A cryptocurrency exchange is a place where swaps can be made for cryptocurrency. The users of an exchange are known as “traders,” and they can either swap between cryptocurrencies or go between fiat currency and cryptocurrency, in either direction.
This means that instead of buying Bitcoin with US dollars directly on Bitcoin’s blockchain, you could allow an exchange like Coinbase to do that for you. From there, you could trade Bitcoin for any other cryptocurrency also listed on that exchange.
While exchanges do create centralized locations of cryptocurrency trading, they are still relatively free of detailed regulation beyond standard crime prevention. Industry enthusiasts are passionate about optimizing exchanges, which explains why so many of them have popped up over the years.
According to Bitcoin.com, there are now more than 500 active cryptocurrency exchanges, with new ones frequently sprouting up. As with any frontier technology, these exchanges have evolved over time—although they all work in the same fundamental way.
How Cryptocurrency Exchanges Work
There are two main types of exchanges: centralized exchanges and decentralized exchanges.
What is a centralized exchange?
The most common type of crypto exchange is a centralized exchange, which involves a trusted third-party that mediates transactions. Transactor funds are deposited temporarily on the exchange, which then carries out the transaction in real-time. Each party involved in a transaction on the exchange relies on it to execute the transaction safely and securely; and since funds are placed on the exchange, transactors are not susceptible to misplacing their wallets or keys.
To buy and sell digital currencies without an exchange, you’d have to open new wallets and manage all of your keys, or the passwords to access and purchase digital assets. Because digital assets don’t all operate on the same blockchain, you’d need to open new wallets for each cryptocurrency you want to trade.
Even worse, without an exchange, you would have to handle each individual transaction on your own every time you wanted to transact between two cryptocurrencies: selling the old crypto, transferring funds, and buying new crypto. All the while, you’d have to manage your keys, track your funds, verify when the transfers are complete, etc.
With a centralized exchange, all of that is done for you. You simply put in an order, declare which funds you are using, and confirm that you want this to be executed. The exchange does all of the management of wallets and transferring of funds for you in the background.
Some of the most popular centralized exchanges include:
Some people argue that there is a potential downside in yielding some control over your wallets to a third party, the exchange, because this might possibly put your funds at additional risk. Many people fear hacks or other similar issues that can arise with any party handling cryptocurrency.
But rather than dismissing exchanges totally, this could simply be another reason to carefully vet a centralized exchange before opening an account with them. What security measures do they have in place? Do they have any history of breaches?
At the end of the day, a centralized exchange can provide a likely safe, convenient way to trade funds—even fiat currency—between different cryptocurrencies, with the specific cryptos available varying based on the exchange.
What is a decentralized exchange?
A decentralized exchange, or DEX, works very closely to a centralized exchange by providing the same environment for swapping between cryptocurrencies or between crypto and fiat currency. The major difference is that a decentralized exchange removes the element of custodial exchange, instead letting the transactors retain direct control over their wallets for the entire duration of the transactions.
The benefit is that at no point do your funds go to a third party. The exchange itself doesn’t manage your wallets or funds directly. Instead, it simply matches those looking to buy with those looking to sell. The funds transfer directly between the two parties’ accounts or wallets.
Some of the most popular decentralized exchanges include:
The range of decentralized exchanges for transactors to choose from is limited compared to the range of centralized exchanges, but they can offer a bit more piece of mind for cautious cryptocurrency holders. DEXes significantly decrease the risk of theft of hacking.
At the same time, in the seemingly unlikely case that theft does occur, it is much more difficult for perpetrators to get caught since DEXes do not participate in “Know Your Customer” (KYC) protocols.
That’s the high-level overview of these exchanges, but they’ve significantly evolved over time. And to truly understand what they are today, we have to also look at where they came from.
How Crypto Exchanges Evolved
Prior to exchanges, cryptos like Bitcoin traded directly. The famous first crypto transaction occurred in 2010, and involved one trader, Laszlo Hanyecz, spending 10,000 Bitcoins to buy two Papa John’s pizzas.
Soon after, peer-to-peer exchanges (P2PX) started popping up, and they are still in existence today. The appeal of a P2PX is that you interact directly with the individual or entity with whom you are transacting, and you release the necessary information to them—not to some third party or group of third parties.
The advantages of using a P2P exchange include:
- Minimal to no fees
- Private and secure, at least because you are not sharing your information with anyone except the one critical for the transaction, i.e. the other party
- Resistance to censorship of transactions – Government interference is not really possible on a P2P platform because there is no central authority running the platform
Some popular P2PX exchanges include:
From there, the first centralized exchanges came to life; the now-infamous Mt. Gox exchange was one of these early exchanges. By 2014, it was the largest fiat-to-crypto exchange, which meant that traders could directly deposit fiat money onto the exchange and trade digital assets.
Mt. Gox’s infamy comes from the fact that it suffered a historic hack. Roughly 6% of the total Bitcoins in the world disappeared during the Mt. Gox hack. And since funds were directly located on the exchange, Mt. Gox lost a lot of people a lot of money—estimated at over $1 billion worth.
