Cryptocurrency exchanges – Forex Academy

What comes to your mind when you hear the word cryptocurrency?

Probably it’s the distributed and consensus ledger technology that forms the basis of the whole crypto universe.

As such, it would seem counter-intuitive if other solutions built around this ledger technology end up diluting its decentralized aspect. Yet, the ratio of centralized exchanges’ trading volume to that of decentralized exchanges suggests that traders prefer the former to the latter.

Well, there are many halftones between the two concepts – decentralized and centralized – with an arguable belief that not everything is always black and white. Besides, if the power of decentralization was to transverse all aspects of our everyday life, wouldn’t it send us into disarray? So, the real question here should be, to what extent should an exchange be decentralized?

Decentralized Exchanges Explained

Much like cryptocurrencies, decentralized crypto exchanges (DEXs), seek to create a trustless environment where buyers and sellers can transact freely. Instead of using matching buy and sell orders in a central book, DEXs utilize smart contracts to link traders directly to each other, eliminating the need for a third-party. In this way, these types of exchanges don’t hold users’ assets or any other personal data. They only serve as a matching and routing layer for trade orders.

Generally, there are two types of decentralized crypto exchanges: currency-centric and currency-neutral. Currency-centric exchanges are tied down to one specific blockchain network escrowing its native currency, e.g., Ethereum, Waves, Tron, and any other blockchain that has smart contract capabilities. Currency-neutral exchanges, on the other hand, tend to be more versatile. This means that they can be built on various blockchain networks and are therefore not tied to one specific digital coin ecosystem.

How Decentralized Exchanges Work

Regardless of their differences, all decentralized exchanges work pretty much the same way. A client brings their funds like ETH, which are stored in the exchange’s network in the form of proxy tokens, in this case, DEX-ETH. Ideally, these tokens serve as collateral for the actual coins stored by the exchange.

To execute a trade, the client sends an order to sell their tokens in exchange for, say DEX-BTC tokens, which also represent the actual BTC owned by the other party. The smart contract then matches and processes the orders, after which the proxy tokens are exchanged between the two parties. The seller gets the DEX-BTC while the buyer receives the DEX-ETH tokens. After receiving tokens, both parties can convert them to the actual currency, ETH and BTC, using the same trading channel or a different one.

Advantages and disadvantages of Decentralized Exchanges

Given their architecture, one of the biggest advantages that rises to the forefront is security. The exchanges don’t hold customers’ funds in a central reserve and are thus not vulnerable to hacks or theft. At the same time, decentralized exchanges don’t require a user’s personal information, which also goes a long way in improving security and anonymity in line with the purpose of crypto.

A DEX eliminates the need for a middleman between traders, helping reduce the trading fees. Additionally, traders who like keeping up with crypto market trends, you might consider using decentralized exchanges. This is especially true if you invest in an Initial Coin Offering (ICO). Often, ICOs find their way into DEXs prior to centralized exchanges.

Despite their numerous advantages, decentralized exchanges have their shortcomings. To start with, they require a higher degree of technical know-how to use efficiently. They also lack essential trading features, which makes them intimidating to new crypto traders.

Due to the small number of users on DEXs, they have a relatively low trading volume. This translates to limited liquidity in addition to difficulties in finding a matching order since there’s a limited number of traders on the platform.

Decentralized exchanges also suffer from slow transactions. The slow speed of transactions may not be a big deal to small-scale traders, but it can be detrimental to trading giants with high-volume transactions.

Also, by their very nature, DEXs have no physical location or proof of existence. Therefore it would be difficult to launch a complaint should an issue arise.

Centralized Exchanges Explained

Unlike their counterparts, centralized exchanges, also known as CEXs, function similarly to traditional stock exchanges. Essentially, they act as a middle-party between crypto traders and, in exchange, collect a small fee on every successful trade.

