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Basic functions of a crypto exchange

Trading on cryptocurrency exchanges is new and confusing for many people. This article explains some of the basics and also introduces Bit.Team, a new decentralized cryptocurrency exchange with some unique features.

As cryptocurrency usage increases, so too does usage of crypto exchanges. For many, this is their first introduction to the world of trading, and they can be forgiven for being somewhat confused.

So, this article is for them. It will give a basic introduction to how crypto exchanges work and try to demystify some of the terminology.

We’ll start by understanding what a cryptocurrency exchange is and what it does.

A crypto exchange is a digital marketplace where traders can buy and sell cryptocurrencies, exchange one type of cryptocurrency for another or exchange cryptocurrencies for fiat currencies. The exchange serves as the intermediary between the buyer and the seller.

Some exchanges are set up primarily to allow for the exchange of cryptocurrencies for fiat. Others are more focused on traders wanting to make a profit from the trading of one currency against another.

Crypto exchanges are similar to traditional stock exchanges. However, on traditional exchanges, traders generally buy and sell assets (shares or derivatives) in order to profit from the change in the value of the asset itself. On a crypto exchange, traders generally use cryptocurrency pairs and they hope to profit from the highly volatile currency rates.

Exchanges can be centralized or decentralized, custodial or non-custodial.

A full explanation of these terms and the pros and cons of each is available in another of our articles, “Centralized, decentralized or custodial — which is the best model for crypto exchanges?”

In essence, a centralized exchange is one where the owners manage all the transactions on the platform, and charge fees for doing so. A decentralized exchange is run on a blockchain. The owners provide a platform to bring buyers and sellers together, but the actual transactions are directly between the buyer and the seller (P2P).

A custodial exchange is one where the exchange holds all the funds in its own wallets. The users’ funds are noted on a database. The funds on the database must be matched by funds in the wallets. Most centralized exchanges work in this way. Hacking into these wallets can result in major losses for users.

A non-custodial exchange is one where the platform facilitates or actually carries out the trades, but the funds are always in the users’ own wallets.

Custodial exchanges are most often also centralized exchanges.

· Binance, Bitrex, Kraken, Poloniex and GDAX are good examples.

Non-custodial exchanges can be either centralized or decentralized.

· Non-custodial and centralized exchanges include Shapeshift, Coinswitch, Evercoin, Changelly

Non-custodial and decentralized exchanges include EtherDelta and IDEX.

A major function of an exchange is to set the price or the rate of the currencies traded on its platform. To a large extent, this is based on the volume of trade and the activity of buyers and sellers on the platform.

Other factors that influence the price include:

· Market supply and demand: The main principle here is that if people are buying, the price goes up; if they are selling, the price goes down.

· News in mass media: This can set off panic buying or selling, or persuade readers of the particular value or threat of a currency

· Technical issues: eg updates or fixes of bugs in the code send prices up; technical glitches or hacks send them down

· Political and economic events worldwide: eg China’s ban or Japan’s acceptance of Bitcoin impacts the price for everyone

· High volatility: This is a measure of how much a trading price varies over time, generally in response to uncertainty or risk in a security’s value

The difference in price across different exchanges represents a trading opportunity known as arbitrage. Arbitrage means striking matching deals to take advantage of the difference in price across markets, the profit being the difference in price from one market to the other.

So, for example, on one day in November 2018, the CoinMarketCap price for Bitcoin was $6,338.95. The price on Huobi was $6,441.94, on Binance $ 6,442.92,and on OKEx $6,440.72. So, the largest exchanges had similar prices. However, a small exchange like LakeBTC had the price at $6,987.60, about $500 higher than the big exchanges, while Cryptology was trading at $6,327.84, over $100 less. In this scenario, a trader could sell his BTC on LakeBTC and immediately buy on Cryptology and make $650 profit per BTC.

This is why so many people trade on the smaller exchanges, even though they can be risky.

It should be noted that this type of profit is only possible if the exchange itself has sufficient liquidity — it has the required number of coins available to trade — and if its systems allow for very quick exchange. The amount of profit also depends on the fees charged by the exchange.

Statistical arbitrage is a trading strategy that is based on the assumptions that the prices for two assets put into a pair are not stationary and that prices will revert to the mean. This means that deviations in price will return to the average. This is why exchanges provide moving averages for periods such as 50 or 100 days.

So, if one coin in a pair outperforms the other, a trader may buy the poorer-performing coin and hold it in the expectation that its price will climb towards the other coin (buying “long”). Alternatively, the trader may sell the better-performing coin, in hopes that its price will go down, to be bought back at a lower price (selling “short”).

