An exchange is a place where individuals or companies can trade currencies, securities, commodities and more. A cryptocurrency exchange allows you to easily trade one cryptocurrency for another (that’s a crypto-to-crypto exchange) or fiat money for cryptocurrencies (a fiat-to-crypto exchange).
Exchanges publish the exchange rate for each trading pair they support, be it crypto-to-crypto (e.g. BTC:ETH) or fiat-to-crypto (e.g. USD:BTC). The clients can trade by publishing buy and sell orders in the exchange’s order book. The exchange’s job is to match suitable orders to execute trades, sometimes collecting a small fee in the process.
Reputable cryptocurrency exchanges, such as Bitstamp, take significant measures to protect the funds of their clients. They keep just as much as is necessary to seamlessly execute transactions in a hot wallet, while locking the rest safely in secure cold storage offline.
Crypto exchange essentials
- A crypto exchange acts as an intermediary between people looking to buy or sell cryptocurrencies.
- Crypto-to crypto exchanges allow users to trade different cryptocurrencies.
- Fiat-to-crypto exchanges allow users to trade traditional money for cryptocurrencies, and vice-versa.
- Buy and sell orders are placed in an order book and matched by the exchange.
- For security reasons, an exchange should keep most of their clients’ cryptocurrencies in cold storage.
Order book
If you want to buy cryptocurrency or sell what you already own, you need to place a buy or a sell order on an exchange. The exchange collects buy and sell orders in their order book and sorts them by price. The list of orders continuously updates as orders are matched and executed.
There are several types of orders, but they usually boil down to two basic types: market and limit orders. When you place a market order, the exchange will trade your funds at the best available market price in the order book. When you place a limit order, you instruct the exchange to trade your funds at a specified price (or better). If there is no matching buyer/seller who would accept your price, your limit order will not be executed.
How does an exchange match orders?
For example, the top-listed BTC sell orders offer:
- 0.1 BTC at the price of 50,000 USD per 1 BTC,
- 0.3 BTC at the price of 50,300 USD per 1 BTC,
- 0.2 BTC at the price of 50,400 USD per 1 BTC.
If you place a buy market order for 0.3 BTC before other buyers, you will pay a total of 15,080 USD for 0.3 BTC. The exchange will match your order with the best prices in the order book, meaning that you will get 0.1 BTC for 5,000 USD and 0.2 BTC for 10,080 USD. The exchange doesn’t match you with the sell order for 0.3 BTC listed above, as you would have to pay slightly more, 15,090 USD.
In this situation, if you placed a limit order to buy 0.2 BTC at a price no higher than 50,000 USD per 1 BTC, you would have to wait until more orders at that price appear in the order book. Since only half of your order could be fulfilled at the present time, your order would be temporarily put on hold.
Similarly, if you placed a limit order to buy 0.8 BTC at 50,400 USD per 1 BTC at most, additional orders would have to be published in the order book before your entire order could be executed. Granted, only three orders are listed in this example, and exchanges usually feature many more. To find out more about how different types of orders function, see this article.
Note that cryptocurrencies such as bitcoin can be divided into tiny subunits: Bitcoin’s smallest subunit is the satoshi, which represents 0.00000001 BTC. This makes trades worth just a couple USD or trades for precise amounts possible and indeed common.
Fiat-crypto vs crypto-crypto exchange
A typical fiat-to-crypto exchange supports both fiat-crypto and crypto-crypto trading pairs. Users can credit their accounts with traditional money via bank transfers, credit card payments or other payment methods.
This type of exchange is suitable for people who don’t own any crypto yet, since they can buy some cryptocurrency from users who already hold them. Investors who decide to trade their coins back for traditional money can withdraw funds to their bank accounts at any time.
A crypto-to-crypto exchange does not support traditional currencies and payment methods. It is suitable for those who wish to trade their cryptocurrency for other cryptocurrencies, perhaps coins or tokens that are not available on fiat-crypto exchanges.
Fiat-crypto and most crypto-crypto exchanges will ask you to verify your account to be able to use their service. To be able to start trading, a valid ID and a proof of residence document is typically requested.
Exchange wallet
An exchange is entrusted with significant quantities of cryptocurrencies. Responsible exchanges keep most of their clients’ funds in cold storage, offline and safe. Only enough cryptocurrency required to execute transactions should be stored in a hot wallet, that is, online, which is inherently less safe than offline storage.
Bitstamp stores the private keys for 95% of cryptocurrencies in an offline wallet and is among the first exchanges to implement the combination of cold storage and secure MultiSig hot wallets.