What is a Bitcoin Exchange?

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bitcoin exchange definitionA Bitcoin exchange is an online marketplace where traders can buy and sell Bitcoin using fiat currencies and altcoins.

These platforms essentially function as matching engines that are used to safely match the orders of those looking to buy Bitcoin with those looking to sell, while acting as an intermediary to ensure trades are completed without issues.

Bitcoin exchanges can be split into 3 main categories:

Depending on what you want to use the exchange for, you’ll be better suited with one category, or the other. For example, if you’re looking to buy Bitcoin as a long-term investment, then spot exchanges are the better fit for you.

How Bitcoin exchanges work

For the most part, Bitcoin exchange platforms are designed to be as accessible as possible, which makes it easy for new investors and inexperienced traders to quickly get to grips with their features.

Usually, Bitcoin exchanges works by allowing users to browse a variety of different digital currency markets, including those for Bitcoin, and often altcoins and stablecoins too. Once a market is selected, traders will then be able to use the order options to create limit or market orders to open a buy (bid order) or sell (ask order) on the order book.

Market orders are filled automatically at the best available rate, whereas limit orders offer more flexibility and will be filled when the market conditions reach those specified in the order.

Depending on the platform you use, the exchange will usually offer either crypto to crypto trading, fiat to crypto trading or both. As the names imply, an exchange offering crypto to crypto trading allows you to trade one cryptocurrency against another, e.g. BTC/ETH, whereas fiat to crypto trading allows you to trade fiat currencies against cryptocurrencies, e.g. BTC/USD.

These platforms can also be divided into two types: spot and derivatives exchanges. Spot exchanges are the most common type and allow traders to directly trade cryptocurrencies, whereas derivatives exchanges are more complex platforms where users trade derivatives like futures and options which track the value of an underlying cryptocurrency and are settled at a later date.

For the most part, those looking to trade Bitcoin for the first time will likely be best served by spot exchanges, whereas more advanced traders that need to trade on leverage or require increased order flexibility may prefer to trade on a derivatives exchange.

Getting started on an exchange usually requires a simple registration process which takes just minutes. After that, if you are using a crypto to crypto exchange, you may need to top up your balance using your external wallet, or add your debit/credit card to the exchange for fiat to crypto purchases.

Things to keep in mind

Exchanges charge fees

As businesses, digital currency exchanges make money by charging customers a small fee on each of their trades. For the most part, these fees are usually very low when buying Bitcoin with another cryptocurrency, but can be much higher when purchasing with a credit card, debit card or wire transfer.

The two most common types of fees you will encounter when buying digital currencies like Bitcoin are maker and taker fees. In short, taker fees are charged to trades that remove liquidity from the market, whereas maker fees are charged for orders that add liquidity to the market. Generally, the taker fee will be larger than the maker fee, though some platforms do charge a flat fee regardless of whether you are a maker or taker.

Depending on the liquidity of the exchange, you might also want to consider the spread. This is the difference between the lowest ask price and the highest ask price on a particular trade pair.

A high spread can indicate you get less digital currency for your money, an issue typically found at trading platforms with poor trading volume.

Besides charging a fee on each trade, some trading platforms also charge a withdrawal and/or deposit fee. Deposit fees are usually very small and only applied to deposits below a certain threshold, while withdrawal fees usually closely reflect the mining fee needed to ensure transactions are confirmed relatively quickly. You will only need to pay withdrawal fees if you with your funds to your external Bitcoin address.

For example, if you are looking to buy two bitcoin at $10,000 each, and the exchange charges a 0.5% fee, then your fee can be calculated as ($10,000 * 2) * 0.5% = $100. This is charged on top of the $20,000 used to actually acquire the bitcoin, so your total expenditure would be $20,100.

Most cryptocurrency exchanges require identity verification

Identity verification, or more commonly known as KYC (know your customer) and AML (anti-money laundering) verification is a process many Bitcoin exchange platforms employ to comply with regulations and prevent the use of cryptocurrencies for illegal purposes.

