What is Cryptocurrency Exchange & How does it work?
A cryptocurrency exchange serves as a digital platform facilitating the trading of virtual currencies for other assets. Acting as an intermediary, it connects individuals seeking to buy or sell cryptocurrencies.
Once users register an account on a cryptocurrency exchange, they gain access to a marketplace where they can engage in transactions involving various cryptocurrencies like Bitcoin (BTC), Dogecoin (DOGE), Ether (ETH), and more.
There are two primary types of cryptocurrency exchanges: fiat-to-crypto and crypto-to-crypto. Fiat-to-crypto exchanges enable the conversion of traditional money into cryptocurrencies and vice versa. On the other hand, crypto-to-crypto exchanges allow users to trade different cryptocurrencies and swap one digital currency for another.
Among the most renowned cryptocurrency exchanges globally are Binance, Coinbase, FTX, Kraken, and KuCoin. Each platform varies in terms of the range of supported cryptocurrencies and offered services. For instance, while some exchanges restrict the transfer of cryptocurrencies to external wallets, others permit it.
The diagram below illustrates the functioning of a cryptocurrency exchange.
Types of Cryptocurrency Exchanges
There are four types of cryptocurrency exchanges:
- Centralized exchanges (CEX)
- Decentralized exchanges (DEX)
- Peer-to-peer exchanges
- Instant exchanges
Each of the types has its pros and cons. Let’s review each type for a more in-depth understanding of how to start a cryptocurrency.
Centralised Exchanges (CEX)
Centralized exchanges serve as intermediaries, facilitating transactions between sellers and buyers, and they are the predominant type of cryptocurrency exchange. Often referred to as custodian exchanges, centralized exchanges store customers’ digital assets securely. Users have the capability to buy, sell, or exchange cryptocurrencies for other digital assets or fiat currencies through these platforms.
Functioning akin to brokers, centralized exchanges levy trading fees ranging from 0.1% to 8% in exchange for providing customers with a secure environment for managing and trading cryptocurrencies.
Coinbase, Binance, and Kraken stand out as prime examples of centralised exchanges in the cryptocurrency sphere.
Advantages:
- User-friendliness
- Feature-rich
- Millions of operations per second
Disadvantages:
- Weaker protection against hackers
- Users have to keep their assets on the crypto exchange
- Fees up to 8% (bad for users, good for exchange’s owners)
Decentralised Exchanges (DEX)
Decentralized exchanges operate on a non-custodial basis, meaning they do not store customers’ digital assets. Transactions occur directly between users’ wallets on the blockchain, without the involvement of third-party entities or centralized servers.
Despite offering increased security and privacy, decentralized cryptocurrency exchanges generally exhibit lower trading volumes and liquidity compared to their centralized counterparts.
Prominent examples of decentralized exchanges (DEXs) include Pancake Swap, Binance DEX, and Uniswap.
Advantages:
- New users registration and verification
- Low fees up to 0.25% (good for users, bad for crypto exchange’s owners)
- Users don’t have to store assets on exchange accounts, which reduces the probability of losses
Disadvantages:
- No third-party moderation
- Traders can revoke payments by PayPal or bank cards
- Users have to wait until other traders are ready to make operations
Peer-to-Peer Crypto Exchanges
A Peer-to-Peer (P2P) exchange functions similarly to a decentralized exchange, facilitating direct transactions between two users without the involvement of intermediaries.
Unlike decentralized exchanges, P2P crypto exchanges employ an escrow service to connect buyers and sellers, ensuring that each transaction is executed at an agreed-upon price and payment method.
Entrepreneurs opting to establish a crypto exchange of this nature can generate revenue by charging a percentage of each successfully completed transaction. P2P exchanges are particularly popular in regions like Africa and other countries where traditional Bitcoin exchanges face regulatory restrictions.
LocalBitcoins and Paxful stand as prominent examples of P2P crypto exchanges.
Advantages:
- Suitable for beginners as only two options are available – buying and selling
- The buyer doesn’t pay fees for the deposit, exchange, and withdrawal
- Seller ratings ensure user protection
Disadvantages:
- Exchanges may take some time
- Sending money to the wrong user may happen
- Difficult to dispute charges after transactions
Instant Exchanges
An instant crypto exchange operates as a swap service, serving as an intermediary that enables users to swiftly exchange one cryptocurrency for another. These platforms facilitate instantaneous transactions by receiving and depositing funds directly into users’ accounts. It’s important to note that instant exchanges do not store customers’ cryptocurrency holdings.
Advantages:
- Highest transaction speed
- Support for large orders
- No responsibility for stored assets
Disadvantages:
- Difficulties to get refunds
- More difficult to use
Examples of instant cryptocurrency exchanges include such services as Letsexchange, Changelly, FixedFloat, and SwapZone.
How To Buy Cryptocurrency
Choosing a Broker or Cryptocurrency Exchange
Before investing in cryptocurrency, you’ll need to decide between using a brokerage or a cryptocurrency exchange. While both allow crypto purchases, they have distinct differences to consider.
