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Crypto currency exchange – Part 1 – Basics

Crypto currency exchanges are becoming more and more popular. That’s little surprise: the greater the number of crypto currencies or tokens in circulation, the more important the ability to freely and efficiently trade individual tokens for another.

As more and more venture capital firms and institutional investors discover the market for digital assets as an interesting investment opportunity, this trend is set to intensify in the future. The Maltese government has also taken up the issue and has established a distinct blockchain license class especially for exchanges.

Gone are the days when crypto-exchanges were merely a pastime for clueless speculators. Crypto-exchanges have become popular trading places and the secondary market for promising tokens of up-and-coming companies.

Reason enough to take a closer look at Crypto-Exchanges. We therefore dedicate ourselves to the topic in a detailed 3-part series of blog articles. And as there are still people who haven’t used such exchanges, we will first deal with the basic functionality and features of Crypto-Exchanges in this first part of the 3-part-series.

Note: The term token and crypto currencies is used synonymously in the articles of this series.

What exactly is a(n) (Crypto) Exchange? And how do they work?

On exchanges, you can trade one good against another. The exchange itself is by exchange fees, i.e. the difference between the selling price (Ask-Price) and the purchase price (Bid-Price), which is also referred to as the Ask-Bid spread or margin. We all know classic stock exchanges, but crypto exchanges are their counterparts in the world of crypto currencies. In other words, crypto currency exchanges are basically nothing more than exchanges on which crypto currencies are traded.

In practice, individual crypto currency exchanges differ depending on which currencies they support. On the one hand, this concerns the question of whether one can trade both Fiat and crypto currencies or only crypto currencies against each other.

Another aspect is that you can’t trade every crypto currency on every exchange. Of course, practically all exchanges support the well-known coins Bitcoin, Ethereum, Ethereum Classic, Ripple and Litecoin. However, this is not the case for many of the emerging crypto currencies, which are also known as “altcoins” (= “alternative coins”).

If you want to buy and trade a relatively new or young Altcoin, you should research the company itself (e.g. in its whitepaper) or Google. There is a high probability that the token can only be traded on a limited number of exchanges.

In order to register with an exchange and buy or invest and trade, you have to go through the bank’s know-your-customer (KYC) process, similar to the opening of a new account with a bank. Under EU law, a financial company must obtain certain minimum information about new users. In this case, you will need to provide first and last name(s), home address, age and date of birth, gender and upload a scan of a photo ID. You will then have to video chat with a customer service representative to prove that you are the person on the photo ID. Once the customer verification is completed, your account is opened and trading can begin (finally!).

What sets Cryptocurrency Exchanges apart?

Cryptocurrency exchanges allow access to many tradable crypto currencies, while it has to be said that not every exchange lists every cryptocurrency. One can deposit Fiat currencies, such as US dollars and euros, and these are then converted into the purchased crypto currency and stored in the respective wallet at the Exchange.

From this wallet it is then possible to trade by buying or selling certain crypto currencies. By accepting future value gains or losses of certain currencies, so-called currency pairs (e.g. BTC/ETH, BTC/XRP etc.) can be traded accordingly in order to achieve returns.

However, the most important role that crypto currency exchanges play is that they represent the secondary market for crypto currencies or tokens. If a company issues a token in the course of its Initial Coin Offering (ICO, sometimes also referred to as “Token Generation Event”), then not all interested parties always get a chance to participate. Or, more commonly, interested investors only learn about the existence of this token after the ICO (damn!).

On a crypto currency exchange, existing token holders can simply sell or “liquidate” their tokens and prospective customers can easily become token holders. Trades can either be executed live at current market prices or can be executed automatically by entering orders when certain price limits have been reached. For example, you could place an order to buy 5 ETH (Ethereum) if the market price of ETH falls below a limit of 180 USD.

You can then sit back and let the exchange, or more precisely its smart contracts do the work. If the hoped-for market development actually occurs and the price falls below the 180 USD mark, the order is executed automatically. The corresponding amount is debited in USD and the 5 ETH is added to  the ETH Wallet at the Exchange.

Central vs. Decentral Crypto Exchanges

There are also differences in the architecture of exchanges: one has to differentiate between central exchanges (CEX) and decentral exchanges (DEX). Since there are proponents and opponents of both models in crypto circles and both have their advantages and disadvantages, these are now examined  in greater detail.

With a central exchange, the entire exchange is operated by a single registered company. The company provides the service via a central server – including support and customer service offered by the same company. Likewise, the central exchange, including the necessary support from banks, ensures that sufficient liquidity is available.

The most important advantages of a central exchange are faster processing of transactions since all transactions are processed by a single node, and a simple and clear user interface, since it was designed to also enable less crypto-affine users to be able to deal with crypto currencies as easily as possible. The central customer support also speaks for central exchanges, which can also work effectively because the entire service is under the control of the company. In addition, users of central exchanges benefit from higher liquidity, which enables rapid execution of buy and sell orders.

At the same time, there are many reasons why crypto enthusiasts in particular are against centralised exchanges and in favour of using decentralised exchanges. An important argument is of a purely economic nature. Because a central exchange must always ensure sufficient liquidity to cover supply and demand peaks, transaction fees are sometimes quite high. Probably the most important argument against central exchanges, however, is security. Because everything here runs and is handled via a central server, the hacking of a single server can cause both the operation of the entire exchange to fail and – even worse for the investor – the wallets in the exchange could be hacked and the funds irrevocably stolen. In addition, the central exchange also contradicts the idea or principle of decentralization, which is important for crypto enthusiasts.

Here is how the central exchange works: Users transfer their respective crypto currency amounts to the Exchange, where the user can access his credit balance via a wallet built into his user account. The wallet itself is thus centrally hosted by the operator of the Exchange.

This is why decentralised exchanges have established themselves as an interesting alternative to “classical” exchanges. As the name suggests, transactions are handled and processed decentrally using Smart Contracts. There is no real intermediary, investors trade directly with each other (peer-to-peer trading), the exchange is only responsible for mediating buyers and sellers.

The biggest advantage from a user perspective is that one never has to transfer or entrust his money to an intermediary with a decentralized exchange – as is usual with central exchanges. Instead, the money is only transferred when a trading partner is mediated, when a trade takes place. The potential loss of money by hacking of an exchange is thus eliminated. In addition, decentralized exchanges have much lower transaction fees due to their simpler structure and lower costs of operation.

This is contrasted above all by lower liquidity, because the exchange itself does not act as a trading partner for order execution, but always has to find another trader first. In addition, the operation of a decentralized exchange is usually more difficult than that of a central exchange due to the variety of functions. Last but not least, only individual crypto currencies can be exchanged for each other, whereas trading against fiat currencies such as USD, EUR or GBP is not possible. Furthermore, the transaction processing is slower, as several nodes are used. In addition, there is of course the risk that one’s own wallet will be hacked and that each user will have to take care of its security himself.

For Ethereum founder Vitalik Buterin, the perceived contradiction between central exchanges and their market power vis-à-vis the blockchain ideals of openness and transparency is so great that in August 2018 he said in an interview that central exchanges should “burn in hell”.

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