How Do Bitcoin Exchanges Work

Understanding cryptocurrency trading platforms can be tricky. After all, they can show different asset prices, which only brings more confusion to the already mysterious nature of crypto.

So, how do Bitcoin exchanges work? Keep reading to learn about the key concepts surrounding these platforms.

What Is a Cryptocurrency?

A cryptocurrency is a decentralized digital currency. It operates outside the world of central banking.

This type of money aims to promote the transfer of any asset of value without relying on banks. Cross-border P2P (peer-to-peer) networks power cryptocurrencies. That’s why no single government or corporation can shut them down or control them.

Unlike fiat currencies, cryptos aren’t legal tender. This means you can’t use cryptocurrencies to pay your financial obligations, like tax payments, no matter where you live.

Nevertheless, regulators can’t stop these digital currencies. So far, they’ve only been able to make crypto assets less accessible, tax them, and scare people from using them.

A cryptocurrency can serve as a medium of exchange, a unit of account, and a store of value. There are many different types, and each one has a unique purpose. If you don’t want to use it as primarily intended, you can simply buy some and sell it at a profit.

Fundamentally practical or not, any crypto can be an investment vehicle. It can grow in value and build your wealth passively as its demand increases. But remember, the prices of cryptocurrencies can drop significantly too. Like any other speculative assets, the valuations of Bitcoin and altcoins can undergo extreme swings.

What Is a Bitcoin Exchange?

Bitcoin exchanges (or cryptocurrency exchanges) are online marketplaces where traders can buy and sell BTC and other crypto assets.

In other words, these platforms are matchmakers for traders. They’re not connected, so each of them is a mini-market of crypto.

Technically, exchanges don’t set prices; the market participants do. The valuations of cryptocurrencies vary from one platform to another. They’re all correct, for the law of supply and demand applies to all marketplaces.

Unlike traditional trading platforms, these digital currency exchanges are global. They’re active 24/7. And therefore, Bitcoin and altcoin valuations can significantly change around the clock.

You may experience some information overload when using a dollar-to-Bitcoin exchange for the first time. To help you navigate them, we’ve laid out the basics below.

Liquidity

Liquidity measures your ability to buy or sell a cryptocurrency at an exact price. The more liquid a marketplace is, the easier it is to find other investors to trade with. Therefore, liquidity can illustrate demand.

The above definition generally refers to exchange liquidity. Cryptocurrency liquidity is different, for it applies to the ease of converting a particular asset into another crypto or cash.

Typically, the most liquid crypto assets experience the least price volatility. However, they can be attractive to market participants to create large orders. These players can influence valuations better than average traders.

Dozens of marketplaces make up the crypto space, so trades are naturally divided. If all crypto investors used just one virtual currency exchange, the whole market would be much more liquid.

Slippage

Slippage occurs when you have to accept a different price than what you want. It could happen when there isn’t enough liquidity in your chosen Bitcoin to dollar exchange. While it isn’t unique to crypto markets, cryptocurrency traders experience it more often than their stock and forex counterparts.

Moreover, slippage can be a good thing. If you find another party willing to fulfill your order at a better price, you’ll come up ahead on the deal.

Trading Volumes

These figures represent the sum of all executed trades within a specific period.

Inexperienced crypto investors often confuse volume with liquidity, but the two are different. Both are good factors to consider when planning your orders. But high volumes don’t necessarily mean high liquidity.

Digital currency exchanges that record-high trading volumes tend to have high liquidity, though. That’s because high volume usually attracts more traders, which may lower the chances of slippage.

Not all trading volumes are available to the public, however. Usually, large trades happen over the counter (OTC). So, considerable sums of cryptos can change hands out of the public eye. High net-worth investors generally take this route.

Some electronic currency exchanging solutions like Kraken also provide one-on-one services for high-volume traders. These market participants may choose to acquire or unload many assets privately to avoid affecting crypto prices.

Unfortunately, OTC crypto trades aren’t always in the spotlight. That’s why most beginners rely only on data from exchanges when assessing the market.

So, what is a Bitcoin exchange useful for if it can’t paint an accurate picture of the demand? These platforms can reveal whether certain cryptos are overpriced or underpriced.

