Q04 – How Does a Cryptocurrency Exchange Work?

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Introduction

The vast majority of cryptocurrency trading occurs on exchanges such as CoinbasePro, Huobi, Kraken and Binance to name a few.

What is a Cryptocurrency Exchange?

A cryptocurrency exchange is a market where you buy and sell cryptocurrencies. It is a central location, usually digital, where buyers and sellers come together to make an exchange between each other.  In terms of cryptocurrencies, these digital marketplaces are commonly referred to as exchanges.

Buyers and Sellers

For an exchange to succeed, there must be both sellers and buyers who wish to exchange goods (In this case, cryptocurrencies).  Cryptocurrency exchanges provide a central location for this activity to occur. Sellers of cryptocurrencies will list their assets on the exchange at the lowest price that the seller would like to get for their product, (known as the “ask”).  By doing this, Sellers provide what is called liquidity to the market.  Buyers then will either pay the asking price, or the buyer can list the highest price they are willing to pay, (known as the “bid”) and wait for someone willing to sell at that price. For more information on Bid and Ask, please see here: What does Bid and Ask Mean?

Sellers with no buyers willing to pay for their goods, or buyers with no one to sell them the goods they are looking for will go elsewhere to do business. So exchanges provide a service by essentially advertising their customer’s bid and ask prices.

Buying and selling occurs in two primary ways:

• Market Order – A market order, whether buying or selling, will happen at the current price bid or ask price listed and will transact nearly instantly (depending on liquidity available). A market order essentially says I am willing to buy or sell at the current market price listed.
• Limit Order – Limit order is a price that is either below all the ask prices, or a sell price that is above all the bid prices.  Traders use limit orders to get a better price in exchange for waiting for the market price to move favorably in their direction.  There is always the possibility that the market will never move to their price and the order, then will never get satisfied, or filled, as it is known.

There are a few variations on the above, but those will be discussed in another course

Taker

Taker trades are when you place an order that trades immediately, by filling partially or fully, before going on the order book.

Trades from market orders are always takers, as market orders can never go on the order book. These trades are “taking” volume off of the order book, and therefore called the “taker.”

Maker

When you place an order that goes on the order book partially or fully, any subsequent trades coming from that order will be as a “maker.”

These orders add volume to the order book, helping to “make the market,” and are therefore termed the “maker” for any subsequent trades.

Conclusion

All transactions on a marketplace incur a small fee in exchange for providing the the service that they provide.

In order to create a robust marketplace, exchanges will offer discounted fees to market makers, or charge a taker fee.  Traders are encouraged to use limit orders when possible to help improve profit margins.