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What are cryptocurrency exchanges?

Investors interested in purchasing cryptocurrencies have more than one way to wade into the water – we explore what a cryptocurrency exchange is, the different kinds of exchange, and unpack their strengths and weaknesses.

Written by Bryan Smith Published on

When making the decision to invest in a cryptocurrency, one has several options. Similarly to fiat currencies, one can receive cryptocurrency as payment for services rendered or goods provided, receive it as a gift, participate in an Initial Coin Offering, or, in similar fashion to buying shares in a company, endeavor to purchase it on an exchange or custodial service of one’s choice.

While some traditional online exchanges do now provide easy access to digital currencies, most investors choose to invest through what are colloquially termed cryptocurrency exchanges.

What is a ‘traditional’ cryptocurrency exchange?

Cryptocurrency exchanges usually operate similarly to traditional stock exchanges where buyers and sellers trade based on the current market price of cryptocurrencies. Trading on such platforms typically involve fees, and some allow fiat-to-cryptocurrency trades – meaning that investors can purchase a cryptocurrency such as Bitcoin through their local fiat currency, such as the US Dollar.

Some cryptocurrency exchanges instead utilize Bitcoin as their base currency – meaning that investors must first purchase Bitcoin from another source, and then move that Bitcoin to the relevant exchange to begin trading in other cryptocurrencies.

There are many online exchanges available in different regions around the world that accept a host of different currencies. Typically, cryptocurrency exchanges are regulated by governments and have to adhere to two sets of important requirements called “anti-money laundering (AML)” laws (which prevents the products of criminal activity from appearing as legitimate money) and “know your customer (KYC)” laws, which ensure that traders have to register their identities on services as proof of involvement.

Thus, most fiat-to-cryptocurrency exchanges require traders to link their personal bank account (where fiat currency can be sent from or received) as well as lodge documents that verify their identity before they can trade. Exchanges around the world differ in terms of verification required prior to trading, transaction fees, trading limits, and fiat currencies accepted.

Despite the fact that centralized exchanges can be prone to hacking attempts, manipulation by individuals with oversight, or can be shut down by governments, such services have typically seen a welcome adoption by traders as well as a high trade volume thanks to their ease-of-use.

What is a ‘decentralized’ cryptocurrency exchange?

While cryptocurrencies aim to create a decentralized and peer-to-peer monetary system, traditional cryptocurrency exchanges still rely on a ‘middleman’ to facilitate financial transactions and verify trades.

Subsequently, several decentralized exchanges have emerged over time which aim to leverage blockchain technology in creating a trustless and secure way to exchange cryptocurrencies without the need for a central ‘broker’.

Decentralized exchanges, as their name implies, are not operated by one co-ordinated entity. Instead, decentralized exchanges run on distributed ledger – meaning that a decentralized exchange does not hold customers’ funds or information, and only serves as a matching and routing layer for trade orders.

On a decentralized exchange, trading is completed utilizing smart contracts on cryptocurrency platforms, which at the time of writing typically run on the Ethereum platform. In such cases, Ethereum-compliant tokens are traded trustlessly.

In the same manner in which a ‘traditional’ cryptocurrency exchange can be vulnerable to hacking attempts (and the theft of cryptocurrencies), traders place their faith in smart contracts – which can be similarly manipulated, poorly constructed, or otherwise prone to failure – potentially resulting in a loss of funds.

Newer decentralized exchanges have promulgated the concept of “cross-chain atomic swapping”, which could allow cryptocurrencies on different blockchains to be traded seamlessly. This, however, is still a new concept and has not been widely adopted by a large number of cryptocurrency projects.

While decentralized exchanges may be far less prone to manipulation or hacking attempts than traditional exchanges, their complexity and relative novelty typically mean that such platforms can expect far lower trade volumes when compared to their centralized counterparts.

What is a ‘custodial service’?

The term ‘custodial service’ describes a platform that retains possession of a trader’s purchased cryptocurrency. This typically means that the service retains possession of an investor’s private keys, and track trades through a balance sheet rather than through a blockchain.

Custodial services usually afford investors with the ability to make trades both quickly and cheaply, though such operations come with a lack of transparency and further see an investor sacrifice their ‘control’ over their respective cryptocurrencies.

The benefit of such services usually involve the ability to deposit and withdraw fiat currency, enjoy high trading volumes, and trade with higher limits.

What is a ‘non-custodial service’?

Non-custodial services, as their name implies, are trading platforms that do not require their users to create an account nor do they hold an investor’s cryptocurrency on a balance sheet. Providing a high degree of security and anonymity. Non-custodial services perform trades instantly on their investors’ behalf.

Principally, a non-custodial service creates a separate wallet for each customer and cannot make unilateral transactions, meaning that a customer must type in his password (or use some other hardware-based method) to authorize transactions.

What are peer-to-peer services?

Should you rather not wish to proceed through an online exchange, you can always accept cryptocurrency through what is called a ‘peer-to-peer’ transaction. This involves a buyer providing a seller with fiat currency or other goods, after which the seller sends an allotted amount of bitcoin to the buyer in question.

It is important to note that given the decentralized nature of cryptocurrencies, transactions are not natively refundable. Should you wish to request a refund, you are relying on the goodwill of another party to oblige your request.

Peer-to-peer transactions can take place in a number of different ways. The most conventional method is for a recipient to provide the public key of their cryptocurrency wallet, where a sender then directs an allocation of cryptocurrency to that address. After a waiting period, the transaction will have been “confirmed” and the transfer will reflect in the wallets of both parties and on the Blockchain.

Some services have further emerged to facilitate this transaction, and help secure trust by placing funds in escrow until the transaction has concluded in full.

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Written by

Editor of CoinInsider. Technology journalist, podcaster, photographer and filmmaker. Hodling - BTC, NEO, ETH.@bryansmithsa