What is a Crypto Exchange and How Do They Work?

A crypto exchange is a buying and selling platform that allows users to exchange traditional currencies, like the US dollar, for cryptocurrencies. Many exchanges also support crypto-to-crypto exchanges, which allow users to swap to a different cryptocurrency with fewer steps. Crypto exchanges offer an easier way to get started buying or selling crypto assets.

In this guide, we’ll answer the question, “What is a crypto exchange?” in more detail, including summaries of the different types of cryptocurrency exchanges. Let’s start with a general definition and overview.

How Do Crypto Exchanges Work?

As a new investor, a crypto exchange provides a relatively easy way to link a bank account or payment card to buy cryptocurrencies like Bitcoin, Ethereum, or even a growing number of fun-to-trade memecoins. When you decide to sell, you can convert your crypto to cash and withdraw it to your external bank account or card. This is how most centralized exchanges work, although some only support cryptocurrency trades and do not support fiat currency deposits or withdrawals.

Many exchanges also offer simple point-and-click interfaces for buying, selling, or converting cryptocurrencies. Converting refers to swapping one cryptocurrency for another, such as swapping Bitcoin for Ethereum.

Buying crypto using a quick-trade widget is simple: Select a cryptocurrency, an amount to trade, and a funding source. Many also support recurring orders, allowing you to put your buys and sells on autopilot.

These quick-trade widgets use a spread (a markup or discount depending on the trade direction) to lock in price quotes in addition to a trading fee. However, under the hood, you can see the real market mechanics at work by using an advanced trading platform. On an advanced trading platform, trades are filled from an order book, which is a list of open fixed-priced buy and sell orders.

The example below shows the BTC/USD chart alongside the order book. Orders marked in red denote sell orders, whereas green indicates buy orders.

Advanced trading platforms give you more control over your trade and often come with lower overall trading costs. However, they have a somewhat steeper learning curve. You can place limit orders or market orders.

• Limit orders, also known as maker orders, make trading liquidity by using fixed-price buy or sell orders. Limit orders execute when the market reaches the price you set for your order.
• Market orders, also known as taker orders, execute immediately at the market price, taking liquidity provided by maker orders.

Advanced crypto trading platforms provide more transparency. You can see the order book update in real-time as market or limit orders execute and as orders are added or removed from the order book. The price difference between the limit buy orders and limit sell orders in the order book is shown as a spread.

Additionally, advanced trading typically requires that you deposit trading funds beforehand.

Advanced trading is a more cost-effective way to buy or sell, but many beginning traders prefer the simplicity of quick trade widgets. Some move to advanced trading as they gain more knowledge.

Types of Crypto Exchanges

While centralized exchanges like Coinbase and Binance serve as the most common first step for new crypto investors, several types of crypto exchanges exist. In addition to centralized exchanges, decentralized and peer-to-peer marketplaces offer ways to trade. There are also hybrid exchanges that combine the features of centralized and decentralized exchanges.

Centralized Exchanges (CEX)

Centralized exchanges (CEXs) are run by a company. Although traders make their own trading decisions, access may be limited based on location or other criteria. Additionally, fees and policies can change based on decisions made by the exchange management team.

Centralized exchanges like Binance provide a custodial crypto wallet. When you purchase Bitcoin, for example, the exchange holds your Bitcoin for you in a crypto wallet that they control. Typically, you can withdraw to a non-custodial wallet that you control. However, the exchange may pause withdrawals broadly or flag your specific withdrawal, preventing you from accessing your digital assets.

Centralization comes with both pros and cons, the latter of which we’ve already touched upon. Pros include ease-of-access and greater liquidity for trading. Many exchanges also offer a wide range of other services, including futures trading, staking, NFT marketplaces, and automated trading bots.

Coinbase, Binance, Kraken, and MEXC are all leading examples of centralized exchanges. However, these exchanges offer vastly different user experiences and extras. Part of the difference stems from marketing focus. For example, Coinbase caters to newer traders, whereas Binance and MEXC bot offer more advanced trading features.

Decentralized Exchanges (DEX)

By contrast to centralized exchanges, decentralized exchanges are not run by a company. Instead, these platforms use smart contracts and liquidity pools to facilitate trades. Smart contracts are computer programs that run on the blockchain using conditional logic. If this action occurs, then do that.

