How do Cryptocurrency Exchanges Work?
In this section, I will explain how do cryptocurrency exchanges work!
So - you’ve heard about cryptocurrencies, you are really excited to jump into this industry, and you are looking for a great way to start your crypto journey by buying some coins and tokens for yourself. Naturally, your very first instinct would be to visit a crypto exchange!
However, as you go to register on a select exchange platform of your choice, you catch yourself wondering - how do cryptocurrency exchanges work, really? Is there, like, a person who takes care of all of your orders? What about some of the additional features of exchanges, such as crypto storage and user data collection? Well, that’s what we’ll talk about, today!
In this section, we are going to talk about cryptocurrency exchanges, and how they work. Specifically, I’ll tell you about the history of crypto exchange platforms, how these exchanges store your crypto and facilitate trades, as well as a bit about the different types of exchanges that you might come across, too!
Without further ado, let’s get to it!
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How do Cryptocurrency Exchanges Work? (Easily Explained!)
The History of Cryptocurrency Exchange Platforms
To start things off, let’s first look into what is a crypto exchange, as well as the general history of crypto exchanges, shall we? Don’t worry - I won’t bore you with the technical details, and we’ll only focus on the bigger picture!
Truth be told, cryptocurrency exchanges have a pretty exciting, yet also often rocky history. Today, it’s really difficult to track the very first exchange - if there’s one thing for certain, though, it’s the fact that the first few exchanges that came around after the creation of Bitcoin back in 2009 were very basic, in their design. All you could really do was trade BTC - admittedly, that was arguably all the market needed, back in those days!
As time went on, the number of cryptocurrencies grew, exponentially - this is especially true after Ethereum launched, and brought smart contracts to the world of crypto. With all of these new coins and tokens, exchanges needed to keep up, as well - slowly but surely, some of the top exchange platforms in the industry started introducing new features to their clients. Now, you could not only trade crypto, but also buy it with fiat money, lend and borrow coins & tokens, stake your favorite assets, and so on.
Essentially, it seems that with every new wave of crypto technology (such as NFTs, DeFi, crypto gaming, and so on), there come new features available on crypto exchanges, as well. This is really good, since it means that exchanges are “keeping up” with the trends, and catering to their clients’ wants and needs.
While all of that sounds like sunshine and rainbows, the reality, however, is quite different. Historically speaking, there have been countless instances when exchanges got hacked, and the funds kept on them got stolen, never to be seen again. If you were to keep your crypto on such an exchange, you’d likely lose the entirety of your portfolio!
Anyone learning about what is a crypto exchange should also look into one of the most legendary of such instances that happened in 2011, with the infamous Mt. Gox crypto exchange. While it’s a story that requires a separate section, in of its own, the short version is that, over the period of a few years, huge amounts of Bitcoin were being stolen from the exchange’s hot wallet, in addition to users having their data leaked to malicious third-party data harvesters. Today, Mt. Gox is still seen as one of the most notorious instances of crypto hacking, and has become a sort of a legend among crypto enthusiasts worldwide.
All of those things - both the good, as well as the bad ones - bring us to the present date. Today, there are a few world-famous exchanges on the market, as well as hundreds of alternatives. For example, probably the biggest crypto exchange in the world is Binance - a platform that houses a huge variety of different features and services, and acts as a sort of a crypto hub. So, each platform strives to be better than its competitors, when it comes to offering their users the ability to interact with their crypto in as many different ways as possible.
Truth be told, many present-day exchanges can now be considered crypto hubs, due to the sheer variety of features that they offer!
How Do Cryptocurrency Exchanges Work?
Now that you know a bit about the history behind crypto exchange platforms, let’s continue by focusing on the core question at hand - how do cryptocurrency exchanges work?
For this, I’ll need you to use your imagination, since we’re going to go through a few examples.
For starters, imagine that you’re a newbie investor, and are looking to buy your very first Bitcoin. You decide to go with a popular exchange platform, such as the aforementioned Binance.
The very first thing that you’ll need to do is register on the exchange, and provide it with proof of your identity. In this regard, crypto exchanges act as any other financial institution - they need to identify you, as a means to prevent any fraud, money laundering, and other shady activities that malicious people might think of doing.
