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How do cryptocurrency exchanges work?

How do cryptocurrency exchanges work?
Asked by
Dennis Mayer categorie-icon time-icon4 months ago

Sheila Olson
Answered time-icon4 months ago

Once there were several cryptocurrencies other than bitcoin it was inevitable that exchanges would pop up for those cryptocurrencies. Traditional exchanges are subject to many rules and regulations, and began as an open outcry system, but with digital currencies the exchanges have evolved digitally as well.

In the most general sense there are three different types of cryptocurrency exchanges, and they each work in somewhat different ways.

  1. Centralized Cryptocurrency Exchange

    A centralized cryptocurrency exchange works much like the traditional forex exchange. It acts as an intermediary, matching buyers with sellers and charging fees for doing so. In some cases the exchange is the counter-party. These exchanges will operate with fiat currencies, allowing for the exchange of cryptocurrency for USD, EUR, GBP, JPY and others. Centralized exchanges have higher fees and are more vulnerable to hacking. Some of the best known centralized cryptocurrency exchanges are Coinbase, Kraken and the largest crypto-exchange Binance.

  2. Decentralized Cryptocurrency Exchange

    Unsurprising given the decentralized nature of the blockchain, there have been an increasing number of decentralized exchanges (DEXs) sprouting up. These are based on blockchain protocols and do away with the broker/client relationship. Instead they use smart contract technology to match buyers and sellers directly with one another, dispensing with third-party intermediaries. These DEXs do not accept fiat currencies and work strictly with cryptocurrencies. They also have lower fees and are more secure. Some of the most well-known decentralized exchanges and protocols include the Kyber Network, the Bancor Protocol, 0x and EtherDelta.

  3. Peer-to-Peer (P2P) Exchanges

    These exchanges also match individuals directly, but they do so in a bulletin board fashion. Sellers can post the coins they have for sale, and buyers look for matches. Initially these P2P exchanges were meant for local exchange, and the two parties would meet physically to make the exchange. Since then they have added escrow settlement and over a hundred different payment methods, including many that are electronic so that they can be used globally. Because sellers are assuming the risk in the sale the prices on P2P exchanges are often much higher than market prices. The best known and oldest P2P exchange is LocalBitcoins. Others include Paxful and Bitsquare.


What to Expect when Using a Cryptocurrency Exchange

If you’re just getting started, you will almost certainly choose a centralized exchange. This will allow you to buy cryptocurrency using your credit card or a bank account. Once you purchase some Bitcoin or Ethereum you’re free to use it for trading, either on the decentralized exchanges or on a centralized exchange. When you want to cash out to fiat currency, you’ll have to transfer any coins you have back to the centralized exchange (possibly converting them to BTC or ETH prior), where you can sell them for a fiat currency like the USD.

Note that most exchanges, especially centralized exchanges, have limits on how much you can buy and sell during a given time frame (daily, weekly, monthly). You’ll also want to keep fees in mind and understand that all of the centralized exchanges will require personal ID documents from you before they allow you to withdraw, and in some cases before they’ll allow you to make any exchanges.

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