Of course, you must know about the movement of cryptos between wallets over certain periods. Such information can come from blockchain intelligence providers. Without it, you can’t make a proper analysis.

Trading Pairs

Before joining a blockchain currency exchange, you should know about trading pairs. They can help you assess the value of crypto assets against other crypto or fiat currencies.

A trading pair is made up of two ticker symbols. An example of a trading pair is ETH/BTC. The first one is the base currency (the one you want to buy), and the second is the quote currency (the one you want to sell). In this example, the trading pair shows the price of Ether relative to Bitcoin. If you agree with the value, you can trade your Bitcoin for Ether.

Each trading pair has its own order book. So, the value of an asset that’s part of multiple pairs is bound to be different.

Further, Bitcoins exchange services support different fiat-to-crypto or crypto-to-crypto trading pairs. You can’t always directly trade one cryptocurrency for another. You may have to place multiple orders using other trading pairs to hold less popular assets.

Usually, large-cap cryptos are the base currencies. The blockchain currency exchange services with native tokens promote the use of their own cryptocurrencies using trading pairs.

As a rule of thumb, choose pairs with high current trading volumes. Or else you may have to wait a long time before other parties fulfill your orders.

Derivatives

BTC currency exchange services don’t just let you buy and sell assets. Some of them allow you to trade financial contracts and speculate on future prices.

These agreements are called derivatives. With derivatives, you don’t necessarily have to own 100% of the assets you want to trade.

You can use leverage. Leveraging allows you to borrow funds from a USD to Bitcoin exchange to increase your exposure to crypto investments without putting down your own money.

There are many kinds of derivatives, but the most popular ones are futures, perpetual contracts, options, and swaps.

• Futures are contracts that state you have to purchase or sell the cryptos at a predetermined price at a later date.
• Perpetual contracts are like futures, except that they don’t have a specified expiration date.
• Options are agreements on the sale or purchase of the assets at an agreed price. They’re called options because they give you the right, not the obligation, to acquire, or let go of the underlying assets.
• Swaps are dual contracts. The first one is for the sale or purchase of an asset. The second is the sale or purchase of the same crypto in the future.

These financial contracts can be risky. If you don’t have advanced crypto trading skills and experience, you should stay away from them. The best use of derivatives is hedging. Using them irresponsibly can wipe out your holdings quickly.

Cryptocurrency Exchange Fees

Trading platform operators stay in business by collecting fees from users.

Operators monetize their platforms differently. The most common sources of revenue are deposits, transactions, and withdrawal fees. They also impose listing fees to include new crypto assets in their selections.

How Do Bitcoin Exchanges Work?

Now it’s time to answer the question, how do Bitcoin exchanges work? It’s imperative to understand that they have different functionalities. Nevertheless, they support four basic functions:

• Capital deposits
• Order books
• Order matching
• Asset exchanges

To get started on a crypto exchange you like, just sign up and follow the identity verification procedure to create an account. Then, fund your account using a supported payment method to convert dollars to Bitcoins or altcoins.

You don’t have to use cash if you already hold the necessary cryptocurrencies to initiate trades. You may choose to move them onto the new digital currency exchange platform.

Afterward, pick a trading pair when you think the value of the base currency is fair. Remember that you must already own the quote currency in your selected trading pair. Otherwise, you may have to use a different one until you have the required asset to buy the crypto you want.

Bitcoin is practically a universal quote currency. Holding it enables you to buy almost any asset you want.

Determine how much of your quote currency you’re willing to sell in exchange for the amount of your desired base currency. Then, you can place your order. Subsequently, it should appear on the order book. When another trader agrees with your demands, the sale completes.

This example is only a simplified version of how electronic currency exchanging platforms work. Exchanges with more sophisticated functionalities will have a bit more complex processes.

Centralized vs. Decentralized Crypto Exchanges

There are two kinds of cryptocurrency exchanges: centralized and decentralized.

Centralized platform operators store personally identifiable data and control the private keys of traders. They’re no different from tech companies such as Google or Facebook.

Decentralized cryptocurrency exchanges are purely P2P. They don’t require sensitive data. On these platforms, users get to hold their private keys the whole time. By definition, you get to own your assets with them.

Which kind is better? Neither is the best at everything. Both centralized and decentralized exchanges have to sacrifice something to achieve the things the other can’t do. Let’s compare them.

