How Does a Bitcoin Exchange Work? In More Ways than One

How Does a Bitcoin Exchange Work?
Courtesy of PXHere.

First things first, what is a bitcoin exchange?

A bitcoin exchange is an online platform or a physical establishment where one can buy and sell bitcoins, as well as other cryptocurrencies. 

Most exchanges support the buying and selling using fiat currencies like the US dollar. But a growing number of exchanges now support only conversions between cryptocurrencies. That means you can only use a cryptocurrency to buy another — for example, bitcoins to buy ethers.

Something to clarify at this point is that increasingly people use the term ‘crypto exchange’ instead of ‘bitcoin exchange. And that is because the term bitcoin exchange was more appropriate when bitcoin was the only cryptocurrency.

Now a crypto exchange may support up to hundreds of cryptocurrencies and blockchain assets.  Poloniex, for example, supports 80 crypto assets and Shapeshift close to 100.

According to CoinMarketCap, an online crypto market tracker, there are close to 3000 blockchain digital assets that exchanges can list.

With that said, people still refer them loosely as bitcoin exchanges. So if you’ve wondered what the difference is between a bitcoin exchange and a crypto exchange, it comes down to whether it supports only Bitcoin or along with other blockchain assets.

Why are crypto exchanges critical?

The rise of crypto exchanges was occasioned by the need to convert between bitcoin and fiat currencies. In particular, a crypto exchange is the easiest way to acquire cryptos. The other ways, such as mining and selling goods and services for them, are a bit more complicated.

And what is the history of crypto exchanges?

In February 2010, having recognized the difficulty new users were having when trying to buy bitcoins, a user on the forum Bitcointalk going by the username dwdollar set up BitcoinMarket. That was the first ever Bitcoin exchange where one could buy and sell bitcoin using, among others, PayPal.

However, the most well-known early bitcoin exchange was Mt Gox. The exchange, which had grown to be the largest, lost about 850,000 bitcoins belonging to its customers in unclear circumstances and filed for bankruptcy in early 2014. 

Crypto exchanges have remained a critical component in the crypto eco-space. As a crypto user, it is hard to imagine life without exchanges.

The number of crypto exchanges has grown to hundreds. Some are global, while some cater to specific countries or regions. CoinMarketCap lists slightly over 250 crypto exchanges.

But how does a Bitcoin exchange work?

It is important to note that all exchanges do not work in the same way. While they basically serve the same purpose, they have different designs and architectures that result in different benefits and user experience.

Broadly, and based on how they work, crypto exchanges can be grouped into two; centralized exchanges and decentralized exchanges (DEXs).

Centralized exchanges

These are exchanges run by registered business entities and, most importantly, from central points. They are companies with investors, offices and staff.

It is essential to point out that an exchange is considered centralized because it has a responsible team that makes and acts on critical business, legal and technical decisions. 

This team determines who accesses the service, what amounts they can transact and what fees they need to pay. It has the technical ability to bar (or censor) a user from the platform. The ability to censor, lack of privacy and high costs are some of the disadvantages of centralized exchanges.

Some of the benefits of centralized exchanges include speed, excellent user interfaces and responsive support to help solve issues users face. 

Centralized crypto exchanges can further be subdivided into the following three categories:

1. Those that buy and sell on their own behalf

These exchanges are those that buy and sell for a profit margin. If you want cryptos, you buy from the company and if you need to sell, the company buys from you. As a buyer or seller, you never interact or transact with other users on the platform.

Also, as a user, all you need is a profile on the exchange through which you make orders. You may not maintain a money account or a crypto wallet on their platform. When buying cryptos, the fiat money you send them goes directly from your bank account or PayPal to their account.

When selling cryptos to them, the coins come from a wallet you control to their hot wallet. Some exchanges in this category, however, do provide wallet services. Meaning you can generate a wallet you manage on their platform and use it to hold your coins. The wallet is completely yours and only you can transact through it.

An example of an exchange in this category is Coinbase. The US-based exchange does provide crypto wallet service. You can sell the coins in your wallet to them and you can also receive the coins they sell you into that wallet. 

To start using an exchange like Coinbase all you need to do is to visit their official website and sign up like you would a social media site. The signup part is always simple and straightforward. 

However, you may be required to provide valid personally identifying information, in particular, a government-issued ID and a physical address to access most of the services available on the site. This is a requirement based on the Know Your Customer (KYC) and anti-terrorist financing regulation by government agencies.

The primary source of revenue for an exchange in this category is the difference between the cost of buying and the selling price of the currencies they support.    

2. Those that buy and sell on behalf of third parties

These are exchanges that allow users to advertize what they want to buy or sell and at what price. Other users will go through these offers and when they find what they like, they authorize the exchange to buy or sell on their behalf. In other words, the exchange is a go-between and a facilitator of a transaction involving individuals who have agreed to trade.

In other words, the exchange matches buyers and sellers by directly helping users find the kind of deals they are looking for. When a match is achieved, the exchange goes ahead and executes the transaction for the parties involved.

The buyer and seller will have accounts with the exchange and the exchange will credit and debit these accounts accordingly. If you need to buy bitcoins, for example, you will first need to transfer the fiat currency from your bank account to an account you have on the exchange. Likewise, if you are selling bitcoins, you need to transfer them to a wallet on the exchange.

An example of an exchange in this category is Binance. The sign up is simple and straightforward. For security purposes, you are asked to set up 2-factor authentication in the form of Google Auth, SMS or email. You may be asked to provide identification information, in particular, a government-issued ID and physical address before you can access all services on the platform.

