What is a cryptocurrency exchange and how do they work?

cryptocurrency exchange

The scene:

You’re about to embark on a cryptocurrency journey and are looking to buy your first digital tender.

You’ve done the research and know which tokens tickle your fancy and have decided on the one. Now you’re ready to buy.

Except you’re not. Not yet.

You see, you might have decided what to buy, but you haven’t decided how or where to buy it.

The how and the where are wrapped up in one neat bundle: cryptocurrency exchanges

What is a cryptocurrency exchange?

Cryptocurrency exchanges are like cryptocurrency’s version of a stock exchange; buyers and sellers are offered a platform to trade different assets which with their valued based on the current market prices. Typically, the exchanges offer conventional fiat-to-crypto transactions as well as offering crypto-to-crypto trades. For example, on South-African based exchange Coindirect, a customer can buy Bitcoin with South African Rand or Euro or can trade their Bitcoin for Ripple’s XRP.

What are the types of exchanges?

There are three types of cryptocurrency exchanges:

Trading Platforms Platforms which connect buyers and sellers to one another.

Brokers: Platforms which sell cryptocurrencies at a price set by the broker. These acts similarly to service providers dealing with Forex.

Direct Trading: Platforms which offer direct peer-to-peer trading. This allows users to exchange currencies across the world and the seller and buyer settle on a price.

What are the requirements for cryptocurrency exchanges?

In order to be allowed to exist and operate, a cryptocurrency exchange needs to adhere to the laws of the country. These laws differ from country to country but generally follow regulations related to the protection of the customer.

Two of these are important in most countries:

  • Anti-money laundering (AML) laws; and
  • Know your customer (KYC) laws.

AML laws exist to prevent any illegal activity related to money coming across as legitimate. KYC laws are to ensure that a platform such as an exchange know who they are dealing with; to protect existing customers, the business, and the integrity of a business transaction. This is a little like having a credit score – whereby the banks trust an individual because they have built up credibility.

In order to regulate this, most exchanges ask traders and users to link their account on the platform to their own personal bank account. Firstly, this helps create a place from which fiat currency can be sent and received. Secondly, it helps verify a person’s identity and credibility.

What is a decentralized cryptocurrency exchange?

There are two types of cryptocurrency exchanges: Traditional exchanges and decentralized exchanges.

A decentralized exchange aims to operate without any central governing figure. This means that the platform is run on a blockchain which doesn’t hold any assets, information, or data but allows transactions between users to take place. By using smart contracts, a decentralized exchange generates something called “proxy tokens” which stand in to represent an asset which offers the opportunity of trading between users.

What are the biggest cryptocurrency exchanges?

At the time of writing, the biggest cryptocurrency exchanges in terms of the market cap according to CoinMarketCap are as follows:

  1. LBank
  2. Binance
  3. Bit-Z
  4. BW
  5. OKEx

The cryptocurrency exchanges with the most markets offered by the platform according to CoinMarketCap are as follows:

  1. HitBTC
  2. YoBit
  3. Binance
  4. Huobi Global
  5. KuCoin

What is a custodial service?

Related to a cryptocurrency exchange comes issues of custody. This refers to the retention that a platform has of a customer’s information, such as their private keys or transaction history by means of a balance sheet instead of through the blockchain.

A custodial service allows a trader a quick and cheap service, but it comes at the cost of transparency.

What is a non-custodial service’?

In contrast, a non-custodial service can be offered by a trading platform which does not require users to create an account on their platform. It also does not hold a trader’s cryptocurrency on a balance sheet. This means that there is an additional layer of security involved as well as anonymity. These services allow transactions to take place automatically.

What do I look for in an exchange?

If you had to create a checklist when picking an exchange, there are several aspects you should consider:

  • Credibility: The exchange should be able to display that it is trustworthy
  • Fees and payment: All exchanges have different fees and you need to make sure you know what you are signing up for in terms of fees. Also, make sure you know which methods of payment the exchange offers. This could be methods such as a local bank, credit card or Paypal.
  • Restrictions and regulations: Some countries are friendly towards cryptocurrency while others are not. Before choosing an exchange, make sure it is compliant within your country’s government.

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