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Cryptocurrency exchange guide
How do crypto exchanges work? We explore the behind the scenes processes at play.

How do crypto exchanges work? We explore the behind the scenes processes at play.

Quick take:

  • Crypto exchanges are online platforms that facilitate the buying, selling, and trading of cryptocurrencies through efficient order matching.
  • Advanced trading options like margin trading carry risks but allow more sophisticated trading strategies.
  • Exchanges offer secure storage options like offline cold wallets and custody services to safeguard assets.
  • Various fees apply for transactions and use of exchange services, though incentives like referral programs aim to attract users.
  • Ample liquidity, compliant operations, and robust security measures characterize the leading crypto exchanges.

Since the boom in 2021 everyone knows about crypto.

But few understand how crypto exchanges actually work.

At a basic level, it's quite simple. Youy give the exchange your money (or a particular type of cryptocurrency) and they help you exchange it for crypto.

Simple, right? You give X, you get an equal measure of Y back.

While this is true, it doesn't explain how the platforms actually work behind the scenes. Let's take a look at what's going on in the areas you don't see so you know exactly what's happening with your money.

Matching buyers and sellers

One of the core functions of a crypto exchange is efficiently matching buyers and sellers to execute trades. Exchanges accomplish this using order books and automated matching systems.

Order Books

The order book is like a ledger that shows all outstanding orders for a particular currency pair, organized by price level. For example, the Bitcoin/USD order book would show a list of all open BTC/USD orders on the exchange.

The order book displays bid prices on the left side - indicating how much buyers are willing to pay. The right side shows ask prices that sellers are willing to accept. Orders are matched when a buy order price matches a sell order price.

Order Types

Exchanges offer different order types to provide traders flexibility. Common order types include:

  • Market Order - Buys or sells crypto at the best current market price. Fast execution but no price control.
  • Limit Order - Sets a defined price to buy or sell. The order only executes at that set limit price or better.
  • Stop-Loss Order - Triggers a market order when a specified price level is reached, to cut losses.

Automated Matching

Exchanges use automated matching engines to facilitate trades. The engine uses an algorithm to match compatible orders in the order book.

It scans for matches, prioritizing orders by price and then time entered. When an opposite order is found, it quickly executes the trade at the market price.

The order matching system allows exchanges to rapidly execute a high volume of trades, providing an efficient platform for buyers and sellers. The exchange credits the accounts of the users involved and the crypto is transferred between them.

Speaking of executing trades, let's dive in a little deeper.

Executing Trades

Once an order match is found on the exchange, the trade can be executed. This involves settling the trade and transferring the assets between the buyer and seller.

Trade Settlement

When a buy and sell order are matched, the trade is automatically executed at the market price. The exchange acts as an intermediary to facilitate the transfer.

The amount of cryptocurrency being sold will be deducted from the seller's account on the exchange. The buyer's account will be credited with the cryptocurrency they are purchasing. Fiat currency can also be transferred if crypto is being traded for fiat money.

This settlement happens rapidly, usually in milliseconds. The speed allows high trading volumes to be processed on exchanges.

Leverage and Margin Trading

Some crypto exchanges offer leverage and margin trading options.

Leverage allows traders to open much larger positions than their capital otherwise allows by borrowing funds from the exchange. For example, 50x leverage means a trader can open a position 50 times higher than their account balance.

Margin trading enables traders to access leverage using deposited funds as collateral. By borrowing from the exchange against this collateral, larger trades can be placed. However, leverage also amplifies losses if the trade moves against the trader.

Offering leverage and margin provides more advanced trading options. However, these come with increased risk, so exchanges need to actively manage risk exposure.

This is the core function of a crypto exchange explained.

However, there's another key element you need to kow about, and that is incredibly important considering the value of what a lot of people store within the crypto world.

Storing Assets

Crypto exchanges provide users with secure storage options to hold cryptocurrency assets after purchasing. The main methods are online wallets, private keys, and custody services.

Online Wallets

Most exchanges offer free online wallet services to easily store crypto. The exchange essentially acts as a custodian, holding users' private keys on their behalf. Funds are accessible on the platform interface.

While convenient, assets stored on an exchange are technically controlled by the exchange. This introduces counterparty risk, where users must trust exchanges to manage funds properly.

There are pros and cons to this.

Some exchanges, like Binance, include security within their offering. If your funds are lost due to the fault of Binance, you get refunded some of your funds.

Binance SAFU fund information

However, many people aren't a fan of storing their assets on an exchange. A lot of crypto users are big fansd of self custody - basically owning the full control to their funds. For this, they store the private keys to their wallets themselves.

Private Keys and seed phrases

For direct control, users can withdraw to external crypto wallets using private keys. A private key is like a password that proves ownership of coins on the blockchain.

Withdrawing transfers crypto to the user's external wallet address, which they control via their private key. However, this removes the convenience of accessing funds on the exchange interface.

The other element crypto wallets have is a seed phrase. Seed phrases give you access to the contents of a wallet.

Some of the wallets will give you a digital copy of your seed phrase. You need to make a note of them and keep it safe as it will give anyone who has it access to your crypto wallet.

Some, like the Ledger brand of crypto wallets, give you a piece of paper to store it on. This reduces the chance of losing it to hacks, but is far less convenient.

Ledger's paper private key

You can read more about this in the guide on crypto wallets.

Custody Services

Exchanges are expanding institutional-grade custody and storage options for large investors. These customized services provide secure cold storage, insurance protections, and offline asset management.

