In the traditional sense, exchanges are marketplaces where securities, commodities, and financial instruments are traded. Stocks and foreign exchange markets are traded in exchanges such as NYSE, or in the case of Forex, international banks and dealers working with exchange rates.
Cryptocurrency exchanges borrowed the idea from traditional exchanges. But instead of securities like stocks and bonds, traders deal with fiat and virtual currencies over the Internet. To have a better understanding of how cryptocurrency exchanges work, we will give some examples from real-world exchanges.
Exchanges are an essential part of the whole cryptocurrency ecosystem. They provide easy access to anyone who wants to trade digital assets apart from cryptocurrency mining. You’ve probably came across some of them, the most popular ones being GDAX (via Coinbase), Bittrex, and Poloniex.
At the moment, there are more than a hundred exchanges operating in many countries across the world today. We will take a closer look at how cryptocurrency exchanges work, and some basic information on how to use them.
How Exchanges Have Evolved
Savvy business owners and investors are always looking at markets for opportunities to further their business and financial goals. To a business owner, they can be used to raise capital by issuing bonds and shares to investors. Think of publically traded companies like Facebook, Amazon, and Microsoft. An investor sees exchanges as opportunities to make more money by purchasing stocks that would eventually grow in value.
However, there’s a certain limit to the number of shares a company could issue based on its total market value, and companies may choose to hold some of them for future use. Once it goes public, these stocks are traded in exchanges and investors can start buying and selling them through brokerages. (Chapter 3 explains how ICOs work in many ways like IPOs)
The first stock to trade on the NYSE was The Bank of New York in 1792 and still operates in Manhattan under the name Bank of New York Mellon.
For decades, trading floors were the center of activity for many traders and investors. Over time, traditional exchanges have evolved and most trading floors are now replaced by online trading platforms and automated trading software. The NASDAQ Exchange, which started out as an electronic price quoting service, was the first to implement automation to an exchange without the need for physical trading floors.
This transition provided the right environment for cryptocurrency exchanges to thrive in the outer reaches of the cyberspace. Cryptocurrency exchanges don’t have physical trading floors like NASDAQ or NYSE, but they provide greater access to millions of people across the world to buy, sell, and trade cryptocurrencies at a much cheaper cost.
Cryptocurrency exchanges also don’t require a sizeable amount of money to start trading, and fees are way much lower compared to traditional exchanges. In traditional exchanges, you usually need at least $1,000 to open and maintain a brokerage account, and you’ll have to pay commissions on each trade, maintenance fees, and low-balance penalties.
In contrast, cryptocurrency exchanges can be accessed directly on a person’s PC or smartphone without going through these brokerages. Anyone with access to the Internet can set up their own cryptocurrency exchange account at no cost and with no minimum deposit.
However, you need to familiarize yourself with exchanges since you’re basically doing all the research and hands-on trading all by yourself. Moreover, cryptocurrency exchanges don’t have the same level of government regulation as do traditional exchanges, and thus involve some risk.
There’s also a limit to certain privileges on most regulated exchanges depending on your account verification level. Typically, the longer you stay or trade on your exchange account, and the more information you give about yourself, the better your chances are at getting verified and increase your trading limits and withdrawals.
Familiarizing Yourself with Exchanges
Cryptocurrency exchanges borrowed many terminologies from traditional exchanges. Experienced traders know these terms by heart, but for those who are just learning the ropes, some words and phrases are a bit baffling. We’ll explain them here in layman’s term and provide some examples as needed.
Order Book – A list of all the buy and sell orders of traders in a market. It specifies the total number of bids and asks on a trading pair (e.g. BTC/USD), their quantity (size) and price, and presents them in graphical form. Order books play an important role in “price discovery” where the majority of traders agree on a certain price, thereby filling those orders and setting the current price of a given asset. Order books are now fully automated, capable of handling millions of buy and sell orders instantaneously. The process can be observed in real time in exchanges like GDAX, Bittrex, and Poloniex.
