A cryptocurrency exchange is a platform that allows users to exchange various currencies and cryptocurrency types.
A crypto exchange has a similar interface to a bank or investment firm, but it differs in some notable ways. The exchange acts as a central platform that connects buyers and sellers of various cryptocurrencies. Its main value is that it offers near-instant 24/7 liquidity for many pairs of cryptocurrency assets.
Popular exchanges like Coinbase and Gemini hold billions of dollars in cryptocurrency, some of which is owned directly by the company and others by users using the. exchange cryptocurrency wallet.
There are a few notable distinctions in the field of cryptocurrency exchange, each of which will be detailed.
- Is the cryptocurrency exchange centralized or completely decentralized?
- Is the exchange depositary or non-depositary?
Here’s what every lawyer, and frankly anyone dealing with the financial world, should know why choosing the right cryptocurrency exchange makes all the difference.
Is the cryptocurrency exchange centralized or completely decentralized?
As you may have learned from reading the Legal Examiner’s Blockchain: a guide for lawyers series, cryptocurrency like Bitcoin is completely decentralized.
This means that there is no company or central entity responsible for Bitcoin – there is no fancy tech startup office in San Francisco, nor a 1-800 number that you can call if the going. go wrong.
This contrasts with a centralized exchange, which is a formally established entity that must adhere to guidelines and regulations. Of course, there are dishonest centralized exchanges that do not meet the âformally establishedâ definition, in itself, but the point remains valid.
A centralized exchange, like Coinbase or several of its direct alternatives, has chiseled out its value proposition of making cryptocurrency much more accessible to the average person.
Rather than two people having to agree to send each other different currencies (i.e. BTC for ETH), a centralized exchange handles the transaction and takes a small share. These fees, often referred to as maker-taker fees, provide an incentive for the central exchange (or the liquidity provider, as we will learn below) to participate in the market. Market makers are the market makers who create two-sided markets (exchange), and takers are those who trade at prices set by market makers.
If you’re curious about how much money an exchange like Coinbase can make with these relatively low fees, check out its S-1 statement it was released before being released to the public in 2021.
Now imagine that you take the centralized exchange out of the equation. With no middleman, the parties to the transaction would be responsible for setting the prices at which they are willing to trade the assets and trusting the other party to send their fair share of the transaction.
As you can imagine, without a structure, this is an incredibly inefficient and unreliable way to trade digital assets on a large scale.
This is where decentralized exchanges (DEX) come in.
A DEX is essentially a decentralized platform that allows users to trade directly and instantly through pre-programmed contracts. The DEX routes the order and does not complete it until both parties have signed the transaction and the blockchain has validated the entire ordeal.
Companies like Metamorphose and MetaMask allow users to instantly exchange funds among themselves without ever entrusting custody of their assets to an intermediary.
How do DEXs make money? They sometimes charge a fee (not to be confused with the actual blockchain network fees, which exist every time a transaction is made, centralized or not), which can be distributed to the token holders of that exchange.
The DEX model gets a bit hairy, but it’s a fascinating journey to learn more about it, especially because it serves as a portal into the world of Decentralized Finance (DeFi).
Is the exchange depositary or non-depositary?
As noted in the previous section, Centralized Exchanges (CEX) are different from Decentralized Exchanges (DEX) in that they support user assets, unlike DEXs.
To be more precise on the technical level, the CEX keep your private keys, because no real “Coins” or “tokens” exist somewhere in a safe. A DEX allows you to negotiate without requiring you to reveal your private key to the DEX or the receiving party.
Trading in securities involves significant risk. On the one hand, if the exchange were to be hacked or revealed as an elusive scam, your private keys are at risk.
The hack of Mt. Gox, a popular early exchange, posed an existential threat to nascent Bitcoin. In February 2014, hackers stole a whopping 840,000 bitcoins from customers of Mt. Gox and the company itself, with only 100,000 owned by the company, which equates to around $ 33.6 billion today. ‘hui.
Other notable hacks and centralized exchange incidents include Bithumb ($ 30 million), Coinrail ($ 37.2 million), BitGrail ($ 195 million), Coincheck ($ 534 million) – with each value set during the hack period.
While today’s exchanges have hopefully learned from the mistakes of those of the past, the threat still exists. These exchanges use a combination of hot and cold storage to ensure that a disaster at Mount Gox does not happen again.
If you’re using a DEX, the biggest threat to your funds isâ¦ well, you. Since you retain custody of your assets at all times, you are the main potential point of failure. If you lose your device and fail to recover your account, or if someone directly targets your wallet, you can lose your funds indefinitely.
However, these events can be avoided almost entirely with good digital security hygiene.
Final thoughts: how to choose the right crypto exchange for you
Your cryptocurrency exchange selection ultimately comes down to convenience, as long as you choose from a handful of trusted and reputable companies.
If you fall into the absolute cryptocurrency newbie archetype, it’s worth setting up a Coinbase account and checking out the beginner-friendly platform. It lacks a lot of the advanced trading features, but it accomplishes what you’re looking for – buying your first bitcoin, ether, or other cryptocurrency.
Coinbase Learn also gives you a few options to learn more about certain cryptocurrency projects and earn a small amount of their tokens.
If you choose to buy cryptocurrency on Coinbase, you will likely exceed the relatively high fees soon.
The good news is, you don’t have to leave the Coinbase ecosystem to escape the high fees. Coinbase Pro is the Coinbase “Pro” version and belongs to the same company. Not only does it have much lower fees across the board, it also has a lot more asset pairs and the ability to deposit and buy cryptos directly in USD.
Other Coinbase alternatives include: Gemini, Kraken, and BlockFi.
However, each option listed above is a custody platform, which means that it supports your private keys in its own cryptocurrency wallet. This removes (albeit does drop) the responsibility of maintaining your private keys, making it much easier for a newbie to the ecosystem.
For those who are aligned with the âBe Your Own Bankâ ethic of cryptocurrency, you may want to consider a non-custodial exchange, such as ShapeShift, MyEtherWallet, or Metamask. You still have custody of your private keys, but you can swap for other assets, likely paying a much lower fee than on a centralized exchange.
Non-depository platforms also tend to facilitate the interface with the world of decentralized finance (DeFi). However, if you are just starting out, we don’t recommend that you get started here right away!