DEXs use liquidity pools, which are deposited tokens, as trading inventory. An algorithm called an automated market maker (AMM) determines the exchange rate for each token relative to the other tokens in the pool. If the pool price begins to diverge from the market price in the outside world, arbitrage traders keep the pool price close to the market price, often using automated trading bots.

Unlike centralized exchanges, decentralized exchanges do not provide custody for crypto assets. Instead, users connect to the DEX smart contract using a crypto wallet owned by the user. Swaps occur directly from the user’s wallet without ever needing to be deposited. For example, if you want to trade USDC for ETH, you can use Uniswap to make a “swap,” exchanging USDC in your wallet for ETH. In the end, the contract deposits ETH into your crypto wallet.

Several popular decentralized exchanges include Uniswap, PancakeSwap, SushiSwap, and Jupiter (Solana Network). Many consider DEX trading to be more advanced than centralized exchange trading because it requires a knowledge of how crypto wallets work, as well as concepts like slippage, which refers to getting less value than expected from an exchange.

In most cases, DEXs do not use an order book, although several order-book DEXs now exist, including dYDx and Polkadex.

Peer-to-Peer Exchanges (P2P)

Peer-to-peer (P2P) exchanges have a long history but still don’t enjoy the same level of trading volume seen on CEX or DEX platforms. With P2P exchanges, you’re buying from or selling to another person or company. Rather than using an order book or a liquidity pool, P2P trades consist of two traders agreeing on a price for a transaction.

However, P2P exchanges typically still occur on centralized exchanges like Binance, which offers a P2P marketplace with trader ratings. Bisq, an app-powered P2P marketplace, offers another alternative to exchange-hosted P2P exchanges.

In many cases, peer-to-peer trades do not require identity verification, making them popular for privacy-conscious investors.

Hybrid Exchanges

Hybrid exchanges combine some features from centralized and decentralized platforms. When trading, they resemble a centralized exchange, offering order-book spot crypto trades and perhaps some other advanced trading options. They’re also run by a company that makes decisions regarding the trading platform.

However, where these exchanges differ significantly is in control of your crypto after making a trade. Centralized exchanges hold your crypto in a custodial wallet controlled by the exchange. Hybrid exchanges send your crypto to a non-custodial wallet. This step eliminates counterparty risk, such as paused withdrawals or exchange insolvency.

Hybrid exchanges offer a relatively new way to trade. One such exchange called GRVT (pronounced gravity) is in beta testing as of this writing. As these platforms evolve, expect to see additional crossover trading opportunities, including access to decentralized finance (DeFi) smart contracts, while holding your crypto tokens securely in your own wallet.

Key Features of Crypto Exchanges

Despite the differences between the types of crypto exchanges, they share some commonalities. Each type provides trading liquidity, each type uses trading pairs, and all come with trading fees. Let’s explore some of these key traits.

Trading Pairs and Liquidity

Trading pairs refers to trading one asset for another defined asset. For example, many exchanges support the BTC/USDC trading pair. If you want to trade Cardano (ADA) for BTC, you’ll have to find an exchange that supports the pair or sell ADA for an asset supported by a BTC pair, such as USDC. Most centralized exchanges pair smaller cryptocurrencies with USDC, USDT, USD, or — in some cases — BTC. This trading pair strategy lets the market find a consensus on the price for the trading pair.

This simple approach also attracts more trading liquidity. By comparison, pairing two obscure assets wouldn’t attract much trading liquidity, making it more difficult to trade because there would be fewer buyers and sellers for the pair.

Security Features

Crypto exchanges also offer several security features, which differ depending on the type of exchange. Centralized exchanges typically offer two-factor authentication (2FA), which prevents someone without the authentication code from accessing your account remotely. Exchanges like Coinbase store the vast majority of crypto assets using offline cold storage. This step protects user funds from online threats, such as hacks or breaches.

Decentralized exchanges use your crypto wallet to log in, so 2FA is not relevant unless you use a multi-signature wallet or a hardware wallet. Instead, DEXs rely on code audits to confirm the protocol’s security. For example, Certik performed an audit for SushiSwap.

Fees and Transaction Costs

Trading crypto comes at a cost. Various fees range from trading fees to deposit and withdrawal fees. Collectively, these fees eat away at profits, However, fees can vary dramatically from one exchange to another and differ significantly between centralized and decentralized platforms.

