This is the first chapter in the series on how exchanges work. You can read part 2 on exchange aggregators, here and part 3 on DEX here.
5 key takeaways
1. Order Execution: Crypto exchanges use order books for recording trades, with liquidity ensured by market makers.
2. Liquidity and Security: The success of exchanges hinges on liquidity and robust security measures, including encryption and cold storage.
3. Regulatory Adherence: Crypto exchanges must comply with regulatory requirements like AML and KYC for safe trading.
4. Hidden Exchange Fees: Additional fees, often undisclosed and misleading practices, can inflate the actual cost of trading on crypto exchanges.
5. Security Risks: Leaving funds on exchanges carries risks like hacking or asset freezing; hence understanding fee structures and security measures is crucial.
Crypto exchanges play a vital role in the world of cryptocurrencies, allowing users to trade digital assets with ease. If you're new to crypto, understanding how these exchanges are built and function is crucial. In this comprehensive guide, we'll explore the inner workings of crypto exchanges, demystifying key components and shedding light on their functionality. Whether you're looking to buy, sell, or trade cryptocurrencies, this article will provide you with a solid foundation to navigate the world of crypto exchanges.
How are crypto exchanges built?
The Foundation: Order Books and Market Makers
At the core of a crypto exchange lies the concept of an order book. Imagine it as a virtual ledger that records all buy and sell orders placed by traders. It displays the current supply and demand for various cryptocurrencies, enabling users to make informed trading decisions. Market makers, individuals or entities, play a pivotal role in maintaining liquidity by continuously placing buy and sell orders. They help ensure that the exchange remains active and accessible to traders.
Order Types: Market and Limit Orders
When trading on a crypto exchange, you'll come across different order types. Market orders are executed instantly at the prevailing market price, allowing users to buy or sell cryptocurrencies immediately. On the other hand, limit orders enable users to specify the desired price at which they want to execute a trade. This gives them more control over the transaction but requires patience until the market reaches the specified price.
Trade Execution and Settlement
Once a buy order and a sell order match in the order book, a trade is executed. The exchange facilitates the transfer of cryptocurrencies from the seller to the buyer, and vice versa. Following the trade, the order book is updated to reflect the new market conditions. It's essential to note that the exchange deducts fees, such as trading fees or transaction fees, from the trade amount.
Ensuring Liquidity and Market Stability
Liquidity is a critical factor in the success of a crypto exchange. Market makers play a crucial role in providing liquidity by continuously placing orders in the order book. Their presence ensures that there is always someone willing to buy or sell cryptocurrencies, improving the overall trading experience and reducing the bid-ask spread.
Security Measures and User Protections
Crypto exchanges prioritise the security of user funds and personal information. They implement robust security measures, such as encryption protocols and two-factor authentication (2FA), to protect against unauthorised access. Additionally, reputable exchanges often employ cold storage systems to store a significant portion of user funds offline, mitigating the risk of hacking or theft.
Regulatory Compliance and KYC Procedures
To operate legally and responsibly, crypto exchanges adhere to regulatory requirements. These include anti-money laundering (AML) and know-your-customer (KYC) procedures. Users are typically required to provide identification documents and other verification information during the registration process. Compliance with regulations helps prevent illicit activities and ensures a safer trading environment.
Understanding fees, hidden costs and risks of crypto exchanges
Understanding the nuances in costs and risks associated with cryptocurrency exchanges is essential for anyone venturing into digital assets. While these platforms offer valuable services, they also present a host of potential issues and less-than-fair practices that can impact users' investment experience. Here's a deeper look into some of these concerns.
Maker vs Taker fees
Taker fees tend to be higher because taker orders diminish liquidity from the market. Conversely, maker fees are typically lower, serving as an incentive for traders to add liquidity to the market, thus making it more appealing for future traders. Market orders generally result in the originator shouldering the taker fees.
If limit orders are not instantly paired with existing orders, they end up in the order book, causing the issuing trader to bear the maker fees. However, if limit orders instantaneously match against existing orders, they deplete liquidity from the market, leading the trader to typically pay taker fees.
Opaque exchange fees
It's important to note that the prices displayed in the order books usually do not reflect the actual price a user receives upon completing a trade. Exchanges often levy an additional fee, which is only displayed after the trade has been executed. This practice can create a degree of uncertainty and potentially erode the profitability of trades.
Furthermore, exchange fees typically scale inversely with trading volumes, meaning larger traders attract lower fees. While this may seem appealing to high-volume traders, it can inadvertently disadvantage small-scale or beginner traders who trade less frequently or in smaller volumes.
Misleading exchange tactics
It's also crucial to be mindful of the price disparities across different exchanges. While it may seem that certain assets are cheaper on one exchange compared to another, the lower cost could be attributed to temporary restrictions on withdrawals. In such scenarios, the true cost of the asset might be misrepresented.
Beware of the common "zero fees" tactic employed by some exchanges. While on the surface this may seem like a lucrative offer, it often implies a hidden spread. Traders may end up paying a worse rate than what's available on the market, which effectively functions as a hidden fee. Unfortunately, this cost isn't declared upfront, leading to unexpected costs for the trader.
While transparency should be a given with any exchange, this isn't always the case. Typically, you can expect transparency when trading via an exchange's web interface. However, some exchanges have been known to add hidden spreads to trades made through their mobile apps, despite claiming zero fees.
Security risks
There are hidden costs associated with leaving funds on an exchange. While it may seem convenient, this practice comes with the risk of losing funds due to a variety of factors such as hacks, exchange bankruptcy, or even the exchange freezing assets without explanation. These risks represent a cost that can be difficult to quantify. On the other hand, depositing and withdrawing funds - a safer practice - also incurs costs that need to be considered.
Conclusion
Understanding the inner workings of crypto exchanges is integral to a successful trading experience. From the basic structure and functionality of exchanges to the potential pitfalls, hidden fees, and unfair practices, awareness and understanding are the trader's best defence. Remember, while these platforms offer an efficient way to trade digital assets, they are not without risks. Thus, it's crucial for traders to scrutinise and understand the exchange's fee structures, security measures, and regulatory compliance. Through diligence and education, traders can minimise risk, safeguard their investments, and make the most out of their crypto journey.
At SwissBorg, we bring transparency to every exchange our community makes, with no hidden fees, and always the best exchange deal for you. Find out more about the SwissBorg Smart Engine here .