Understanding Cryptocurrency Exchanges:
Cryptocurrency exchanges are platforms where buyers and sellers trade cryptocurrencies. They typically offer lower fees but may have complex interfaces with various trade types and advanced charts, which can be intimidating for beginners.
Platforms like Kraken are well-known cryptocurrency exchanges. While they offer user-friendly purchase options, they often come with higher fees compared to standard trading interfaces. It’s essential to ensure your chosen exchange supports fiat currency transactions and purchases.
Some exchanges only allow crypto-to-crypto transactions, requiring users to buy tokens elsewhere before trading on the platform. Researching supported currencies and transaction options beforehand is crucial for novice investors.
Related: Best Crypto Exchanges
What is a cryptocurrency broker?
A cryptocurrency broker is a service provider that facilitates the buying and selling of cryptocurrencies on behalf of their clients. Unlike cryptocurrency exchanges where users trade directly with each other, brokers act as intermediaries between buyers and sellers. They typically offer simplified platforms and user-friendly interfaces for purchasing cryptocurrencies, often catering to beginners or those who prefer a more straightforward trading experience. Cryptocurrency brokers may also provide additional services such as portfolio management, market analysis, and educational resources to assist their clients in making informed investment decisions.
Creating and verifying an account
After selecting a cryptocurrency broker or exchange, investors proceed by signing up to open an account. Depending on the chosen platform and the intended purchase amount, they might need to undergo identity verification. This step is crucial for fraud prevention and compliance with anti-money laundering regulations.
Until the verification process is complete, investors may not have the ability to buy or sell cryptocurrency on the platform. This typically involves submitting a copy of their driving license or passport, and in some cases, providing a selfie to verify their appearance matches the submitted documents.
Deposit cash to invest
Before purchasing cryptocurrency, investors must ensure they have funds in their account. This may involve depositing money into their crypto account through bank account linking or debit/credit card payments. However, it’s important to be cautious of high charges associated with credit card transactions.
Depending on the exchange or broker and the chosen funding method, investors may experience a waiting period of several days before being able to use the deposited funds to buy cryptocurrency.
A significant caution for investors is regarding credit card transactions. While some platforms allow deposits via credit card, this method is often risky and costly. Many credit card companies treat cryptocurrency purchases as cash advances, resulting in higher interest rates and additional cash advance fees. For instance, investors may face charges of up to 5% of the transaction amount, on top of any fees imposed by the crypto exchange or brokerage, potentially leading to a total loss of 10% of their crypto purchase to fees.
Placing a cryptocurrency order
Once funds are available in their account, investors can proceed to place their first cryptocurrency order. With hundreds of cryptocurrencies available, ranging from popular options like Bitcoin and Ethereum to more obscure ones like Theta Fuel, investors have a wide array of choices.
After deciding on the cryptocurrency to purchase, investors can input its ticker symbol (e.g., BTC for Bitcoin) and specify the quantity of coins they wish to buy.
Most exchanges and brokers allow investors to purchase fractional shares of cryptocurrency, enabling them to acquire a portion of high-priced tokens such as Bitcoin or Ethereum without needing to invest large sums.
According to a survey by Forbes Advisor, approximately 27% of respondents reported holding cryptocurrency assets valued up to £500, while nearly 24% stated their exposure to the sector ranged between £501 and £1,000. It’s essential for investors to only invest what they can afford to lose.
Select a storage method
Cryptocurrency exchanges lack protections such as the UK’s Financial Services Compensation Scheme, leaving them vulnerable to risks like theft or hacking. Additionally, crypto owners face the possibility of losing their investment if they forget or misplace the access codes to their accounts. Hence, it’s crucial to ensure secure storage for cryptocurrencies.
As mentioned earlier, when purchasing cryptocurrency through a broker, investors may have limited control over how their cryptocurrency is stored. Conversely, if the purchase is made via an exchange, there are more storage options available:
- Leave the crypto on the exchange. When buying cryptocurrency, it’s typically stored in a so-called crypto wallet attached to the exchange. If an investor doesn’t like the provider the exchange partners with or wants to move it to a more secure location, they might transfer it off of the exchange to a separate hot or cold wallet. Depending on the exchange and the size of your transfer, investors may have to pay a small fee to do this
- Hot wallets. These are crypto wallets that are stored online and run on internet-connected devices, such as tablets, computers or phones. Hot wallets are convenient, but there’s a higher risk of theft since they’re still connected to the internet
- Cold wallets. Cold crypto wallets aren’t automatically connected to the internet, making them most secure option for holding cryptocurrency. They take the form of external devices, like a USB drive or a hard drive. Investors should be careful with cold wallets, though: if they lose the key code associated with them or the device breaks or fails, access to that cryptocurrency may be lost for good. While the same could happen with certain hot wallets, some are run by custodians who can help investors get back into their account if they are locked out.
Reference: Forbes
