What Is A Bitcoin (or Cryptocurrency) Exchange & How Does it Works?
- Is Bitcoin traded on the stock exchange?
This is one of the most asked questions by those who come to cryptosphere for the first time. They confuse stock exchanges for crypto exchanges but let me tell you, both are different.
Of course, from outside it looks like both are the same, but they aren’t.
Stock exchanges, we all know trades stocks, bonds, equities, and derivatives like instruments. They are a platform where buyers and sellers come together to collaborate to buy/sell stocks as per their needs and strategies.
Similarly, cryptocurrency exchange or Bitcoin exchange is a place where crypto traders come together to collaborate and buy/sell various cryptocurrencies like BTC or ETH.
And that’s where the similarities between a stock and crypto exchange end !!
While buying/selling stocks the settlement rights for the trade are not with the stock exchange, but in cryptosphere, cryptocurrency exchanges act as a place to exchange, settle and even keep your cryptocurrencies in custody of the exchange.
Furthermore, because crypto exchanges act as custodians also, they are prone to hacks and cyber attacks more than stock exchanges.
To give you perspective, we have compiled the list of some of the biggest cryptocurrency exchange hacks that have happened so far in the cryptosphere.
Now the question arises when crypto exchanges are different, how do they work? And that’s what we have tried to answer in the next section.
However, we want to clarify that we haven’t run crypto exchanges ourselves, but we do have tried to gather as much as information from our sources to give you the best possible picture of workings of Bitcoin exchanges.
How a Bitcoin or cryptocurrency Exchange Works?
Bitcoin/crypto exchanges work similarly to a barter system where you give one thing and receive another thing in exchange for it.
Here buyers and sellers join the platform to place mostly two types of orders, i.e., limit orders and market orders. And when the conditions are met as per their orders, the trade is executed between the buyer and seller.
Let’s understand this with a hypothetical example:
Imagine, you have 100 bitcoins which you want to sell. You are in a hurry, and you want the money in your bank account ASAP. Bitcoin is trading at $10,000 market price on your exchange. Now since you are in a hurry, you put your bitcoins to sell at $10,000 per BTC, which is the market price too.
Your bitcoins are sold immediately as you have quoted for the market price and this is called market order.
In another scenario, where you are in not so hurry of selling your bitcoins and are anticipating a price appreciation, you decide to put a sell order of your bitcoins at $10,500 per BTC.
Now since the market price is still $10,000 per BTC, your sell order will not get fulfilled immediately and will reflect on the order book of the exchange.
Later, when the market moves and no more orders are offering BTC at $10,100 or $10,200 or $10,400, the buyer will naturally be compelled to buy BTC at $10,500 per BTC.
These types of orders are called limit orders, and they are only responsible for the order books that you see when you log in at exchanges like Binance or Bittrex.
But this order book is very critical and essential part of cryptocurrency exchanges, so let’s take a moment to talk about it also.
Order books are simple, buy and sell orders listed in ascending and descending fashion, respectively. That’s because when you are buying cryptocurrencies, you naturally want to buy at minimal cost and when you sell, you want to sell for the maximum price.
Here is a sneak peek into an order book:
Furthermore, as users, you need to deposit the cryptocurrencies that you want to sell on the addresses provided by different cryptocurrency exchanges. And vice-versa, you should withdraw your cryptocurrencies in your wallet when you have made a successful trade.
When you deposit, your cryptocurrencies goes to the large pool of currencies that the exchange hold in multiple wallets, and when you withdraw the exchange’s software takes care of the accounting in the backend.
However, not to mention some of these cryptocurrencies are also held in hot wallets while the majority of currencies are kept in cold wallets where your private keys are offline.
So that’s how on a high level a cryptocurrency/Bitcoin exchange works from a users perspective
How To Start a Bitcoin/Cryptocurrency Exchange?
To start with, we are not an expert on this topic, but we still can provide you some useful insights that you may use if you want to start your own crypto exchange.
So for starters:
- Decide where do you want to set-up your exchange? In which jurisdiction?
- Find out cryptocurrency laws and crypto exchange laws of that land.
- Hire local lawyers and compliance personnel to adhere to the laws.
- Obtain a license, if required.
- Find out the technology solution provider or develop your team to make the technology (technology mainly includes, web design, matching engine, security practices, user account management, etc.)
- Integrate best security practices and payment processors.
- Go live and do beta testing.
- Start marketing and PR efforts.
- Develop customer support capabilities.
- Maintain legal team for future compliances.
Is Bitcoin/Crypto Exchange Regulated?
Bitcoin and cryptocurrency exchanges are regulated in jurisdictions such as Malta, Japan, USA, UK, Singapore, Hong Kong, etc. But there are even more countries where cryptocurrency exchanges are not regulated, such as India, China, Pakistan, Canada, Russia, etc.
Bitcoin/Crypto Exchange’s Business Model
The business model of cryptocurrency exchanges is pretty straightforward.
They charge both buyers and sellers a small percentage of the fee when they exchange cryptocurrencies on the platform. Mostly exchanges follow the maker and taker model to charge 0.1-1% on the trades made on their exchange.
Exchanges charge this fee for maintaining their platform and for providing liquidity to the buyers and sellers to satisfy their needs of trading cryptocurrencies.
This is mostly the case with order book exchanges, but broker like exchanges may charge higher fees or a fixed fee for providing you liquidity.
On the other hand, when you do fiat to crypto or crypto to fiat exchanges, the charges are usually higher because banks/credit cards typically take a higher fee. So when exchanges accommodate their margins into it, the exchange fee becomes even higher.
But that’s the way things work as of now in the realm of centralized cryptocurrency/Bitcoin exchanges
Conclusion: What Are Bitcoin exchanges & How They Work?
PS: This is how exchanges that maintain order books work, especially the centralized ones. Some classic example of such types of exchange are:
- Coinbase Pro
- Exmo etc…
But there are broker exchanges and centralized exchanges too that we haven’t covered in this article.
To give you a high-level overview, broker exchanges keep an inventory of cryptocurrencies with them, and whenever they get a buy/sell order from a user, the exchange fulfills it from its inventory. Here are some of the best Bitcoin brokers that we have tried so far !!
So in this case you are trading the exchange itself instead of peers on the other side who are interested in buying/selling cryptocurrencies.
On the other hand, some decentralized exchange maintain order books and function in a similar fashion of centralized order books exchanges, and sometimes they allow peer to peer communication mechanism to connect buyers/sellers.
That’s who Bitcoin or cryptocurrency exchanges work, and we hope you find this article informative and worth sharing with your friends.