Decentralized Exchange Fees

Let’s discuss decentralized exchange fees first. In many cases, you’ll pay 0.25% of the trade amount, which is the fixed rate for decentralized applications (dApps) like Uniswap V2. However, Uniswap V3 supports several fee structures, including fees as high as 1%. The dApp’s routing may direct all or part of your trade to a pool with higher fees if slippage for the transaction is high. In reality, slippage becomes another transaction cost with low-liquidity tokens but can be reduced by trading in smaller amounts.

Additionally, you’ll pay network costs for using the smart contract. Network costs vary based on the demand for the network, smart contract complexity, and the market value of the fuel token used by the network.

Centralized Exchange Fees

Centralized exchanges often have more fees. Let’s examine some of the most common fees.

• Trading Fee: Advanced trading platforms can come with fees as low as 0%. However, on the low end, 0.1% is more common, and some exchanges and brokers charge 1% or more for advanced trades. Expect to pay higher fees for simple-trade widgets.
• Spread Fee: Simple-trade widgets use a spread fee to lock in a price. When buying, you’ll pay more than the market price. When selling, you’ll receive less than the market price.
• Deposit Fee: Deposits made via payment cards can be particularly costly, although exchanges often combine trading fees with the card fee. On average, you might pay 3% to 4% for using a payment card. Bank-funded deposits are often free.
• Withdrawal Fee: Bank withdrawals may be free, although crypto withdrawals require network fees. The amount you pay for crypto network fees may also contain a markup.

Services such as staking also come with fees, although exchanges often quote the after-fee yield, burying the fee deeper in the fine print.

User Interface and Experience

Exchanges like Coinbase and Kraken are known for their user-friendly interfaces. While both platforms offer advanced trading, fewer options make the platforms easy to navigate. Crypto exchanges with more features can become more cluttered, inviting mistakes if you’re not familiar with them.

Look for an exchange that offers the features you need while also providing a clean interface. Many traders may not need advanced features like crypto options or trading bots.

Differences Between Crypto Exchanges & Crypto Wallets

Crypto wallets offer a secure way to store your cryptocurrency. However, some wallets offer more functionality, including the ability to make swaps, top up your balance, or buy a new type of cryptocurrency. This added functionality seems to put some wallets in competition with exchanges, but the mechanics beneath the user interface are quite similar or even shared with existing apps.

For example, a crypto wallet that supports DeFi swaps may use a DEX aggregator to compare swap prices at various decentralized exchanges. Similarly, the Coinbase wallet allows you to buy several popular cryptocurrencies directly from Coinbase without using a separate app.

Crypto Exchange Fees

Trading fees can take a big bite out of profits on some leading crypto exchanges, and the payment method you choose can also add to the cost of trading. Paying with a debit or credit card can cost up to 4% or more.

Generally, the best way to reduce trading fees is to use a direct bank deposit (often free) and advanced trading for your trade. Platforms like Coinbase and Kraken let you choose between simple and advanced trading. Let’s compare some examples using a $100 purchase and bank funding.

These trading fees also apply when selling and are usually calculated as a percentage of the trade amount. Buying $100 of Bitcoin can then selling it without a meaningful gain can cost as much as $10. However, on the low end, you can trade some pairs for as little as $0.20 using limit orders to buy and sell.

Are Crypto Exchanges Safe?

Crypto exchanges have a spotty history, but the industry has come a long way from its Wild-West beginnings. Bitcoin Market, the world’s first crypto exchange, launched in 2010. Shortly thereafter, the Mt. Gox exchange launched, quickly becoming a hub for Bitcoin traders. In 2011, the Mt. Gox exchange was hacked, leading to the loss of 647,000 bitcoins.

However, two leading crypto exchanges emerged in the same year: Coinbase and Kraken, both known for relative safety. More than a decade later, Kraken has never been hacked, although 6,000 Coinbase users were affected by an SMS 2FA hack in 2021. Coinbase also supports authenticator apps, which aren’t vulnerable to sim-swap scams.

While reputable exchanges are generally considered to be safer, the best strategy may be to withdraw your crypto to a non-custodial crypto wallet after trading and secure your account with a passkey or authenticator app.