Once you pass all of the identification processes, you will now be permitted to buy your very first crypto. Since this is 2022 and not 2010, most exchanges - Binance included - will allow you to use a fiat payment method, such as a credit or debit card.
Think of it as if you were to go and purchase ice cream from a vendor at the beach. You choose which ice cream it is that you want, pay for it with an accepted payment method (perhaps the ice cream vendor only accepts cash?), and that’s it - you can enjoy your fozen treat. Buying crypto these days is really that simple!
All that you need to do is pick the cryptocurrency that you’d like to buy (such as Bitcoin), add a payment method, and enter the amount of money that you wish to spend. In just a few seconds, your exchange account will be credited with your newly-acquired BTC!
Now, where does all of that Bitcoin go, you might ask? Well, this is a big part of understanding how do cryptocurrency exchanges work - the crypto exchange will create an account for you, specific to that cryptocurrency that you’ve bought. Your account will be distinguished by a public wallet address (some people call it a public key - that’s not entirely correct, but ya, it still refers to the same thing, in this context).
So, instead of you having to go out and “create” a wallet account for yourself, the exchange that you are using will create one for you. Also, that address will be specific to the crypto asset that you’ve bought - this is true for most cryptocurrencies. That’s because, as you might know, most cryptocurrencies are based on their own networks, and can’t really communicate with one another directly - thus, they can’t be stored on the same wallet, either!
If all of that sounds really complicated to you, make sure to check out other sections in our Crypto 101 Handbook. You’ll be able to find all of the concepts that I’ve just mentioned - crypto wallets, different blockchains, and so on - explained in detail. However, let me still give you an example, to illustrate my point.
Imagine that you’ve decided to fill your car up with some fuel. You pull up to the gas station, and instinctively start filling your car’s tank up with petrol. After all, it’s a petrol car! Nearby, you notice a few charging stations, for electric vehicles.
Now, can you charge up your petrol car at an electric station? No, of course not! That’s because petrol cars are completely different from electric ones, even though both of them are still vehicles that serve the same general purposes.
The same is true with cryptocurrencies, too - they can’t be stored in a single wallet, since they are based on completely different networks. However, in the car example, there are both petrol pumps and electric charging stations available in the same gas station. This is equivalent to a cryptocurrency exchange housing multiple different wallets, on the same, single client’s account!
Haha, I admit - these are some of the more-advanced concepts to wrap your head around! However, it’s still at the core of the services that cryptocurrency exchanges provide.
Once you have your Bitcoin, the next thing that you might want to do is trade it - once again, that’s a service that you will find available on all exchanges. In this regard, trading works very similarly to how it does with stocks - you have the market makers (people who create an order, or buy) and takers (people who will fill out that order, or sell). The exchange’s mission is to match these two people with one another, and fulfill the order!
Of course, as you can imagine, usually things aren’t as simple as that. For example, you might be trading with a liquidity pool of the crypto exchange, instead of an actual person on the other end. Furthermore, I won’t even get into the details of advanced trading features, such as leveraged or margin trading - that’s a whole, separate section.
CEXs and DEXs
Up to this point, we’ve exclusively talked about what are known as centralized, or custodial exchanges. These are cryptocurrency exchange platforms that have a company behind them, and that allow you to keep your crypto on their platforms.
However, there’s another popular form of exchanges, as well - those of a decentralized nature.
Now, I won’t go too in-depth into DEXs, and how they work, since it’s quite a hefty and complicated topic, in of its own.
As far as this section is concerned, though, you should know that DEXs offer peer-to-peer trading, and don’t hold any of your cryptocurrencies. Such exchanges preserve the anonymity and privacy of their users, however, they are also considered to be quite complicated, in addition to placing the entirety of the cryptocurrency management and wallet creation process on you - the user. So, as you study what is a decentralized cryptocurrency exchange, just keep in mind that, if something were to go wrong, there would be no customer support to reach out to - that can be scary!
While decentralized exchanges are a really cool concept, if you’re just starting out, it’s best to stick to the popular, established platforms. With them creating a wallet for you, and allowing you to store your crypto with them, it’s a far more beginner-friendly approach. On top of that, the traditional buyer-seller matching available with centralized exchanges is much simpler to understand, if you’re just trying to figure out how cryptocurrency exchanges work!