Victor Ugochukwu · Dec 14, 2020 . 5min read
What are Crypto Exchanges? A Beginner’s Guide
Cryptocurrency exchanges are businesses that allow users/customers to trade digital currencies for other assets, such as conventional fiat money, or different digital currencies.
By Victor Ugochukwu · Aug 3, 2020 . 15min read
In this piece, you will learn:
- What is a cryptocurrency?
- How cryptocurrency exchange works
- Types of cryptocurrency exchanges
- Cryptocurrency exchange custody
Let’s dive in.
What are Cryptocurrency Exchanges?
Cryptocurrency exchanges are businesses that allow users/customers to trade digital currencies for other assets, such as conventional fiat money, or different digital currencies. They allow conversion of one cryptocurrency for another, the buying and selling of coins, and the exchange of fiat money into crypto.
How do Crypto Exchanges Work?
To begin with, crypto exchanges function based on their types. However, there are basic operations any cryptocurrency exchange must facilitate in order to be called a cryptocurrency exchange. In simple terms, crypto exchanges work similarly to regular stock exchanges except that stock exchange allows traders to buy and sell assets such as shares and derivatives while traders use cryptocurrency pairs to their advantage to profit from the volatility of digital assets.
“Did you know that cryptocurrency exchanges are just like stock exchanges except that traders use cryptocurrency pairs to target profit in cryptocurrency exchanges?”
Cryptocurrency Trading Pairs
A pairing essentially establishes a baseline on which an exchange user trades other coins or tokens. To trade in one of these markets, you will need to own the base currency to purchase new currencies in that market. A currency pair consists of two currencies which an exchange allows its users to trade for each other. Here’s an example of a popular pair: ETH/BTC, LTC/BCH, ETH/XRP etc. With these pairs, users can buy ethereum and sell for bitcoin, buy Litecoin and sell for Bitcoin Cash, buy Ethereum and sell for Ripple.
Importantly, the scale of financial transactions an exchange user can make on exchange depends on some factors. One is the number of currencies exchange (fiat) offers and the number of trading pairs that exchange supports. Suffice to say, the more trading pairs the better the chances of a user profiting from trading. However, your profiting from trades also depends on your trading skills.
Cryptocurrency Exchanges and Custody Issues
Most exchanges have users trading on them majorly for the purpose of making profits. Thus, this borders on the volatile nature of digital assets. Bitcoin and other cryptocurrencies are characterized by periodic rise and fall in prices. Volatility, of course, gives an opportunity for traders to capitalize for gains. Additionally, the same volatility is also responsible for which severe losses on the part of the traders.
Also, many of these cryptocurrency exchange users merely trade their holdings and convert it to to fiat anytime the need arises. Moreover, due to the centralized nature of exchanges, assets owners do not fully control their holdings. In-house hacking or other forms of hacks have led to exchange users losing their funds. Some of these losses borne by users are not even through hacks but other bad practices by exchange owners. This was the case with QuadrigaX, a Canadian based cryptocurrency exchange. The owner was reported dead without giving other management executive access to the private keys of the exchange wallet. This, therefore, meant where users’ funds were permanently lost. This is why the phrase “not your keys, not your coin” is popular in crypto space.
Custody Solution Necessary for Institutional Funds Inflow
With big investors such as hedge funds managers coming into the arena of cryptocurrencies, it has become essential and compulsory for their assets to be protected from the prying eyes of hackers or even other risks such as the QuadrigaX case cited earlier. This has necessitated the booming business of cryptocurrency custody.
Consequently, cryptocurrency custody solutions are third party providers of storage and security services for cryptocurrencies. Custody solutions aim their services at institutional investors. These include hedge funds, who hold large amounts of bitcoins or other cryptocurrencies. The solutions generally incorporate a combination of hot storage, or crypto custody with connection to the Internet, and cold storage, or crypto custody that is disconnected from the Internet. Big exchange operators like Coinbase Custody offer this service to institutional customers.
“Did you know that cryptocurrency custody solutions such as Coinbase Custody provide storage and security services for hedge funds who hold large amounts of bitcoin or other cryptocurrencies?”
Types of Cryptocurrency Exchanges
Traditional Cryptocurrency Exchanges: Like traditional stock exchanges allow buyers and sellers trade on the basis of the current market price of cryptocurrencies with the exchange acting as the middle man making the transactions possible. Examples include Binance, Coinbase Pro, Kraken, OKEx etc. Some of these types of exchanges deal only in cryptocurrency, others allow users to trade fiat currencies like the U.S. dollar for cryptocurrencies like Bitcoin Ethereum, Ripple etc. These types of exchanges require support and other forms of the human element to relate with the users.
Cryptocurrency Brokers: These category of exchanges allow customers to buy and sell cryptocurrencies at a price set by the broker and not the buyer or any seller. The implication is that the broker sets his price by combining market price plus a small premium as profit for his effort. Coinbase, Changelly, Shapeshift etc., good examples of cryptocurrency brokers. These are good platforms to onboard newbies in cryptocurrencies because of their simple interface and ease of use. For this simplicity, users will always have to pay slightly higher.
Direct/Peer-to-Peer Trading Platforms: These are the most popular of all cryptocurrency exchanges. They offer direct peer-to-peer trading between buyers and sellers. Price is variable and not set by the exchange platform but by the traders. Sellers set rates while buyers take this rate or enter their own rates they are willing to buy for. The function of Peer-to-Peer exchange is using its powerful matching engine to connect trading parties with little or no human element involved in the transactions except in cases where disputes may arise from trading parties. There are centralized and decentralized versions of this type of exchange. Localbitcoins and Paxful are good examples of centralized direct/P2P exchanges while Airswap.io, Kyber Network are decentralized examples.
Popularly called ETF, these are pools of professionally managed cryptocurrency assets which allows public buy and hold cryptocurrency via the fund. Using a fund, an investor can trade in a cryptocurrency without having to purchase or store it directly. As a trade-off, you can’t use crypto in a fund as money, these are strictly for investment. Read more about Exchange Traded Funds.