What Is a Cryptocurrency Exchange?
A cryptocurrency exchange, also referred to as digital currency exchange (DCE), is a business that allows customers to trade cryptocurrencies for other assets, such as fiat money or other digital currencies.
Cryptocurrency exchanges serve as a medium between the process of selling and buying, and make money through the transaction charges.
How Do Crypto Exchanges Work?
Crypto exchanges match buyers with sellers. Similar to a traditional bank account, if you want to trade on most crypto exchanges, you need to register first. Once you have been authenticated after the KYC process, your account is opened and you can transfer funds to digital accounts from the platform. You can then use this platform to make purchases.
Types of Cryptocurrency Exchanges
Below are a few of the different cryptocurrency exchange classifications you may encounter:
- Brokers: A few brokers can act as mediators between cryptocurrency platforms and investors who want to trade their digital assets. Anyone can visit an online broker and buy cryptocurrencies at prices set by the agent. An over-the-counter broker, also known as an OTC desk, is used while executing a large trading order. This move prevents slippage that may occur while placing a market order on an exchange.
- Traditional Crypto Exchanges: These platforms facilitate the trading of digital assets based on daily market updates. Traditional exchanges often charge a transaction fee. While some exchanges deal only in cryptocurrency, others enable users to trade fiat currencies, like the USD, for cryptocurrencies like Bitcoin (BTC). Within this category, there are two types of exchanges, namely centralized and decentralized.
- Centralized Cryptocurrency Exchanges serve as a third-party mediator between a seller and a buyer. Centralized exchanges offer more sustainability since they are owned by a sole company. Nearly 99% of all crypto transactions are made through centralized exchanges.
Some examples of centralized cryptocurrency exchange platforms include:
- Huobi Global
- Decentralized Cryptocurrency Exchanges (DEX) allow users to execute peer-to-peer transactions without the need for a third party or mediator. Due to some of the concerns associated with centralized exchanges, decentralized exchanges are preferred by some investors. A decentralized crypto exchange lacks third-party oversight, is open source, and depends on peer-to-peer (P2P) trading.
Let’s take a look at some of the popular decentralized cryptocurrency exchanges:
- Uniswap (V2)
- 0x Protocol
- Venus Protocol
Advantages of Centralized Cryptocurrency Exchanges
Centralized markets provide new buyers with an amicable environment for trading stocks in cryptocurrencies. Unlike when using crypto wallets and peer-to-peer transfers, which can be complex, consumers of centralized exchanges can log in to their accounts, access their financial statements, and execute payments through several available applications and platforms.
Centralized exchanges offer higher levels of comfort as it offers an extra layer of security and reliability when it comes to transactions and trading.
Disadvantages of Centralized Cryptocurrency Exchanges
Potential Risk of Hacking
Service providers, who own consolidated systems, are responsible for the security of their customers. Big deals usually involve billions of cryptos, which put them at risk of hacking and theft.
Unlike peer-to-peer transactions, centralized platforms often charge high transaction costs for their services and comfort, which can be high when trading in high figures.
Advantages of Decentralized Cryptocurrency Exchanges
Mitigating Hacking Risk
Users of decentralized exchanges do not need to transfer their assets to a third-party mediator, eliminating the risk of a company or organization being hacked.
Preventing Market Manipulation
Due to their nature of enabling the peer-to-peer exchange of cryptocurrencies, decentralized exchanges prevent market manipulation, preventing the users from fake trading and wash trading.
These exchange users do not require their customers to fill out know-your-customer (KYC) forms, providing privacy and anonymity to them.
Disadvantages of Decentralized Cryptocurrency Exchanges
Users of these exchanges must remember the credentials to their crypto wallets, or their assets are likely to be permanently lost and can never be recovered or traced. They require the user to familiarize themselves with the platform and the process.
Lack of Fiat Payments
Decentralized exchanges do not allow fiat currencies to be traded for digital assets, making them less suitable for users that aren’t already holding or trading cryptocurrencies.
Approximately 99% of crypto transactions are carried out by centralized exchanges, which makes them accountable for a majority of the trading volumes. Due to the lack of volume, decentralized exchanges often lack liquidity, and it can be a struggle to find buyers and sellers when trading shares are low.
Choosing a Crypto Exchange
Crypto exchanges, both centralized and decentralized, are relatively new, so it is important to do thorough research before investing in one. As cryptocurrencies are volatile and some crypto exchanges to date have succumbed to hacking, it is a prerequisite to consider a variety of factors before selecting an exchange, including:
- Deposit/withdrawal limits
- Payment methods
- Regional restrictions and regulations
- Verification requirements
It is up to the individual to find the crypto exchange and digital assets that best suit their particular requirements, price range, risk tolerance, and security expectations. It is also important to note that some crypto exchanges are mobile-only, while some require computers, and each has varying levels of security and associated fees.