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What is Crypto Exchange?
A crypto exchange is a platform that allows users to trade cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), and other digital assets. While the crypto exchange definition centers on trading, centralized crypto exchanges, such as Coinbase, also play an important role as a fiat onramp and offramp for cryptocurrencies.
For example, you can use traditional currencies like USD or GBP to buy BTC or other cryptos. Most exchanges also allow users to sell crypto assets for USD or other currencies, sending the proceeds back to their bank or funding account.
A centralized exchange (CEX) run by a company like Coinbase provides a convenient way for people to buy or sell cryptocurrencies using USD or other currencies. However, some exchanges focus on crypto-to-crypto trades. A
nother type of exchange, called a decentralized exchange (DEX), uses automated algorithms to facilitate crypto-to-crypto trades directly from a crypto wallet.
Key Takeaways
- A crypto exchange is a platform for trading cryptocurrencies, allowing users to buy, sell, and swap digital assets.
- Centralized exchanges (CEXs) manage assets through an order book system and hold user funds in custodial wallets.
- Decentralized exchanges (DEXs) use automated algorithms to allow crypto-to-crypto trading directly from users’ wallets.
- Exchanges offer trading pairs (e.g., BTC/USD) and order types, making them flexible for different trading styles.
- Choosing an exchange depends on ease of use, assets available, fees, and security, aligning with user goals and experience.
- For security, assets not needed for trading are best kept in self-custody wallets to reduce exchange risks.
How a Crypto Exchange Works
Most centralized crypto exchanges support fiat currency deposits as well as crypto deposits, giving traders multiple ways to fund their trading accounts.
Many also support simple trades, which allow easy purchases or sales with just a few clicks. However, behind the scenes, a more complex dynamic makes this possible.
A centralized crypto exchange uses an order book to facilitate trades. Traders can place limit orders, which are fixed-price orders to buy or sell a given cryptocurrency. These orders comprise the order book and provide liquidity for the exchange. Many of these fixed-price orders are placed by market makers, which are individuals or firms that acquire a trading inventory to help ensure adequate liquidity.
Most exchanges also support market orders, which buy or sell against the existing limit orders, taking trading liquidity off the exchange. Many exchanges make limit and market orders available through an advanced trading platform that typically also includes customizable crypto charts and additional order settings, such as stop-loss orders.
Crypto exchanges use trading pairs, much like forex currency trading. For example, the exchange may offer a USD/BTC pair, allowing traders to buy BTC with USD or sell BTC for USD. If you buy BTC using a centralized exchange, the exchange will hold your BTC in a custodial crypto wallet controlled by the exchange.
However, you have the option to move your newly purchased crypto to a self-custody crypto wallet that you control. Some traders keep a small balance on their chosen exchange while safeguarding larger balances with a non-custodial wallet.
Types of Crypto Exchanges
While centralized crypto exchanges like Coinbase or Kraken are the most common way to onboard new crypto investors, there are two primary types of exchanges as well as a hybrid version.
In addition, online brokers like eToro function much like an exchange from a user standpoint. Lastly, another type of exchange called a perpetual futures exchange allows derivatives trading, meaning speculation on future crypto prices using leverage. Perpetual exchanges are available both through centralized exchanges and as decentralized applications (dApps).
CEX
A centralized exchange allows users to buy, sell, or trade cryptocurrencies from inventory held on the exchange itself. Typically, centralized exchanges offer 100+ types of cryptocurrencies. Orders are executed using an order book system, as shown below.
DEX
A decentralized exchange uses liquidity pools and automated market maker (AMM) algorithms to allow traders to swap cryptocurrencies, exchanging Crypto A for Crypto B. Decentralized exchanges use smart contracts, which allow trading without a centralized management team. Typically, a DEX offers a wider selection of cryptocurrencies, although limited to tokens supported by a specific blockchain. Trades execute directly from your crypto wallet without a need to transfer funds to the exchange beforehand.
- HEX: A hybrid exchange bridges elements of both a CEX and a DEX, providing centralized trading for most crypto assets while also supporting liquidity pools for specific assets.
CEX: Most CEXs allow purchases with debit cards or deposits through bank-funded transfers. Fiat withdrawals are supported.