Legality of Crypto Exchanges

Crypto exchanges are legal in most parts of the world. However, the industry isn’t without legal controversy. In 2023, the US Securities and Exchange Commission (SEC) sued Coinbase, alleging the exchange sold unregistered securities. Later that year, the SEC sued Kraken, using similar charges. While the legal debate continues over which cryptocurrencies may or may not be securities, some exchanges have suspended trading for crypto assets that appear in SEC filings.

Also, in 2023, the US Department of Justice charged Binance and its then-CEO with violations related to the Bank Secrecy Act. The charges centered on allowing US citizens to use the international exchange, potentially leading to money laundering and other risks due to lax standards for identity verification.

So, while crypto exchanges are legal, many have had compliance challenges and several jurisdictional questions are still to be resolved in courts. When choosing a crypto exchange, research the company well and look for platforms with proper licensing, such as a money services business registration.

The Future of Crypto Exchanges

Centralized exchanges have served as a fiat on-ramp to the crypto market. However, other types of exchanges are gaining in popularity and may be the only way to trade specific tokens.

For example, popular memecoins like Pepe and Brett got their start on decentralized exchanges. By the time these tokens reached exchanges, they had already seen considerable market cap growth.

Many traders expect decentralized trading to continue growing, boosted in part by improvements in trading tools, such as liquidity pool management tools and DEX support for limit orders.

However, as much as decentralized exchanges and companion tools have evolved, they still prove to be an expensive way to top-up or fund your crypto wallet. Centralized exchanges are better in this role. Companies like Coinbase are building for both sides of the market, integrating many of the exchange’s features with the Coinbase Wallet app.

Conclusion

Centralized crypto exchanges serve as a fiat on and off-ramp for crypto, allowing users to buy cryptocurrencies with traditional currencies or sell crypto to cash out. Users can also trade one crypto for another. However, decentralized crypto exchanges are also growing in popularity and offer a wider range of tokens, often at ground-floor prices. While more complex to use, decentralized exchanges continue to capture market share.

Whether centralized or decentralized, or even peer-to-peer, crypto exchanges aid in price discovery and offer trading liquidity, without which cryptocurrencies like Bitcoin might still be worth much less.

FAQs

What is the biggest crypto exchange?

Binance is the largest crypto exchange by daily trading volume. However, Kucoin and MEXC offer a wider selection of cryptocurrencies.

Which crypto exchange has no fees?

All crypto exchanges have fees. However, MEXC offers 0% trading fees for some pairs and most exchanges offer discounts for based on trailing 30-day trading volume.

How many cryptocurrency exchanges are there?

Crypto data aggregator CoinMarketCap tracks 251 crypto exchanges for spot trading, although other estimates put the number between 500 and 1,000.

What are the best crypto exchanges for beginners?

Coinbase and Kraken are both well-suited to first time traders. Both exchanges offer a quick-trade widget to making buying or selling easy. However, they also offer advanced trading with comparatively uncluttered interfaces.

What is the most secure crypto exchange?

Kraken has earned the reputation for being the most secure exchange. The exchange has never been hacked and has been in business since 2011. The platform was also among the first to provide proof of reserves, which is a method of proving that the exchange has the cryptocurrency showing in your account.

References

• It’s Bitcoin Pizza Day: The Story Behind $700 Million In BTC Spent on One Dinner (finance.yahoo.com)
• Buy and sell bitcoin for fiat (or other cryptocurrencies) (bisq.network)
• Redesigning Finance (grvt.io)
• What does Coinbase do with my digital assets? (coinbase.com)
• SushiSwap Certik Audit (certik.com)
• Russian Nationals Charged With Hacking One Cryptocurrency Exchange and Illicitly Operating Another (justice.gov)
• In Crypto, Some Trust Is Necessary — and Kraken Is Trustworthy (nasdaq.com)
• Hackers Exploit MFA Flaw to Steal From 6,000 Coinbase Customers (finance.yahoo.com)
• SEC Charges Coinbase for Operating as an Unregistered Securities Exchange, Broker, and Clearing Agency (sec.gov)
• SEC Charges Kraken for Operating as an Unregistered Securities Exchange, Broker, Dealer, and Clearing Agency (sec.gov)
• Binance and CEO Plead Guilty to Federal Charges in $4B Resolution (justice.gov)
• Money Services Business (fincen.gov)