These exchanges are structured in such a way that they own their users’ private keys (or wallets), meaning that all transactions have to be executed in the mechanisms laid out by the central authority. Their having access to users’ wallets is a double-edged sword.

First, in case of a lost password, a user can easily recover their funds by simply contacting the exchange’s support team. At the same time, centralized exchanges are prone to hacks and thefts since they store client funds in a centralized database. But even with this downside, CEXs continue to attract a higher number of users than decentralized exchanges.

Such popularity can be attributed to the seamless fiat to cryptocurrency trades carried out on the centralized exchanges. As such, it is easier for a new crypto trader to enter the market. Moreover, centralized exchanges boast of useful trading features like the stop losses, margin trading, and lending, which are not available on decentralized exchanges.

Thanks to their high number of users, centralized exchanges have higher liquidity than DEXs. The liquidity is further enhanced by the fact that most CEXs accept fiat currencies and can even be linked to debit cards or bank accounts.

To Centralize or Not to Centralize?

Currently, centralized exchanges control the lion’s share of the global cryptocurrency trading volume. Although they deserve it due to the convenience they offer, they have watered down the idea of decentralization in the blockchain and crypto industry. Perhaps as decentralized exchanges continue to grow, there will be a major shift to these platforms since they maintain users’ privacy and security, which is becoming increasingly important as more centralized exchanges fall victim to hacks.

In the early days of Bitcoin, getting your hands on some crypto meant mining or meeting someone physically and paying cash. However, Bitcoin becoming more popular and other cryptocurrencies coming on the scene meant there had to be a simpler and safer way of getting crypto. The old method of one on one wasn’t going to be sustainable anymore.

Cryptocurrency exchanges provide a safer and simpler way to interact with this asset class. If you’re going to buy, trade, or sell a cryptocurrency, it’s almost guaranteed that you will have to use a crypto exchange.

In this explainer, we’ll discover what a cryptocurrency exchange is, what to know before committing to one, and how a crypto exchange works.

What Are Cryptocurrency Exchanges?

Cryptocurrency exchanges are websites where you can exchange one cryptocurrency for another cryptocurrency or fiat currency. The exchange acts as the intermediary between buyers and sellers of various cryptocurrencies.

Crypto exchanges that let you trade professionally – with access to industry trading tools, will require you to fulfill KYC (Know Your Customer) procedures, i.e., submit your identity credentials in order to register with them. But there are also exchanges that let you make the occasional, simple trade (without requiring sophisticated trading tools) without requiring you to open an account.

How Cryptocurrency Exchanges Work

Cryptocurrency exchanges match buyers with sellers. When a trader places an order, they are authorizing the exchange to trade their coins for the best available price.

To transact on a crypto exchange, you must first open an account with the exchange and go through a verification check to authenticate your identity. Once this process is successful, you need to fund this account before you can buy coins.

To fund your account, you will need to deposit cryptocurrency or fiat currency. Different exchanges accept different payment methods for depositing funds. Most exchanges will accept bank wire, debit/credit cards, money orders, etc. Some exchanges may also accept PayPal or even gift cards. For withdrawals, you can use any of the options provided by the exchange, which may include bank transfer, PayPal, check mailing, credit card transfer, bank wire, etc.

You will then place a ‘buy’ order on the exchange, requesting to buy your preferred cryptocurrency at any amount below the specified maximum price. When you place an order, the exchange will put this in its ‘order book.’ An order book is a list containing all outstanding orders from traders who either want to sell or buy crypto.

The exchange seeks to find matching offers for traders. For example, let’s say you want to sell one BTC at no less than $11,000. The exchange will try matching you with a buyer who’s willing to spend that money for that amount of crypto. If they find one, the sale happens. If no prices match that amount, no transaction takes place.

Makers and Takers

Cryptocurrency exchanges usually designate traders as either makers or takers. Makers and takers are also provided with different trading fee structures. Maker fees are generally lower than taker fees. This is because a maker order is not executed right away, and this contributes to liquidity for the market – which is what any exchange wants. By contrast, a taker ‘consumes’ liquidity’ by placing a market order that immediately gets filled, hence the higher fees.