DEX: DEXs may offer third-party services to purchase crypto with fiat currencies. Swaps use crypto liquidity pool pairs.
CEX: Trading funds must be held on the exchange but can be withdrawn when trades are completed.
DEX: Users trade by connecting a crypto wallet to the exchange to authorize crypto-to-crypto swaps.
CEX: A CEX has a centralized management team that creates and enforces trading rules.
DEX: A DEX runs according to software rules and allows trading directly from a crypto wallet without using an intermediary.
CEX: Many exchanges are registered or licensed with various regulatory agencies.
DEX: DEXs are unregulated.
CEX: CEX trades are not visible on the blockchain.
DEX: All trades are visible using blockchain explorers.
CEX: Centralized exchanges support cryptocurrencies like BTC that are not natively available on DEXs.
DEX: Tokens are limited to those supported by the blockchain for the DEX. For example, a DEX may only support ERC-20 (Ethereum standard) tokens.
CEX: Advanced trading fees can be well under 1%, although simple trades often cost as much as 5% or more.
DEX: Trading costs typically range from 0.3% to 1, plus gas fees.
Choosing a Crypto Exchange
Which crypto exchange you choose is largely a matter of preference. Some traders prefer an exchange with advanced features, such as OKX or Binance, while others favor a beginner-friendly exchange like Coinbase or Kraken. Other considerations include regulation, selection, fees, reputation, and support.
Location-Based Availability
Your location can also affect which exchanges you can use. For example, many popular crypto exchanges don’t support traders in specific jurisdictions. Often, restricted jurisdictions parallel US-sanctioned countries listed by OFAC.
Following lawsuits from the US Securities and Exchange Commission (SEC) against exchanges like Binance, Kraken, and Coinbase, many crypto exchanges outside the US no longer support trading for US residents. Other jurisdictions around the world, such as Canada and the UK, may face similar restrictions.
Crypto Exchange Safety
Crypto exchanges that enforce Know Your Customer (KYC) requirements store personal identity verification on users, including a copy of a government-issued ID as well as a Social Security Number or equivalent. In addition, centralized exchanges also store crypto and fiat funds on behalf of users.
Both personal data and crypto held on exchanges make tempting targets for hackers. To reduce risk to crypto assets held by the exchange, exchanges typically store most assets in cold storage, a method of storage that stores the private keys for exchange wallets offline.
However, cold storage doesn’t protect against potential insolvency. In 2022, the FTX exchange collapsed, leaving many investors without a way to withdraw funds.
As an option, you can move crypto you don’t need for immediate trades to a self-custody wallet that you control.
Crypto Exchange Pros and Cons
With the recent launch of crypto exchange-traded funds in many countries, investors have multiple ways to gain exposure to crypto markets. However, crypto exchanges bring more direct access to crypto markets, which comes with both pros and cons.
Pros
- Access to the most prominent cryptocurrencies on the market compared to ETFs or crypto-related stocks
- Ability to diversify an investment portfolio beyond traditional investments
- Access to cryptocurrencies that can be deployed in decentralized finance (DeFi) to earn additional yields
Cons
- Centralized exchanges bring storage concerns
- Initial purchase fees can be higher compared to buying a Bitcoin ETF
- Many exchanges are unregulated and not transparent regarding financial strength
The Bottom Line
Centralized crypto exchanges offer a convenient way to buy cryptocurrencies using fiat currencies like the USD or GBP. In addition, users can trade one cryptocurrency for another using supported trading pairs.
Decentralized exchanges are also growing in popularity, giving intermediate and advanced users more trading platforms and access to hard-to-find crypto tokens.
FAQs
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References
- Proof Of Reserves | Full Reserves | Kraken (Kraken)
- Sanctions Programs and Country Information | Office of Foreign Assets Control (Ofac.treasury)
- SEC Files 13 Charges Against Binance Entities and Founder Changpeng Zhao (Sec)
- SEC Charges Kraken for Operating as an Unregistered Securities Exchange, Broker, Dealer, and Clearing Agency (Sec)
- SEC.gov | Media Kit (Sec)
- Why Did FTX Collapse? Here’s What to Know. - The New York Times (Nytimes)
