMart.
But the one most significant difference of this type of exchange is that you can only obtain and trade cryptocurrencies which are on the same blockchain network.
The motivation behind the invention of hybrid exchanges was to combine all the benefits and try to avoid the disadvantages of both centarlized and decentralized exchanges. Therefore the hybrid exchange has integrated the best possible features from each of its predecessors and has thus turned into an exchange platform which provides liquidity, safety and privacy. This type of next generation exchange does not impose transaction fees and grants the user full access to their private keys.
Find out more about the different types of cryptocurrency exchanges here.
What to look out for when choosing a crypto exchange
Every crypto enthusiast should do extensive research before finally choosing the exchange that best fits his needs. There are some very important pieces of criteria that should be considered in the process of searching for the optimal crypto exchange.
Trading in a secure digital environment is a priority for all people who take their cryptocurrency funds seriously. If you’re looking for a type of exchange which would grant you security, you should opt for using either a decentralized or a hybrid exchange, because they both operate on a decentralized system by working with smart contracts.
KYC information requirements
One of the best features of the decentralized exchanges is that the user is anonymous. DEXs don’t require the submission of any personal information, which is the biggest perk for most crypto traders who seek confidentiality. Centralized exchanges, on the other hand, do require their users to submit the so-called know-your-customer information, before they are verified to make purchases on the platform.
Whenever you want to sell a certain cryptocurrency coin, you should always look for the exchange which has the biggest trading volume of that exact coin, so that you can get the best price for your assets. Since CEXs are the most used types of exchanges, they have the biggest trading volume of most mainstream cryptocurrencies on the market.
Cryptocurrency exchanges have to make money, too, that’s why there are transaction fees, which the user pays for each transaction. Although these trading fees do fluctuate and are dependent on the volatility of the cryptocurrency prices, they are a key component of the trading process. Hybrid exchanges can be very tempting for those crypto investors, who want to avoid such additional fees, because they don’t make their users pay any transaction fees.
Although decentralized crypto exchanges are secure and grant autonomy, they are not as user-friendly for crypto beginners as they should be. CEXs are optimized in a way which makes crypto noob feel more in control of the investing and trading procedures.
Speed of the transactions
As soon as the deal is done and over, you can finally relax and look forward to making your next trading deal. CEXs provide the optimal transaction speed, but the DEXs still lag in that aspect, which is also influenced by the trading volume.
The smart contracts which DEXs use are open-source which means that anyone who understands code can easily check out whether or not the code is trustworthy. This level of transparency allows people to have access to the inner workings of the exchange, before creating an account on it.
How many coins are supported?
Although all mainstream cryptocurrencies are offered in most crypto exchanges, you may not always be able to buy the ones you’re interested in. Always choose the exchange platform based on the availability of the cryptocurrency you want to invest in.
Platforms like Binance provide the option of staking crypto – the longer your assets are locked in the exchange, the more rewards you would get, because this would contribute to work of the PoS consensus mechanism the network uses.
When you lend your crypto assets to a decentralized finance platform you gain the chance of earning rewards as a result of yielding crypto coins and tokens. But be careful, because all of these passive income methods can be risky and not always as profitable as expected.
In which countries is it available?
The most crucial thing everyone should look out for is whether or not they can use the exact exchange in their own country. You may have limited access to some exchanges and that’s why you should choose the one which not only is available where you live but also allows you to trade not only with people in your country.
Always look out for the trading pairs which you find most convenient. Some exchanges support only the most common currencies such as USD, Euro or GBP while others suport dozens of them.
Just like any other institution, cryptocurrency exchanges are being regulated by governments. Different political policies affect these platforms in ways which could limit the user from taking advantage of one exchange’s services. The best example in this case is China which has imposed such strict restrictions regarding the crypto exchanges that nobody there can use them.
Crypto exchange alternatives
Although crypto exchanges dominate as the number one place to purchase and sell cryptocurrencies, there are still a few other ways you could acquire digital assets. Bear in mind that each alternative has its advantages and disadvantages, which doesn’t make it either a better or a worse option than the traditional exchanges.
Cryptocurrency brokers are online platforms which, unlike the exchanges, require the user to deposit either fiat money or crypto and then the brokerage locates and connects the buyers and sellers, who can then make a deal. And although these brokerages are preferred by those who have substantially larger funds, it is still not the right alternative for everyone. The transactions done through crypto brokers usually do come with higher fees.
Coinmama is an online platform, which enables people to buy cryptocurrencies directly from the company. That means that all transactions are facilitated between the user and Coinmama. It doesn’t provide you with a hot wallet and you have to use the wallet which you already have. The user can choose from 10 different crypto coins and use a debit or a credit card to purchase the desired assets. This is a big advantage to many but can also be costly due to the greater bank transfer costs and the transaction fees. On this platform you can only pay for the cryptocurrency coins with fiat money. Another perk of Coinmama is that it now allows you to sell Bitcoin to the company and receive money on your ordinary bank account.
You can now also buy different cryptocurrencies through Ledger, which is a type of hardware wallet for crypto assets. All you have to do is download the Ledger Live App, choose the crypto you want to buy and then it is sent to the address of your hardware wallet. That means that the assets are all under your control and are safely stored in your Ledger.
*This article explores topics which should be researched in-depth before acting on the obtained information. The provided data is not professional advice!
Zornitsa is the Editor-in-chief at Coinlabz. She is involved in researching the impact of blockchain technology and the way crypto is transforming peoples’ perceptions of finances.