KYC requirements are mostly seen at cryptocurrency exchanges that have a fiat on-ramp, allowing customers buy cryptocurrencies with fiat currencies. Some examples of these include Coinbase, Coinmama, Bitit, and Kraken.

With that said, many exchange platforms allow unverified users to buy or sell a small amount of cryptocurrency without passing KYC checks.

Although completing identity verification is generally considered to be a hassle, the process usually doesn’t take long and only needs to be done once.

For the most part, KYC checks will involve answering some basic identity questions, such as your name, current address and resident country, and you will also need to upload some proof of identification—typically a passport, national identity card or driver’s license. Some platforms also ask for a recent utility bill and a selfie as further proof of your identity.

Oftentimes, these documents are automatically processed, leading to near-instant verification, whereas some platforms still manually these documents before verifying your account.

Exchanges are not always safe

As the cryptocurrency trading industry has grown in recent years, many exchanges are now used to store huge amounts of cryptocurrencies. Unfortunately, this increased popularity has also led to unwanted attention from hackers, who seek to exploit loopholes in the way some of these platforms store user funds to commit theft.

For the most part, these hacks tend to affect newer, less secure platforms, though several major cryptocurrency platforms have also fallen victim to hackers. For example, Bitfinex—currently considered to be one of the most reputable exchanges—has been hacked twice since it opened in 2012. Likewise, even the world’s most liquid spot exchange Binance was hacked for $40 million in 2019.

Fortunately, customers were eventually reimbursed for both of these cases, but not every hack has a happy ending. Likewise, there are also cases where the exchange operators simply up and leave with customers funds, including the recent PlusToken exit scam, which saw a reported $2.9 billion worth of digital currencies stolen. The funds are rarely recovered in these situations.

With that said, although the majority of digital currency platforms employ strict security protocols to keep your funds safe, we only recommend keeping the funds you intend to trade with on these platforms. Any excess should be withdrawn to a more secure external wallet, such as a hardware wallet.

Example of a trade on a Bitcoin exchange

To help clarify exactly how to trade Bitcoin, we will run through a quick example.

Let’s suppose you want to place a market order for 5 bitcoins and the current going rate is around $10,000 each. By placing a market order on a cryptocurrency exchange for 5 BTC, you will buy 5 BTC at the lowest available ask price available in the order book.

For example, if there is 3 BTC available at $9999.90 and 10 BTC available at an ask of $10,000, then the first three bitcoins of your order will be filled at $9999.90, whereas the remaining two will be filled at $10,000. As such, the total cost of buying 5 BTC would be $49,999.70 (3* $9999.90) + (2* $10,000), plus the associated market taker fee as described earlier.

Alternatively, if you think Bitcoin is likely to decrease in price and want to buy it at a lower value, then you can instead open a limit order. As an example, if Bitcoin is currently worth $10,000, but you think it will drop to $9,500, you can place a limit order of $9,500 that will be added to the order books. This order will only be filled if Bitcoin does indeed drop to $9,500 or below. Once filled, you would need to pay a maker fee on top of the cost of buying the Bitcoins.

Decentralized exchanges

Although most Bitcoin exchanges can be considered centralized platforms, a large number of decentralized exchanges have appeared in recent years.

Decentralized exchanges differ from their centralized counterparts in that they have no central authority but still allow the safe peer-to-peer trading of digital currencies like Bitcoin. Most decentralized exchanges are non-custodial, which means traders retain full control over their cryptocurrencies and are hence less at risk of theft.

Beyond this, decentralized platforms typically require less personal information from users and can be used in countries where centralized platforms are restricted, such as the United States and China.

However, these trading platforms are often much slower and less intuitive than centralized platforms and typically suffer from relatively poor liquidity. Likewise, a lack of advanced trading tools and derivatives can make them unsuitable for professional traders.

Nonetheless, if privacy and security are your primary concerns, then decentralized cryptocurrency exchanges are likely the way to go. Likewise, Bitcoin mining is another private way to obtain BTC.

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