What is a Crypto Exchange?

Last Updated on December 24, 2023 by Kevin Groves

What is a crypto exchange?

The basic function of any asset exchange is to provide a place where buyers and sellers can be matched. For investors and traders looking to access cryptocurrencies, or to trade one crypto token for another, an exchange can facilitate the process.

When a trader goes to a crypto exchange, there are various options available for accessing the cryptocurrency tokens of their choice. Depending on the exchange, a trader might be able to buy a token with fiat currency using a bank transfer or a credit or debit card. Once they have that token, they can exchange the token for another crypto, or they can sell that coin to another buyer in the hopes of getting more than they paid.

A crypto exchange can also facilitate peer-to-peer transactions. For example, there are crypto exchanges that allow parties to directly interact with each other and agree to exchange tokens for goods or services, as well as for other tokens.

How do crypto exchanges work?

At a basic level, crypto exchanges work by matching crypto sellers with buyers. The seller indicates an interest in selling a specific crypto token. The exchange can then use an algorithm to help find a buyer that has placed an order for that token.

There are two basic types of orders on a crypto exchange:

• Limit: This is an order that indicates the desired price for a token. For example, a buyer might buy ether (ETH) at a price of $2,610. They create a limit order that the exchange doesn’t fill until there is a seller that is willing to accept this price. Likewise, a seller can create a limit order that indicates they want to complete a transaction when the exchange finds a buyer willing to pay their desired price.
• Market: On the other hand, a market order is one that is filled immediately, at current market prices. Rather than trying to match a specific price point, a market order is one that is one that is filled at the best price.

Every exchange operates what it calls an “order book.” This is a digital record of all the orders placed on the exchange.

Those who create orders on the exchange — whether they are buying or selling orders — are called market makers. Makers provide liquidity and depth to the exchange. Makers create demand in exchange for various assets.

On the other hand, those who simply place market orders and buy crypto tokens are called takers. In some cases, someone placing a limit order can be considered a taker if their buy order matches a sell order already listed in the order book. For the most part, though, takers are generally those who expect to simply buy a token using a market order for the current best price.

How do crypto exchanges make money?

Crypto exchanges make money by taking a share of fees. Additionally, depending on the exchange, it’s possible to make money on the spread. This is the difference between the price that is asked for and the price that is paid.

Some cryptocurrency exchanges charge flat fees for any trade. There might be other fees as well, depending on the type of payment used. There might also be a combination of flat fees plus a spread, or a small flat fee plus a percentage of the transaction.

Any investor or trader using a crypto exchange should pay attention to the fees. While every exchange charges them, they vary widely. For example, Coinbase is known for charging high fees, while Uniswap is noted for its relatively low fees.

Some exchanges also make money based on fiat deposits and withdrawals. Many exchanges don’t charge deposit fees, but they do exist. Basically, if a trader decides to use a bank transfer, wire, PayPal, card or some other means to add fiat funds to their exchange account, they might be charged a fee for the transactions.

More common than deposit fees, though, are withdrawals. Many exchanges institute fees if a trader wishes to withdraw their crypto funds to a bank account, PayPal account, or some other fiat-based account. There might be a fee levied in the crypto token withdrawn, as well as a minimum. For example, a trader might decide to withdraw bitcoin (BTC) from an exchange. They might pay a fee of 0.0005 BTC and be required to meet a withdrawal minimum of 0.001 BTC. Depending on the exchange, withdrawal fees can change based on the value of the token in question.

The higher the fee — and the more fees there are — the lower the real returns a trader will see.

Centralized vs. decentralized crypto exchanges

When learning about how crypto exchanges work, traders should know the difference between centralized vs. decentralized exchanges.

Centralized crypto exchange

Even though many blockchains operate with the characteristic of having no central authority, some crypto exchanges are centralized. A centralized crypto exchange is one that has custodial authority. When a trader decides to use a centralized exchange, they usually transfer assets to the exchange, where they are kept in an account. In practice, a centralized crypto exchange functions much like a traditional brokerage account for stock trading and investing. The trader places an order and it’s fulfilled, and the exchange is an active intermediary between buyers and sellers.

These assets can be fiat funding for the account or they can be cryptocurrencies transferred from a wallet onto the exchange. Holding assets on the exchange has the advantage of being readily accessible. A trader can execute market orders much easier when the funding is already present on the exchange.

However, some centralized exchanges require more disclosure of personal information. A trader might have to share identity documents and other information in order to use the most desired features of a centralized exchange, or they might have to provide documentation in order to have higher trading limits.

Some of the most popular exchanges, including Binance, Coinbase, Kraken and FTX, are centralized exchanges.

Decentralized crypto exchanges

On the other hand, decentralized crypto exchanges (DEX) don’t have a central authority managing the order flow. While the decentralized exchange can help match buyers and sellers, they aren’t necessarily custodial. Traders on the exchange maintain control of their assets.

In many cases, a decentralized exchange makes use of smart contracts to manage order pricing, liquidity and other aspects of transactions. Additionally, while there’s a basic “order book” idea with a DEX, the latest iteration is what’s known as automated market makers.

Automated market maker protocols are designed to work with liquidity pools, allowing traders to make instant transactions between their wallets. When adding a token to a DEX, like Uniswap, that uses an automated market maker protocol, there must be a pool that maintains a set ratio of tokens involved.

With decentralized exchanges, traders interact directly with each other and takers can buy from those providing liquidity in liquidity pools, or complete direct, peer-to-peer exchanges.

Many decentralized exchanges have a higher level of privacy since personal information isn’t usually collected at the same level as with centralized exchanges. Instead, the main requirement is that traders actually have the asset they are trading. A trader that wants to exchange ETH for SOL simply has to connect their wallet to the exchange and have the necessary ether to complete the exchange for the amount of SOL they want (plus fees).

In addition to Uniswap, other popular examples of decentralized crypto exchanges include SushiSwap, Balancer and PancakeSwap.

Deciding between centralized vs. decentralized crypto exchanges

Once traders understand how crypto exchanges work, they need to decide what is likely to work best for them. It’s also possible to use a combination of centralized and decentralized exchanges, based on their goals and the tokens they’re most interested in.

In general, centralized exchanges have higher fees than decentralized exchanges. However, for beginners, a centralized exchange can sometimes feel easier to use because the interface is similar to a traditional brokerage account. Some beginners are more comfortable starting with a centralized exchange before moving to a decentralized exchange later.

Additionally, decentralized exchanges often offer a wider variety of tokens for trade. However, this can lead to liquidity issues with less popular crypto tokens. Centralized exchanges often have a liquidity requirement to add a listing, while a decentralized exchange can potentially accept almost any token. However, for tokens with low liquidity, it can be difficult to sell the coin if a trader decides they don’t want to hold it anymore.

Decentralized exchanges also offer more potential for earning at a higher rate from crypto. While centralized exchanges offer staking and rewards, they are usually at lower rates. On the other hand, liquidity providers on decentralized exchanges might be able to more effectively participate in yield farming and have access to other methods of earning money, such as lending their crypto to others.

Finally, no matter what type of exchange is used, it’s important to use due diligence when deciding on tokens. A trader might be more susceptible to scam coins on DEXs, though, due to the lower bar for identity verification and the presence of peer-to-peer transactions. Any time a trader or investor looks at an asset or transacts business, it’s important to take steps to review the situation and protect themself.