All cryptocurrencies exist in the digital realm and cannot be transferred into the real world without some external help from third-party sources. The blockchain is an immutable register of information, meaning that all the data on transactions stored within it will remain there, and the funds locked within will also remain digital, available for being used as a means of payment for a variety of goods and services within the digital domain.
Such a state of affairs may be lauded by the adherents of complete decentralization and cryptography, who are seeking to do away with all the mucking about in between the participants of the traditional financial system. However, the vast majority of online users, or netizens, be they crypto enthusiasts or not, still live in the real world and have to deal with participants of the traditional economy – banks, shops, public services.
All of the aforementioned economic constituents are still reliant on fiat funds and very seldom accept cryptocurrencies as legal tender. This means that there has to be a gateway, or an off-ramp for cryptocurrencies to be converted into fiat funds for them to be used in the real world.
This is where a slew of mythical monikers steps in – Gemini, Kraken, Coinbase, Binance, CoinEgg, and a host of others – cryptocurrency exchanges that act as gateways between the world of cryptocurrencies and the real world.
What Is a Crypto Exchange?
All crypto exchanges take root from the original cryptocurrency exchange – Bitcoinmarket.com, which was founded back in 2010. Though now defunct, the crypto exchange gave rise to the idea and consequent development of a platform for exchanging cryptocurrencies for one another, and for fiat, subsequently. Mt. Gox followed with dozens of other types and kinds of crypto exchanges.
The basic idea of a crypto exchange is a mirror reflection of its traditional economic counterpart – a platform where buyers and sellers come together and exchange the assets they have on hand either for other types of cryptocurrencies, or for fiat.
Anyone willing to exchange a digital currency has to go to a crypto exchange and open an account to have access to its functions. The basic functions any exchange offers include – buying, selling, converting, and exchanging digital assets either for other types of digital assets, or for fiat. As a rule, all crypto exchanges exact a fee, or commission for their services, some more than others. Most crypto exchanges offer a variety of add-on services for turning themselves into all-in-one, go-to solutions to satisfy the growing needs of their customers.
Apart from acting as trading platforms for crypto assets and providing the necessary gateways for converting cryptocurrencies into fiat for subsequent withdrawal to bank cards, accounts, or e-wallets, crypto exchanges also provide educational services. Users seeking knowledge about how to exchange cryptocurrency assets or trade them can always rely on the resources reputable crypto exchanges provide and delve into a vast ocean of information regarding trading strategies, types of assets, and much more.
Types of Crypto Exchanges
There are two major types of cryptocurrency exchanges on the digital assets market – Centralized Exchanges, and Decentralized Exchanges. Both of these types of platforms differ in their underlying technologies, security layers, legality, and other factors.
Centralized Exchanges
The first ever type of exchanges on the market was centralized – meaning that these platforms have a single point of access and control, much like a traditional exchange, such as Wall Street or Nasdaq. Centralized exchanges are usually the first point of contact of a crypto user with the industry, considering that virtually all of the major names on the market are centralized.
The advantages of centralized exchanges are many, and these factors are being used to great effect not only as marketing tools for promoting such platforms, but also as weighty reasons for crypto users to resort to such gateways in their operations.
Pros
- Centralized exchanges are legal, since all of them have to be registered with state authorities and pay taxes for their operation, report to financial authorities, and have the necessary licenses to trade. This makes working on such exchanges legal in itself for users and allows them to avoid persecution in tax matters. In addition, the legal status of a centralized exchange obliges it to refund its users in case it gets hacked and the funds are stolen from its centralized storage.
- The availability of liquidity is the next biggest advantage, since such platforms have been on the market for longer, they are reputable, and attract users with a host of functionality and tradable asset pairs.
- High speeds of transactions are guaranteed on centralized exchanges along with overall better user experience and convenience that make such platforms preferable on the market as gateways.
- High trading volumes on centralized platforms ensure near instant order execution. A handful of these platforms are also responsible for the majority of all crypto market trading volumes.
Cons
- Ironically, the centralized and legal nature of centralized exchanges also means that they are custodial – meaning that user balances and private keys are in the custody of the exchange. Users are not in full control of their assets and may lose them if the exchange is hacked.
- Security is another disadvantage of centralized exchanges precisely due to their centralization, which allows hackers to gain access to it through a single point of access.
- Opacity has also been cited as a con for centralized exchanges, since they contradict the virtues of decentralization and are susceptible to internal manipulation.
Decentralized Exchanges
Decentralized exchanges are considerably more recent developments on the crypto market. They were developed for users who demanded full decentralization, control of their accounts and higher security. However, such boons came at a cost that had to be compensated by the bolstering of functionality and overall value provided by such platforms.
Decentralized exchanges have no single point of entry, they have no centralized authority, and are fully distributed among a slew of computer nodes, making them both impermeable and dubiously legal.
Pros
- Custody is the biggest advantage of decentralized exchanges, since they are non-custodial and users have full control of their accounts and private keys.
- Security is another major advantage, considering that decentralized exchanges are distributed and are not susceptible to internal manipulation, the human error factor, infiltration or hacking.
Cons
- Decentralized exchanges lack legality, since they are not registered anywhere and using them is not regulated anywhere by any authority, allowing the latter to raise questions on a legal basis, if necessary.
- Expensive operation is a considerable drawback of decentralized exchanges, since order cancellation is costly for market makers, who are forced to incessantly update orders and rely on mining limitations.
- Order type limitations are the biggest disadvantage, since stop-loss and many other complicated types of orders are impossible on decentralized exchanges, largely because there are no third parties to rely on.
- Failures in orders are also possible, especially for limit orders, all because blockchains reflect transactions only after the underlying coins are fully mined. This means that users will be attempting to fill the same transaction, being unaware that it has already been mined, leading to network-level failure for all those who followed the first to successfully mine the block.
How To Select a Crypto Exchange
Given the slew of crypto exchanges on the market, users have to be extremely careful when selecting a platform to start trading.
The first factor that has to be considered is accessibility and overall usability, which comes hand in hand with convenience. The interface is the most important instrument to consider and has to be intuitive and uncluttered to allow users to instantly react to dynamic trading conditions.
Security is next, as it is directly related to the safety of user funds. Users must check the platform’s history and security layers, the availability of multi-factor authentication and guarantees of refunds in case of losses resulting from hacks.
The commissions vary from one exchange to the other, meaning users have to analyze which platform offers the best rates. Though the average 1-3% may not seem as much, if the trading volumes involved are high, the end tally will be a considerable sum, resulting in substantial losses from profits gained.
Liquidity and trading volumes on the platform are just as important, since they will have a direct impact on the speed of order fulfillment and the availability of funds on the part of other participants to satisfy market orders. This also relates to the available trading pairs and listings, considering that there are over 10,000 tokens and coins on the market.
Lastly is legality, which is a very important question for all those engaging in trading. Centralized exchanges offer not only accounting, but localized access and license availability, which has a direct impact on the possibility of withdrawing funds to bank accounts without fear of being accused of money-laundering, or the availability of wire-transfers for credit and debit card connections to the exchange’s account.
Interesting related article: “What is Blockchain?“