Custody caters to institutions like hedge funds that must store substantial crypto assets. By outsourcing storage to exchanges' robust custody infrastructure, funds reduce security risks.

Crypto Exchanges' Fees and Incentives

We have a full section explaining how crypto exchanges make money over here. However, I'll cover the basics in this article.

Crypto exchanges generate revenue through various fees charged to users. Understanding the fee structure helps traders minimize costs. Exchanges also offer incentives to attract users.

Trading Fees

Exchanges charge trading fees as a percentage of the total trade value.

Fees typically range from 0.1% to 0.5% per transaction. Part goes to the exchange, while some covers network costs needed to facilitate the trade.

For the high volume traders, the exchanges often offer a lower rate to keep them trading ont heir platform.

Maker and taker fee models charge less for providing liquidity via limit orders. Exchanges compete on trading fee pricing models as they all want to attract the high volume traders. Why? because they take a cut of the trades as the trading fee.

Withdrawal and Deposit Fees

Most exchanges impose minor fees to deposit crypto or fiat currency. This covers the processing costs and also helps increase profits for the exchange.

Withdrawing crypto off the exchange also has a transaction fee to send assets to an external address. Withdrawal fees depend on the cryptocurrency, with Bitcoin usually the highest.They also depend on the network being used, and the number of trades going through at that poinmt.

Often referred to as Gas fees, if there's a lot of traffic on the network, the gas fees can be a lot higher. It's why a lot of people try to time their withdrawals for when gas fees are lowest (usually early AM US time)

A graph showing gas fees for the Ethereum network
Gas fees for Ethereum

Referral Programs

To incentivize new sign-ups, exchanges offer referral programs. Users can earn a kickback bonus for getting friends or affiliates to open accounts. This promotes organic user growth for exchanges.

You'll also find a lot of the links in articles, guides, and websites like this one will be "affiliate" links. This basically means the website referring users gets a % of the trading fee for referring new people to the exchange.

Other promotions like trading competitions, staking rewards, and discounted fees give users incentives to try out exchanges. Fee discounts and rewards give users more value from the platform.

Liquidity and Price Discovery

Liquidity refers to the ability to buy and sell an asset quickly without dramatically impacting the price. Liquid markets are characterized by high trading volumes and tight bid-ask spreads. Crypto exchange liquidity plays a vital role in efficient markets and price discovery.

The Importance of Liquidity

A liquid market means transactions can flow freely with less slippage. Slippage is when the executed price moves unfavorably from the expected price. Lower liquidity leads to greater slippage due to the wider spread between bid and ask prices.

Exchanges with substantial liquidity for a crypto pair allow investors to seamlessly enter and exit positions. This provides stability and confidence in the market. Traders can trade fluidly without worrying about significant price fluctuations from their transactions.

Contributing to Price Discovery

Price discovery refers to the process of determining an asset's price based on supply and demand dynamics. Exchanges contribute significantly to price discovery in crypto markets.

The trading activity occurring on exchanges directly influences an asset's price based on order flow. Higher demand bids up the price, while more selling supply drives it down.

The aggregated order book depth and transaction volumes on leading exchanges are key inputs into price discovery. This makes crypto prices on exchanges the dominant reference prices for other crypto businesses.

In summary, ample liquidity and active trading on exchanges are integral to efficient crypto market dynamics and price transparency.

Crypto Exchange Security and Compliance

Given the billions of dollars traded, security is paramount for crypto exchanges. Robust measures safeguard user assets and data. Exchanges must also comply with regulations for consumer protection.

Security Measures

Leading exchanges incorporate strong security including:

  • Cold storage - Keeping majority of funds offline in hardware wallets to minimize hacking risks.
  • Encryption - Encrypting sensitive data like private keys using cryptography to prevent unauthorized access.
  • 2-Factor Authentication - Requiring a second form of verification, like a text code, for users logging in. Adds security.
  • Security audits - Independent audits to identify and fix vulnerabilities proactively.
  • Bug bounty programs - Rewarding white hat hackers for finding and reporting bugs.
Binance's 2FA page and options
An example of 2FA methods employed by Binance

Insurance Protection

Some exchanges take out insurance policies that cover a portion of user funds in cases of hacking or theft, providing an added protection layer.

As mentioned before, there are certain exchanges that have their own policies and setups (Binance's SAFU fund). Others use third party insurers that are financial authority approved.

Some users, however, prefer to set up their own crypto insurance.

Regulatory Compliance

To operate legally, exchanges must comply with relevant regulations. This generally falls into 2 buckets.

You have the first bucket which is all around the customer insight. Exchanges have to know who their customers are so that any bad actors can be tracked down. it kinda goes against a lot of the Web3 "own your data" beliefs, but unfortunately for centralised exchanges it's a must.

Decentralised exchanges don't have this requirement which is both a benefit and a downfall.

  • KYC - Know Your Customer rules require exchanges verify users' identities by collecting personal documents.

The other side of it is to do with authority and regulatory needs. This is ensuring they have the right licenses to operate in different territories, and also that they're doing what they can to prevent bad actors.

  • AML - Anti-money laundering regulations require exchanges monitor and report suspicious trading activity. Helps avoid illicit activity.
  • Licensing - Proper business licenses and registrations must be obtained in the jurisdictions exchanges operate in.

Summing up

So, that's the basics of the ins and outs of how crypto exchanges actually work.

You should know understand, at the very least, the basics of what's happening behind the scenes and understand why certain thigs like KYC are required.

If you want to continue your learning, keep reading the guide.

Other articles in this blockchain guide series