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”.

About Philipp Sauerborn

In 2005, Philipp Sauer­born joined the firm of St. Matthew in Lon­don, one of the lead­ing Ger­man account­ing firms in Eng­land renowned for its exper­tise in cor­po­rate, com­mer­cial and tax law, as a depart­ment head. After three years, he was a part­ner and man­ag­ing direc­tor.
Towards the end of 2011, he decid­ed to move to Mal­ta, where he first worked at inter­na­tion­al law firms and con­sul­tan­cies in an employed and con­sult­ing capac­i­ty. Since the begin­ning of 2013, he has been a senior employ­ee at Dr. Wern­er & Part­ner. Mr. Sauer­born is cur­rent­ly com­plet­ing his ADIT ‑Advanced Diplo­ma in Inter­na­tion­al Tax.

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