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December 18, 2023

Decoding the Basics: How Do Crypto Exchanges Work Explained Simply

Amidst the buzz of the cryptocurrency market, understanding the mechanics of crypto exchanges is instrumental in navigating this dynamic digital landscape. From facilitating the trading of digital currencies to safeguarding assets, crypto exchanges play an essential role in the crypto economy. Let’s demystify “how do crypto exchanges work” and dive into the world of centralized and decentralized exchanges.

crypto ecosystem

Understanding Crypto Exchanges: Centralized and Decentralized

Crypto exchanges, the digital marketplaces for trading digital currencies such as cryptocurrencies, come in various shapes and sizes. At their core, they’re platforms designed to enable buying, selling, and trading digital assets. These exchanges can broadly be categorized into centralized and decentralized cryptocurrency exchanges, each with unique features and functions.

Centralized exchanges, or CEXs, act as intermediaries between buyers and sellers, earning revenue through transaction fees. They offer a user-friendly interface, allowing users to access their accounts, view their digital currency balances, and initiate transactions quickly. However, these advantages have potential risks like exchange failure and fraudulent activity.

Centralized Exchanges (CEX)

Centralized exchanges, also known as centralized exchanges or centralized cryptocurrency exchange platforms, bear similarities with conventional stock exchanges. These CEXs serve as online platforms that enable the purchase, sale, and trading of cryptocurrencies, acting as mediators between buyers and sellers. However, as the control over private keys lies with the exchange, users must trust them to safeguard their funds.

While offering a user-friendly process, centralized exchanges require users to entrust them with their assets and, in turn, charge fees for executing trades. Some well-known exchanges include:

  • Binance
  • Coinbase
  • Kraken
  • Gemini

These digital currency exchanges offer a wide range of services for purchasing and selling cryptocurrencies and trading them against fiat currencies, including the most common fiat currency options.

Decentralized Exchanges (DEX)

Unlike conventional facilitators, decentralized exchanges (DEX) operate differently. They function as a decentralized exchange, working on distributed ledger infrastructure, allowing users to trade cryptocurrencies directly without intermediaries. With enhanced security and asset ownership, DEXs provide an advantageous platform for trading, albeit with reduced liquidity and a requirement for more technical expertise. They are often used in crypto gambling.

DEXs (Decentralized Exchanges) have several advantages over CEXs (Centralized Exchanges):

  • DEXs allow individuals to trade cryptocurrencies directly, ensuring users maintain control over their assets.
  • DEXs change how a crypto exchange works by removing the need for a central authority.
  • DEXs provide a buffer against market manipulation, safeguarding users from deceptive trading practices.

Trading Mechanics on Crypto Exchanges

Trading on crypto exchanges extends beyond simple buying and selling. It’s a multifaceted procedure involving different order types, where liquidity and trading volume significantly affect market efficiency. Some common order types on crypto exchanges include:

  • Limit orders
  • Market orders
  • Stop orders
  • Stop-limit orders

These order types facilitate seamless trading on crypto exchanges.

The order book system, a tool used by centralized exchanges, arranges and classifies buy and sell orders by the intended purchase or sell price. This system ensures the matching of buyers and sellers based on the most executable price given the desired lot size. The exchange rate of any cryptocurrency is directly influenced by buy and sell orders. This can be tracked in a live order book.

Order Types: Limit and Market Orders

Limit Order and Market Order, the two predominant exchange orders, significantly affect trading mechanics. A limit order is an instruction to the exchange that allows traders to secure a predetermined price for their funds. This enables them to purchase or sell at the desired price. However, it doesn’t guarantee that the order will be fulfilled. It can also be rejected for certain reasons.

A market order is an instruction to the exchange to trade your funds. This means that the asset’s price will be the best available price in the order book. It enables investors to execute their trades promptly at the prevailing market price, making it suitable for traders who wish to buy or sell cryptocurrencies promptly.

Liquidity and Trading Volume

Within crypto exchanges, liquidity refers to the speed at which a cryptocurrency can be bought or sold without drastically altering its value. High liquidity implies the presence of numerous buyers and sellers in the market, leading to narrow bid-ask spreads and minimal price fluctuations.

Trading volume directly impacts the liquidity of crypto exchanges, increasing the ability to buy or sell assets quickly and easily. Higher trading volume leads to higher liquidity, ensuring that orders can be executed at desired prices without significantly influencing the asset’s price.

technical analysis

Revenue Generation for Crypto Exchanges

Similar to any business, crypto exchanges generate income through various means, including:

  • Trading fees: Exchanges charge a fee for executing trades.
  • Withdrawal fees: Fees are applied when users withdraw their funds from the exchange.
  • Issuance of native exchange tokens: Some exchanges have native tokens, which can be used for various purposes and may generate revenue for the exchange.
  • Additional services: Exchanges may offer other services, such as margin trading and staking, which can generate income.

These revenue streams help sustain the operations of crypto exchanges.

While the commission rate for trades on centralized exchanges can be as low as 0.1%, new exchanges may choose to collect listing fees for coins to be listed on their exchange and to facilitate Initial Exchange Offerings (IEOs). These additional income streams, which include crypto exchanges that charge fees, help businesses sustain their operations and grow.

Trading and Withdrawal Fees

Trading fees, typically calculated as a percentage of the transaction amount, and withdrawal fees, which may vary depending on the asset and network conditions, form a significant part of an exchange’s revenue. Depending on the exchange, the fee structure can range from 0.05% to 3% of the transaction volume.

Keep in mind that the transaction value can affect the trading fee. Many exchanges employ tiered pricing, where the fee is adjusted in relation to the transaction value. For instance, a 0.5% fee on a $100 transaction would equate to a payment of 50 cents to the exchange.

Native Exchange Tokens and Other Services

Crypto exchanges also derive substantial revenue from native exchange tokens. These tokens are intended to help build an ecosystem within the exchange, providing fee incentives to holders on their respective exchanges. Notable native exchange tokens include:

  • Binance Coin (BNB)
  • Huobi Token (HT)
  • KuCoin Shares (KCS)
  • OKB
  • Bitfinex Token (UNUS SED LEO)
  • BitMax Token (BTMX)

In addition, exchanges offer margin trading, a process where one borrows funds to increase their position, thereby creating leverage. Exchanges that provide margin trading typically levy additional fees based on the amount borrowed and an interest rate.

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