What is a Crypto Exchange and How Does it Work?

A crypto exchange is a trading platform that connects buyers and sellers of cryptocurrencies. Crypto exchanges operate in a similar way to a traditional stock market. Buyers can indicate a buy price, and sellers can show a selling price for their assets. 

The main difference between a crypto exchange and the stock market is the assets traded and how these assets are traded. For instance, in a traditional stock market, you cannot withdraw your Apple stock and store it somewhere private. With crypto exchanges, you own and control your assets, with the ability to move them offline when you are done trading.

How Does a Crypto Exchange Work?

Different cryptocurrency exchanges work differently. For professional traders, the exchange may have sophisticated tools that track changes and forecast prices. They may also offer managed services for people with large sums of money invested. 

Others are more retail-oriented, serving traders with smaller amounts. They allow quick buy/sell actions between different cryptos and easy conversion of crypto to fiat. 

The third class of crypto exchanges is P2P exchanges. These connect individual buyers to individual sellers. 

Crypto Exchange vs. Crypto Wallet?

You have probably heard the terms exchange and wallet used frequently in the world of cryptocurrencies. Here are some key differences between the two: 

  • Function – wallets are used to store cryptocurrency, while exchanges are used for purely buy/sell actions. You cannot participate in an exchange without a wallet. 
  • Features – Wallets allow you to store your cryptocurrency securely while exchanges give you access to the open market. Some wallets offer hardware-level storage, meaning you can store your cryptocurrency on a USB-like device. 
  • Fees – Crypto exchanges charge you fees for trading. Most wallets charge a transaction fee for any cryptocurrency you move into or out of your wallet. 

Centralized Exchanges vs. Decentralized Exchanges

Centralized Exchanges

Most exchanges are centralized, meaning, all trading is accomplished between traders and a centralized entity (the exchange). In this scenario, you directly buy and sell cryptocurrency with the exchange. While this has its advantages, it can get expensive in terms of fees and trading margins. 

Decentralized Exchanges 

These are also known as peer-to-peer exchanges. In P2P crypto exchanges, you buy and sell cryptocurrency with individuals. Since there is no easy way to ensure the exchange will complete successfully online, most P2P exchanges require meeting a buyer or seller in person.

A Word on Arbitrage

Arbitrage is the act of taking advantage of price differences across different exchanges. For example, you can exchange Bitcoin for Litecoin on Coinbase and then exchange Litecoin back to Bitcoin on Binance. If the price difference is enough to offset fees and afford some margin, you can make a profit. 

While few people pursue arbitrage because of the razor-thin margins, if you have a big enough investment, you could benefit from arbitrage. Just keep in mind that price volatility can quickly wipe out your advantage within minutes.