Trading Pair – Two different currencies traded on a market. With ETH/BTC trading pair, people are either buying Ethereum with Bitcoin, or selling them for Bitcoin. Traders set the bid and ask price of the currency they want to trade with using another currency. To put into perspective, in an ETH/BTC trading pair, ETH is the “commodity” being bought and sold, and BTC is the “currency” used to pay for them. Although, not an exact analogy, people who are new to cryptocurrencies and trading might be able to understand better using a more simplistic approach (both ETH and BTC are digital assets, and thus, barter transaction would be more appropriate). In a BTC/USD pair, it’s a lot easier to grasp since we’re talking here of a digital asset and a real-world currency (fiat). Also, in a trading pair, a currency can increase or decrease in value relative to its pair – much like Forex in a sense. In an ETH/BTC pair, if more ETH orders are being filled and greater quantities are sold at a higher price, it will be valued higher in BTC, and vice versa. In the grand scheme of things, a currency’s value is summed up based on how it performed across all online exchanges where it’s listed. (See https://coinmarketcap.com/ for a list of all exchanges.)
Bid/Ask – Bids specifies the price traders are willing to pay on a trading pair for a given quantity of cryptocurrency. Asks, on the other hand, specifies the price traders are willing to sell their cryptocurrencies for. Bids and asks are usually shown in graphical form in order books as the “bid and ask wall” juxtaposed against each other, often resembling a valley – also called “market depth.” The lowest point is where traders agree on a certain price. Orders placed somewhere near the current price (“market orders”) are often filled almost immediately, while those placed further away (“limit orders”) may take some time. Traders may cancel their orders and move them elsewhere if it takes them too long, or if they want to take advantage of a major price action days or weeks ahead.
Bid-Ask Spread – A gap formed when both sides of the market don’t agree on a common price and no orders are being filled. It is the difference between the lowest bid and ask price on a trading pair. For instance, a trader wants 0.1 BTC for $1000, and another wants to sell his at $1,010. We have a price spread of $10. The bigger the difference, the wider the bid-ask spread. Too wide of a bid-ask spread will have an impact to a market’s liquidity.
Trading Volume – The total amount of cryptocurrency traded in the market at any given time. For instance, in a BTC/USD trading pair, the trading volume for an hour of trading could be $35,000,000, closing at $10,000 per BTC. They’re usually shown as multi-coloured or monochrome bars at the base of a price chart. In a multi-coloured price chart, green-coloured bars meant the closing price is higher than the previous one; for red-coloured bars, it’s the other way around. A dark-coloured bar meant the closing price is equal to the previous one. In most cryptocurrency exchanges, viewers can change the duration from a 1-minute, 5-minute, 30 mintue, 1-hour trading volume, and so on. Markets with high trading volumes are considered to have high levels of liquidity.
Price Chart – A graphical representation of the price actions with respect to time. Price charts reveal whether a currency’s value is on an uptrend (“bullish”), downtrend (“bearish”), or has undergone periods of stagnation, high volatility, parabolic moves (market bubble), and sell-offs. They can be shown in candlestick or line format. Candlestick charts also have a colour scheme (green for “bullish” and red for “bearish”) that matches the trading volume. Sometimes bearish candles will close at a higher position relative to the previous one resulting in colours which are opposite to the trading volume. In a line format, each point represent the closing prices. Viewers can also change the duration from a 1-minute, 5-minute, 30-minute, 1-hour price chart, and so on.
Circulating supply – The best approximation of the number of coins circulating in the market and in the general public’s hands (https://coinmarketcap.com/faq). In traditional exchanges, these are the total number of publicly traded stocks as opposed to locked-in stocks withheld by the company or shareholders. Circulating supply helps determine the total market value (market capitalization) of a cryptocurrency.
Maximum Supply – the total supply of cryptocurrency that will ever be produced. Most cryptocurrencies are deflationary in nature, i.e., they have a fixed supply. Bitcoin is set at 21 million BTC, while some premined coins such as Ripple has a maximum supply of 100 billion XRP, 55% of which is being held in escrow by the company.
Market Capitalization – The total market value of a cryptocurrency, determined by multiplying the circulating supply with the current market price of each coin or token. It’s the equivalent of a company’s total market value in a public exchange, which is also determined by multiplying the total number of outstanding shares with the market price of each share.