Alternatively, the trader will simply buy one currency with another to benefit from the relative difference in price between them.

The exchange decides on the number of currencies (coins and tokens) that it will list, and therefore what pairs are available.

So. for example, an exchange like Coinbase which sells more Bitcoin than any other exchange, has until recently limited the number of currencies it has listed to BTC, ETH, Bitcoin Cash (BCH), Litecoin and Ethereum Classic. Binance, on the other hand, one of the largest exchanges by volume, is quick to list new tokens and coins, provided the company can demonstrate that its currency has real value.

Many startups are also establishing their own exchanges to ensure that their native coins and tokens are included in pairs. This might be helpful to founders and initial investors and might help to build the exposure and later value of the currency.

The reality, though, is that volume of trading matters. It is easier to buy and sell on an exchange with high volumes where more buyers and sellers are in the market, and the required currencies are available.

Rather than having to continuously monitor prices, traders can set limit orders with an exchange. These are instructions to execute trades when a currency price hits a certain level.

Limit orders can be used for buying or selling.

· For buy orders, this is an instruction to buy a certain amount of currency at a limit price or lower

· For sell orders, the instruction is to sell at the limit price or higher

A strong feature of the Bit.Team exchange is that there is a high level of automation for orders set by users, including those using bot-to-bot trading.

Look out for further articles, where we will look at other trading terms, including order books, makers and takers, market orders and stop orders, using bots and others.

The first step is to register on an exchange. This generally includes several steps to verify identity. Some exchanges don’t require this, depending on where they are based, but KYC (know your customer) and AML (anti-money laundering) protocols are important for the more reputable exchanges.

The next step is to deposit funds into the newly opened account. Exchanges that accept fiat currencies will accept credit cards, direct bank transfers, PayPal payments, wires and other traditional methods. For exchanges that do not trade in fiat (like Binance), the user will first have to go to an exchange that does (for example Coinbase) to buy a currency that can then be transferred into his account at the first exchange.

It is clear that users wanting to trade in several currencies may have to open accounts in several exchanges to make sure that their choices are available. This is why some exchanges are opting to list as many coins as possible, to keep traders on their sites.

Every transaction on an exchange carries some type of cost. This is how exchanges make their money. This is also where they try to differentiate themselves, offering special deals, low or no fees for some transactions, or referral discounts.

Some of the fees include:

· Making deposits and withdrawals. The amount is often dependent on the method used. A bank transfer or wiring money is risk-free for the exchange, so lower fees can be charged. If a credit card or PayPal are used the transaction can be reversed, so there is more risk to the exchange and it will charge more.

· Converting from one fiat currency to another. If there is a conversion from one fiat currency to another there is an added cost. For example, trading Euros to an exchange that deals only in American dollars will attract a conversion fee. The best solution is to deal with an exchange that deals in your local currency.

o Bitcoin exchange Poloniex has its rate ranging from 0 to 0.25%

o GDAX fees range from 0 to 0.30%

o Kraken’s fees range from 0 to 0.36%, and

o Paxful charges 1% of the amount of a sale to the seller but buyers don’t get charged.

The Bit.Team exchange will apply a dynamic fees system that will depend on the user’s monthly traded volume. The initial fee will be 0.2% for a closed deal. There will also be fees for deposits made to users’ accounts. The amount will depend on the method used.

The most notable feature is that it is built on the principles of maximum simplicity and absolute safety of transactions.

Deals are easy. When users are logged in, they can search for existing buy/sell offers or post their own. Users can set their own offer prices. Once a match is found, the user sends a transaction request directly to its author. There is a chat service on the exchange platform for the parties to talk to each other. No-one else has access to the details of their agreement and there are no intermediaries. Once the deal is agreed, the seller sends his/her account details and the buyer transfers the funds. A variety of payment methods are available to make this step really easy.

The platform ensures the security of the deal by blocking the seller’s crypto until the payment has been made. Only then is the transfer made to the buyer’s wallet. In the case of a dispute, the platform will fulfill an arbitration role.

Security is also assured through the use of specialized cold wallets, two-factor authentication (2FA) plus a system of notifications on email or Telegram. In addition, users will be ranked on the platform, based on the number of successful deals made, and users will be able to rate each other. This will build trust in the parties who are participating.

There is a significant amount of automation on the site to further simplify its usage and to make it possible for a trader to do multiple trades in a short period of time. Automation also makes deals accessible to traders using bots. They can set their limits and leave the bots to do the rest.

By the time the Bit.Team ICO is held in 2019, this decentralized exchange will be up and running, and it looks to be a good investment opportunity.

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