Cryptocurrency exchanges, are the next big thing. They are the platforms, that enable users of cryptocurrencies, to buy, sell, invest, and amass wealth using various cryptocurrencies. So what are these exchanges? What types are out there? How do they work? Let's get answers to these questions.
After learning all there is about cryptocurrencies, the next thing on the list is finding the right platform, to buy and sell, or invest: whatever the case might be.
And that’s where cryptocurrency exchanges - or crypto exchanges - come in. In fact, just as important as banks are to fiat currencies, so is cryptocurrency exchanges important to cryptocurrencies: they sort of complement each other.
However, unlike CBN and fiat currency, you can't get cryptocurrency without exchanges: they serve as middlemen (sort of) between buyers and sellers.
You're about to get a deep dive into cryptocurrency exchanges, how they work, and some examples you can use.
But first...
Cryptocurrency exchanges are platforms for buying, selling, and investing in cryptocurrencies. They serve as a platform to exchange one coin for another, change a coin for fiat currency, purchase coins for fiat currencies, such as dollar (USD), Euros, and many more. Or for exchanging cryptocurrencies for other digital assets.
The prices quoted for every cryptocurrency listed on various exchanges are a reflection of the extrinsic value of such coin, influenced by market forces, news, and many more.
Some exchanges can be complex to navigate while others are perfect for beginners in the crypto space. As you continue reading, I’ll be giving you some important things to consider, when choosing a cryptocurrency exchange.
Get this:
Cryptocurrency exchanges act the same way as online brokerage platforms, used to trade stocks - but with some minor differences, which cues in my next point…
Crypto exchanges are divided broadly into two: centralized exchanges and decentralized exchanges.
Just as the name implies, centralized exchanges (CEXs) are controlled by a single, central authority, acting as an intermediary between buyers and sellers while decentralized exchanges (or DEXs) have no central authority.
To get a better understanding of centralized exchanges, it’s okay to liken centralized exchanges, to central banks - who have a simliar cenral authority of control.
CEXs are majorly used for trading and swapping digital currencies or cryptocurrencies, for fiat currencies. On the other hand, DEXs are mainly utilized for swapping one digital currency for another.
Also, CEXs retain possession of the private keys of the wallet of all users on their exchange, and all transactions are under their control. But DEXs, rely completely on blockchain technology and have no control, nor demand any identity of the users.
The unique features differentiating CExs from DEXs, births specific advantages and disadvantages.
A major advantage of Centralised exchanges, is the higher functionality they offer.
They offer margin trading, futures trading, trading pairs (as in forex), lending, important data such as charts, and many more, which you’re bound to not find on decentralized exchanges.
Also, most centralized exchanges are dabbling into services that traditional banks offer: wallets, crypto-debit and -credit cards, etc.
Secondly, most centralized exchanges allow fiat transactions, directly from your bank account. You can buy any coin of your choice, using your credit or debit card.
Additionally, some CEXs allow you to sell a cryptocurrency in exchange for fiat currency and withdraw the money directly into your bank account.
Finally, if you’re a newbie, or not too geeky, then centralised exchanges would be easier to navigate.
Centralized exchanges make profits only if several users sign up to their platform. Hence, they optimize massively for user-friendliness.
Now to the not so good side of CExs: the disadvantages.
Ironically, centralized exchanges go against the fundamental reason for the founding of cryptocurrencies: anonymity/privacy.
Before you’re allowed to open an account on their platform, you must fill a KYC (Know-your-customer) form, that contains your name, bank details, government-issued ID, and even your home address.
This is done in an effort to abide by government regulations.
For instance, the European Union 5 Anti Money Laundering Directive (AMLD5), mandates all centralized exchanges to ensure all users fill a KYC (know-your-customer) form. Without doing so, they can’t make withdrawals to their cards or perform large transactions.
A summary of the law staes:
In some cases, hackers have taken advantage of loopholes in these exchanges, to steal customer information and use them for nefarious activities.
A very good example of this was the hack of Mt Gox. It was formerly the largest centralized exchange but had to close down, due to a hack that led to the loss of 850,000 bitcoins.
You can find a comprehensive list of such hacks on self key.
Secondly, centralized exchanges experience server downtimes, especially when there’s increased market volatility, that is, when there’s a significant downward or upward movement in price. Or when there’s an upsurge in trading or withdrawals.
Many cryptocurrency traders, are unable to take advantage of the dip. Or, even worse, they can get liquidated.
Thirdly, centralized exchanges make a profit, mainly through fees they charge for transactions. And these fees are high when compared to transaction fees charged by decentralized exchanges.
Finally, Centralized exchanges are subject to government policies and regulations. Hence, they can be banned or closed down at a moment's notice, by any government authority.
Top on the list is the increased security.
Unlike centralized exchanges which are susceptible to hacks, hacking decentralized exchanges is next to impossible due to their use of a distributed ledger technology (blockchain). Many nodes are in possession of the ledger which eliminates errors and makes any temperance of the ledger, to be evident.
Also, because their source codes are open source, any bug that can result in a hack is spotted and dealt with early.
Secondly, there are no server downtimes.
Decentralized exchanges are operated via communication, between a distributed network of nodes. Hence, there're no downtimes: if one has a problem, the others can cover it.
Also, due to their operation on a distributed ledger technology, decentralized exchanges can’t be shut down by any government or central authority. They operate autonomously.
Hence, any user from any part of the world can perform a transaction on the exchange.
Thirdly, you’re not required to submit personal information, deposit fiat currency, etc. It runs on a permissionless and trustless network, controlled by a protocol - which is simply a computer program on the blockchain. Hence, all trades are anonymous.
Finally, the transaction fees are usually infinitesimal, compared to that of centralized exchanges.
