How do crypto exchanges work?
Crypto exchanges generate billions of dollars in trading volume a day, but what exactly do they do?
For those finding out about cryptocurrencies for the first time, there’s a lot to take in. First you have to understand how Bitcoin, Ethereum and other coins work, discover blockchain’s role in the process, and appreciate why some see this technology as a compelling alternative to fiat currencies.
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But the steep learning curve doesn’t end here. Anyone interested in owning a digital asset for themselves needs to think long and hard about where to buy them securely and for a good price. This is where crypto exchanges come in – and, when browsing the countless trading platforms that have popped up recently, there’s one thing you should bear in mind: they are not all created equal.
Cryptocurrency exchanges: How do they work?
Let’s go back to basics. Crypto exchanges have multiple purposes. First, they can help individuals and businesses convert fiat currencies such as dollars, pounds and euros into cryptocurrencies. These platforms often serve as a bridge between the two economies – and, because fiat is involved, transaction fees and withdrawal charges can be higher than average. Most of the top crypto exchanges will offer “trading pairs” that pair major fiat currencies with mainstream cryptos, such as BTC/USD, ETH/GBP and LTC/EUR. Don’t be disheartened if you are seeking to buy crypto using a local currency such as the Russian rouble or the Hong Kong dollar, as specialist platforms will provide the trading pair you need.
These platforms can also be used for crypto-to-crypto trading, a service which usually commands much lower fees. According to Nomics, a website that aims to provide transparent crypto data, more than 2,240 coins and tokens are actively being traded at the time of writing. Cryptocurrency exchanges don’t tend to offer support for all of these assets. In some cases, you may need to convert your funds into Bitcoin on Exchange A, and then make another trade on Exchange B in order to get the coin you desire.
Many of the largest cryptocurrency exchanges require new users to complete a registration process before they can begin buying and selling coins. The levels of verification do vary – in some cases, confirming an email address will be enough, while others require applicants to upload a photo of their passport. These “know your customer” checks are in order to ensure that crypto businesses comply with anti-money laundering measures.
Top cryptocurrency exchanges: What to look for
A common problem for crypto enthusiasts when comparing exchanges is that each of them promise to be the fastest and cheapest on the market.
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To cut through the noise, it’s worth using a comparison site to find out the going rate for major cryptocurrencies. At a glance, you’ll be able to get up-to-the-minute information on how much each exchange charges in dollars for a single Bitcoin. Alternatively, you can visit the platforms you’re interested in individually, but do bear in mind that BTC prices can jump up and down quite erratically at short notice. The difference between exchange rates on rival websites can be surprising – and in some cases, it’s driven by local demand and their own trading volumes.
Talk of trading volumes brings us to liquidity, another crucial piece of research to complete when browsing crypto exchanges. This describes how quickly a trader can buy or sell their asset in the marketplace. Low levels of liquidity can cause delays in finding a willing partner for a transaction, creating a high risk that an asset will cost more or be worth less when the trade is finally completed.
Security is another concern. Over the past decade, hundreds of millions of dollars’ worth of user funds have been stolen – even from the largest cryptocurrency exchanges – by hackers who were able to circumvent their security measures. These trading platforms often rely on two methods to store coins and tokens. While “cold storage” refers to cryptocurrencies held in wallets that are not connected to the internet, making them harder to access for malicious actors, “hot storage” is connected to the internet. Hot wallets are necessary to deliver liquidity and ensure trades can be completed speedily, but there is a risk of extensive losses if they are not secured adequately.
Last but not least, you’ll want to look for a crypto exchange that is user friendly and easy to navigate. Complicated layouts can often result in mistakes, especially when a trade is being carried out in the heat of the moment. There are exchanges that cater to beginners by offering an interface that takes them through the process of buying crypto step by step, with detailed guides enabling them to learn more. Equally, other platforms are tailored towards experienced users who need to execute trades speedily. To this end, some of these exchanges offer a cryptocurrency API that connects to automated services such as trading bots, which enable coins to be bought and sold as soon as pre-set conditions in strategies are satisfied.
Cutting through the noise can be difficult, as even “impartial” online reviews need to be taken with a pinch of salt. Back in 2014, Mt. Gox was the world’s dominant crypto exchange, handling an estimated 70 per cent of all BTC transactions. A devastating hack saw its users lose 740,000 BTC (worth about $550m at today’s rates) and victims are still struggling to recover their funds. It just goes to show that no platform is too big to fail.
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The largest cryptocurrency exchanges
According to the Nomics network, Bitmex is the world’s biggest crypto exchange in terms of trading volume – and at the time of writing, this stood at $1.3bn in a 24-hour period. Binance was second on $543m, and FTX was third on $116m.
There has been controversy surrounding the rankings of top cryptocurrency exchanges of late, especially considering that a report submitted to the US Securities and Exchange Commission in March 2019 suggested that 95 per cent of reported trading volume on exchanges is fake. The motivation for exaggerating these figures is clear – unscrupulous platforms can make themselves appear to be much bigger than they really are, making it easier to attract unsuspecting new traders.
As a result of this, Nomics has provided transparency ratings for each of the crypto exchanges in its rankings based on the amount of data they provide on past trades. Those with an A+ rating use a cryptocurrency API to share raw trade data instantaneously, meaning they can be vetted and assessed for reliability.
For the cryptocurrency world to prosper – and for newcomers to trust crypto exchanges – such levels of transparency are going to be crucial. One of the biggest hurdles to mainstream adoption has been a lack of confidence in the industry’s integrity, and it could be argued that this is why popping into a supermarket and buying groceries using Bitcoin is nowhere near as common as some once thought.