Types of Crypto Exchanges

There are four types of exchanges and which are explained below.

1. ‘’Traditional’’ Cryptocurrency Exchanges – these exchanges are akin to the traditional stock exchanges. Traders can exchange crypto based on the prevailing market price. These exchanges usually charge a fee for each transaction. Some traditional crypto exchanges allow only crypto to crypto exchanges, while others allow for crypto to fiat exchange. Coinbase Pro is an example of a traditional crypto exchange, as is Kraken.

2. Cryptocurrency Brokers – these are online exchanges that allow traders to buy and sell crypto at a price determined by the broker. The transaction is thus between the buyer and seller and the broker, and not between buyer and seller. If you’re a new crypto trader, this is a favorable option because it’s easy to use, and the broker handles the transaction for you. However, you’ll pay a slightly higher price than the traditional crypto exchange. Coinbase and Shapeshift are examples of this exchange.

3. Direct Trading Platforms – these exchanges offer direct peer-to-peer trading where people across the world can exchange crypto with each other. These platforms do not have a fixed market price; instead, buyers and sellers settle on a price. AirSwap and LocalBitcoins.com are examples of this exchange.

4. Cryptocurrency Funds – these are pools of professionally managed cryptocurrency assets that allow you to purchase and hold crypto via the fund. These funds allow you to invest in crypto without having to store it directly. Cryptocurrency funds are usually for investment purposes only. Grayscale Bitcoin Trust is an example of such a fund.

What Is A Decentralized Cryptocurrency Exchange?

A decentralized cryptocurrency exchange (DEx) is an exchange that operates without any governing authority. That means that the platform is run on a blockchain where traders can buy/sell on a peer-to-peer basis. Since it operates on a blockchain, a DEx does not hold any assets, user info, etc.

A DEx uses smart contracts to generate ‘proxy tokens,’ which are used instead of an asset- and this proxy token is used as the base for trades by users.

What to Look For In an Exchange

Before choosing your ideal crypto exchange, it will help to do a little research. Here are some aspects you should consider:

☑️ Reputation – it’s important to find out what other people say about an exchange. Look at reviews and ask questions on forums like BitcoinTalk, Quora, Reddit, and so on. Also, look at what reviews by reputable industry websites have to say.

☑️ Fees – before signing up for any exchange, be sure to look through the website and understand their deposit, transaction, and withdrawal fees. Different sites have varying fees.

☑️ Payment methods – check the payment options offered by the website. Is it a debit/credit card? Bank wire? PayPal? If an exchange has many options for payment, the better for you. Bear in mind that buying crypto with a credit card requires identity clarification and is slightly expensive because it’s prone to fraud, and it has higher processing fees. Also, buying crypto via bank wire will take longer than other options because it takes time for banks to process.

☑️ Verification requirements – the majority of the big names in crypto exchange will require some proof of identity before you make deposits and withdrawals. Other exchanges might allow you to remain anonymous. Just remember verification might be necessary to protect the exchange against scams – which comes down to protecting you and your holdings as well.

☑️ Geographical restrictions – some exchanges will exclude certain countries from their entire platform, while others will only restrict some services. You want an exchange that offers full access to all user functions and tools that you need in an exchange.

☑️ Exchange rate – exchange rates can differ substantially from one exchange to another. You can save a lot if you do a little homework before settling for any particular exchange. That said, expect rates to fluctuate up to 10% or higher, sometimes.

Conclusion

Cryptocurrency exchanges allow us to interact with crypto securely. Picking the crypto that matches your specific needs can be a daunting process. Remember to look at things such as fees, payment options, country-specific services, and reputation, etc. before settling for an exchange. Bear in mind too that you’re not limited to using only one crypto exchange.