You'll agree with me that everything has a good side and a bad side: Decentralized exchanges are no different.
Decentralized exchanges have a user interface that's difficult to use. It takes someone well-grounded in the cryptosphere, to use such platforms. It’s for this reason that CEXs surpass them in terms of popularity.
Secondly, there’s no room for any transaction, involving fiat currencies. You can only exchange cryptocurrencies and can only pay in cryptocurrencies.
Finally, decentralized exchanges are quite limited in their functionality. They’re limited in the coins they offer financial services and trading activities they support, and the services they render. This is due to their limited trading volume and liquidity.
Many proponents of decentralized echanges, believe that the current disadvantages of decentralized exchanges, are simply obstacles that will be surmounted as the crypto space grows in knowledge, technology, and mainstream adoption. But the future will tell.
In the case of centralized exchanges, it’s pretty straightforward.
They work the same way that stock exchanges work: set price in tandem with buy and sell orders in their order book.
But when it comes to DEXs, it becomes a bit complicated.
Before we go deep into the nuts and bolts, it’s important to understand the meaning of liquidity pools, automated market makers (AMMs) and smart contracts.
Smart contacts are a series of codes residing on the blockchain, that are triggered to perform a specific action/s when some conditions are met. It’s essentially like an if-then loop.
On the other hand, AMMs are the protocols, which make use of smart contracts that power DEXs.
Liquidity pools are a collection of cryptocurrencies, provided by investors - known as liquidity providers - and locked in a smart contract. The Liquidity providers (LP) are incentivised, with a percentage of the profits that come from transaction fees which though small, becomes huge when pooled together from different transactions.
Now, how do these come together, to make DEXs work?
DEXs rely on specific mathematical equations or algorithms, defined in smart contracts, to work and control the prices of each cryptocurrency locked in the liquidity pool, depending on its current supply.
In essence, users of the exchange trade against the liquidity pool instead of a central body.
To get a better understanding, I’ll use an illustration with the Uniswap DEX.
Uniswap uses a mathematical equation known as x*y=k, where x and y are the cryptocurrencies while k is a constant.
Let us say a USDT/BTC liquidity pool has 50 USDT tokens and 50 BTC.
If a trader, called Alice, exchanges 10 USDT tokens in exchange for 5 BTC, the amount of USDT tokens in the pool increases to 60, while the BTC reduces to 45.
Hence, when another trader, Bob, comes to perform an exchange, the AMM would have automatically adjusted the prices of both tokens to reflect the current supply in the chain: USDT tokens would go lower in price, while BTC (which is less in supply) would increase in price. This way, the equation is obeyed.
There are several centralized cryptocurrency exchanges. But I'll only list the top four, with the highest trading volumes.
Binance, is heads above all other cryptocurrency exchanges, in terms of trading volumes, which exceed $23 billion.
The user interface for trading is easy-to-understand and advanced traders have the option of switching to its advanced interface which offers more features such as stop limits, take profits, and many more.
To aid analysis, Binance provides an in-depth chart, details on the lowest and highest amounts over a 24-hour period, and trading volume.
The transaction costs are one of the lowest. And they’re a wide range of cryptocurrencies available on the platform (over 500).
They also have their blockchain network and native cryptocurrency, known as BNB, which currently has a market capitalization of over $6 billion.
Its NFT marketplace is also gaining traction, with a current trading volume of over $5 billion.
In terms of popularity, Coinbase tends to defeat Binance by the nose. Its popularity rose, after launching on Nasdaq, on the fourth of April, 2021. About 50 cryptocurrencies - a tenth of what’s on Binance - are listed on the platform
It has two platforms: the beginner-friendly Coinbase and Coinbase pro for advanced users.
Coinbase has the easiest user interface that can be understood by beginners. However, the transaction fees charged on the default beginner-friendly platform is more than what’s charged on the Coinbase Pro platform.
If you want to learn more about the crypto space, you can do so on their academy program. They incentivize learning, by giving rewards.
On this list, FTX is the most recent, having launched in May 2019 and currently has a trading volume of just over $3 billion dollars.
There are over 130 cryptocurrencies - and counting - listed on the platform. And beginner traders can perform spot trades while advanced traders, can trade futures, options, stocks, and many more.
To receive more rewards, you can buy and stake the native token, FTT.
Kraken was launched during the early days of bitcoin, way back in 2011. Perhaps, its consistency and existence up till this moment, tells a lot about the trustworthiness of the platform.
The range of cryptocurrencies it offers is very large and the fees are low.
However, if you’re still growing in your knowledge of the crypto sphere, the user interface could be overwhelming.
Although the trading volume of DEXs is dwarfed by CEXs, they’re slowly growing in popularity. And it’s highly likely, that they may stand toe to toe with CEXs in the future.
Uniswap is the largest decentralized exchange, with a trading volume of over $3 billion dollars. Its governance token, UNI, has gained popularity and is listed on several exchanges.
It allows for the swapping of several popular tokens, built on the Ethereum blockchain (ERC-20 tokens).
To control price based on available liquidity, it uses an algorithm known as a constant product maker model.
Launched in 2020, Pancakeswap has quickly risen to the second-highest DEX, with a trading volume of over $1 billion.
Built on the Binance Smartchain (BSC), it’s used to swap tokens on the Binance Smartchain.
As expected, the trading fees are low and when withdrawing, they only charge network fees which are meant for the miners who maintain the network.
Cryptocurrencies are slowly becoming mainstream. And cryptocurrency exchanges have a huge role to play in this development.
Whether decentralized exchanges will surpass centeralized exchanges, remains to be seen. But whatever the case may be, they’ll play a key role in the mainstream adoption of cryptocurrencies.
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di Maurizio Delgado
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