Centralized Digital Currency Exchange Pros

Centralized platforms are attractive to many crypto traders because they:

• Support US dollar to Bitcoin conversion (and vice versa).
• Vet crypto assets more thoroughly.
• Authenticate user identity to comply with regulations. 
• Insure investors’ funds.
• Provide customer support.
• Deliver a user-friendly experience.
• Offer advanced features for seasoned traders.
• Charge relatively low fees.

Centralized Digital Currency Exchange Cons

Not every crypto coin trader is happy with centralized exchanges, for these services:

• List a small number of cryptocurrencies.
• Deny access to unwanted users.
• Hold private keys to investors’ assets.
• Have been vulnerable to hackers.
• Can go bankrupt.

Decentralized Crypto Money Exchange Pros

Unlike centralized platforms, decentralized exchanges:

• List broader ranges of altcoins.
• Provide access to hard-to-find crypto assets.
• Promote self-custody key management.
• Offer a transparent system for trading cryptocurrency for profit.
• Don’t do identity checks.
• Support hundreds of DeFi (decentralized finance) integrations.

Decentralized Crypto Money Exchange Cons

Decentralized exchanges are not for every crypto coin trader since they:

• May not support tokens built on different blockchains.
• May charge high fees due to network congestion.
• Offer limited built-in charting features.
• Have large slippage occasionally.
• Provide no customer support.
• Don't allow fiat money to crypto conversion.
• Lend themselves to hackers.
• Have thin track records.

Centralized cryptocurrency exchanges dominate the present market. Decentralized ones hope to be the standard in the future. However, hybrid trading platforms might rule the space during the industry’s transition.

By design, hybrid exchanges address the weaknesses of highly centralized and decentralized services. The competition between these kinds of cryptocurrency exchanges will only get more intense.

Centralized, decentralized, and hybrid platforms will always try to attract as many users as possible. Sometimes even at the expense of others. But they may continue to coexist in the foreseeable future.

Crypto investors have different preferences, so all three types of exchanges will likely stay in demand.

Top Crypto Exchanges

Today, there are more than 300 cryptocurrency exchanges in the world. Learning how to use a few can give you flexibility. It’s hard to tell which platforms are legit until they rip you off.

To help protect your best interests, we’ve listed the top crypto trading platforms around. Below are two of the friendliest ones for newbies.

Coinmama

This service accepts users from about 200 countries. With Coinmama, you can buy and sell blue-chip cryptos (such as Bitcoin, the Ethereum native token Ether, and Cardano’s ADA).

You can move funds into your account with your credit or debit card. It’s also possible to use bank transfers and Apple Pay.

Coinmama is more of a broker than an exchange. Instead of helping you find other traders to exchange assets, it trades with you. That’s why it can offer instant Bitcoin exchange transactions.

It charges cryptocurrency exchange fees on different activities on its platform. But Coinmama provides discounts to loyal users.

The platform has a KYC (Know-Your-Customer) policy, but its identity verification process is fast. Although it has fallen victim to a data breach before, it helps you store your assets in a ZenGo cryptocurrency wallet.

eToro

If you want to step up your trading game, eToro can be a good gateway platform. It’s not a pure crypto exchange, for it also supports a multitude of financial assets.

Nevertheless, it can give you access to not just the best cryptos to invest in. With up to 120 cryptocurrencies to choose from, you can buy less popular assets to diversify your portfolio.

eToro gives beginners the ability to learn from successful traders themselves. You can even use a practice account to see how altcoin and BTC markets behave without any risk.

Although it charges users for converting and transferring cryptos, it doesn’t collect any deposit fee. It supports several payment methods, including credit cards and fintech (financial technology) apps like PayPal or Skrill.

As an eToro user, you can use a secure cryptocurrency wallet for storing your holdings, not just for trading.

Other notable crypto exchange platforms include Bybit, BitMEX, Coinbase, and Binance.

Wrap Up

Mastering how to navigate exchanges is crucial for success in crypto. Now that you’ve finished this “How do Bitcoin exchanges work?” article, you’re ready to make your first trade.

Spoiler alert: while you make more mistakes to start with, you’ll only become more experienced over time.