After signup, you can then deposit from your bank account or your crypto wallet. With funds on the platform, you can then go through what offers others have made or you can make your own orders. When you make a sale or buy offer on the platform, you are a ‘Maker,’ and when you take a buy or sell orders by others, you are a ‘Taker.’

This primary source of revenue for an exchange in this category are the fees they charge every transaction.  

3. P2P crypto exchanges 

What is a P2P Bitcoin exchange?

A P2P crypto exchange is an online platform that allows traders to transact with one another directly. The platform doesn’t get hold of the funds involved and does not move the funds between the traders or on their behalf. Each counterparty is in the control of their funds and they exchange simultaneously with each other.

How does P2P Bitcoin exchange work?

The first step to using a P2P crypto exchange is to create an account or profile. You do this by signing up with your email address. On almost all of the P2P crypto exchanges, you are prompted to set up 2-Factor authentication for security reasons. 

With an account, you can access and read ads that other users have posted on the platform. The ads are in two categories; those by sellers and those by buyers. If you do not find offers that you like, you are free to set up and publish your own ads, of course, subject to terms and conditions. You are free to offer competitive prices. 

The P2P exchanges provide the necessary tools to make the transaction between individuals possible. The tools include an escrow service, which means during the transaction period funds are moved to a wallet with multiple keys with the platform support having access to one. In the event of a dispute, they can step in and transfer the funds to the deserving user.

On some of the P2P exchanges, traders can meet in person to complete transactions. That means you look for offers on the platform by people living near you then set a meeting to trade, which includes using physical cash. 

The crypto exchanges in this category include Localbitcoins, Paxful, Remitano and CoinCola. The primary source of income for the exchanges are the fees they charge for one to put up a sell or buy an ad. 

Often people confuse P2P exchanges with decentralized exchanges. They are not the same and, indeed, their architectures are very different.

The next section is about decentralized exchanges but it is important to state at this point that the difference between P2P exchanges and decentralized exchanges lies in how they are run and managed. 

P2P exchanges are centralized businesses with investors, offices and staff. They have full control of how the platform works. They can arbitrarily change the rules, deny services to some and even shut down accounts.

Meanwhile, decentralized exchanges are not companies or centralized business entities. They are open source protocols that provide the necessary tools for people to transact. No one has the power to arbitrarily change the rules, censor others or shut down accounts (wallets). Any change to how the platform works is done through consensus and collaboration by independent developers. 

Decentralized exchanges (DEXs)

Bitcoin and other cryptocurrencies are decentralized, and protects users from censorship, breach of user privacy and high costs.

Exchanges are critical components of the crypto ecosystem, but they have turned into single points of failure (SPOF). Due to them being controllable, they expose users to the same issues they are probably trying to avoid by choosing cryptocurrencies over the centralized payment methods.

By having to use a centralized exchange, one is at the risk of being censored, especially given that the company running it could be pressured by an outside authority such as a government. For exchanges to operate in many countries, they are expected to follow laws and regulations on money business services. 

That also includes collecting personally identifying data for KYC compliance, which exposes users to breach of privacy. Indeed, centralized exchanges go against most of the things that cryptocurrencies are about; free from censorship, anonymous and cheap to use.

It is for these reasons that decentralized exchanges have been developed.

But what is a decentralized exchange?  

Decentralized exchanges (DEXs) are protocols (set of rules) that allow users to convert between currencies without having to go through a third party. For a long time, what stood in the way of implementing decentralized exchanges was what is known as the atomic swap problem

If Alice and Bob are exchanging digital assets, one of them has to go first. If Alice sent first, Bob might decide not to keep his side of the bargain and therefore defraud Alice. This problem has been solved through the application of smart contracts, self-executing agreements written in code. 

But how do decentralized exchange work?

Most of the DEX projects are in the early stages. But those that have gone through the tesnet phase work with an implementation of the protocol through open source software or application that a computer runs to join networks. That means for one to trade with others, they need to either download and run the application.

The DEX protocols software acts as the interface between payment platforms. For example, the protocol could arbitrate with a smart contract between users on two blockchains. With that said, the detail implementation is different for each DEX project.  

Bitcoin ATMs

Bitcoin ATMs are machines put at strategic locations like shopping malls, bars and coffee shops. These machines are technically Bitcoin or crypto exchanges. You can buy bitcoins from them as well as sell to them if you need to. 

The essential advantage of using a Bitcoin ATM over other types of exchanges is that you do need to share your personally identifying data to use the service. All you need to do to buy bitcoins, for example, is to share your bitcoin address with the machine through a QR scanner and to insert bills into a slot.

You can find a Bitcoin ATM near you by using Bitcoin ATM tracking maps such as CoinATMRadar. 

Physical agents

Another form of crypto exchanges that you might have to use are agents in stores and malls. These are mostly cashiers who can help you convert between Bitcoin in particular and fiat. 

LibertyX is a US firm that has partnered with cashiers and small businesses across the country to make this service possible.

How does this type of crypto exchange work?

You sign up on the official site, and also down their app to your phone. With your account, find an agent near you and when you find one, initiate a buying transaction, indicate the amount you want to transact and share the address to which the bitcoins should be sent. 

LibertyX will display a one-time use code that you should copy and carry to a local agent in the store, coffee shop or bar. Once the agent sees the code, they will receive your payment and your cryptos will be sent to you. 

So, how does a bitcoin exchange work? There is evidently more than one way.

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