This single event is one of the most prominent reasons why some traders continue to steer clear of centralized exchanges.
As a result of the Mt. Gox hack, additional steps have been put in place at these kinds of exchanges including know-your-customer (KYC) and anti-money laundering (AML) compliance practices. But fear of hacks isn’t the only major force behind exchange evolution.
Government regulations and oversight have remained major factors for exchanges to be aware of and proactive in handling. Binance, a huge player in this industry, was formally forced out of China after government crackdowns on exchanges and cryptocurrencies in general. In many ways, this actually backfired against China because Binance continues to trade crypto in China.
The Binance exchange had to formally move to Japan to continue operating in 2017. It has since opened up additional offices elsewhere to reduce the risk of a single government shutting it down. But even mighty giants like Binance are not safe from hacks; in 2019, over $40 million worth of cryptocurrency was stolen from Binance.
Clearly, with hacks of these sizes, the need to both understand and vet any exchange is crucial to safely use them and take full advantage of their benefits to trading cryptos, but this even starts as early as selecting the type of exchange you choose to operate on.
What to Look for in a Cryptocurrency Exchange
Before you even think about opening an account on a crypto exchange, there are a few things you must answer:
- What are your trading goals? If you plan to trade between cryptocurrencies frequently, an exchange might be right. But unless you also plan to frequently deposit or withdraw fiat currencies as part of your trading strategy, you might not need a fiat-to-crypto exchange.
- Do you have specific cryptocurrencies in mind you want to trade? Obviously, if you do, you’ll need to know what trading pairs are on offer from prospective exchanges. Not all exchanges can handle all cryptocurrencies.
- What is your risk tolerance in terms of potential hacks? If you blanched at those above stories about centralized exchanges losing traders’ funds due to hacks, you might want to avoid exchanges altogether, or at least centralized ones which store your funds between transactions.
If after answering those questions, you still want to trade on an exchange, there’s more work to do. You see, with at least 500-plus exchanges available, you have options. Since this is still very much an underregulated industry, those options can vary greatly.
Here are the top five criteria you may want to start with in vetting a potential exchange:
- Security – Obviously, this is the place to start. Googling an exchange and words like “hack” or “fraud” can actually get you quite far in discovering an exchange’s history of breaches. A single breach might not necessarily be a dealbreaker, particularly if you can get any details on what measures were taken to resolve the vulnerabilities.But you should also be aware of where the exchange is geographically located. While cryptocurrencies themselves might not have a central location, centralized exchanges obviously do, and this could affect where transactions are said to occur. Find out what rules and protections an exchange’s home country forces on them and how they must comply.
- Trading Pairs – Opening an account on an exchange that doesn’t let you trade the digital assets you want to trade makes no sense. So, even if the exchange itself checks out as safe and legitimate, make sure you can perform your desired transactions on it.
- Volume – There are some great resources like CoinGecko that can give you clear information on how much of any particular crypto has traded on the various cryptocurrency exchanges over the last 24 hours. This is important because greater volume can mean both faster trades and also better prices.
- Fees – As with everything else in the finance world, you need to keep an eye on whether you will incur a trading fee or any other charges. The fees incurred can vary greatly between different exchanges. Some of the larger exchanges offer discounted fees on more common types of cryptocurrency. Knowing what you want to trade and what kinds of fees others charge can make or break this decision on which trading platform to use.
- User Interface – This might seem extremely low on your priority list, but an easy-to-use and highly-detailed user interface can tell you a lot about the digital currency exchange you’re working with. The more details it provides on each trade, the more peace of mind you’ll have on how your funds are moving around. And if you don’t understand how an exchange works after you’ve spent a bit of time looking at it, you probably shouldn’t be using it at all.
Vetting an exchange is obviously crucial to trading on exchanges. Security is above and beyond the most important feature. As noted above, there should be plenty of readily available security information on most exchanges, providing transparency about their measures and how they interact with your cryptocurrency wallet. If you cannot locate security details, that could be a red flag.
But security can also mean how an exchange handles new accounts and crypto assets. Be aware of what information you are asked when you sign up for a digital currency exchange. Read the details and fine print offered by each crypto trading platform. While many of us might not want to read an Apple “terms of service,” everyone should when it comes to exchanges. Remember, each cryptocurrency exchange platform is still virtually unregulated compared to securities like stocks and bonds, and so what they define will be highly specific to the exchange and not necessarily following any conventional guidelines.
Going forward, the lack of conventional guidelines will likely change. Governments and regulatory bodies around the world have started enforcing rules on exchanges while also learning more about crypto and blockchain. The standards for safety and regulation that each exchange platform must adhere to are rapidly and continuously evolving.
So, if you haven’t yet decided on an exchange, or even if you want to use one at all, keep all of these considerations in mind. Be sure to do your due diligence to find out which exchanges are offering the right fit for you and your desired cryptocurrency transactions.