What is an Exchange?

An exchange is an organized marketplace where financial instruments are traded. Exchanges provide liquidity to traders looking to buy and sell their financial products. Secondary markets where traders are buying and selling among themselves. exchanges usually specialize in their asset class (stocks, bonds, commodities, or cryptocurrencies), but offer a variety of trading options and services to their traders (futures, options, and trading data).

Background

When there is underlying risk of holding an asset, there will always be speculation for what the price of the asset should be. Exchanges are a marketplace where buyers and sellers participate in that price discovery. In this market, traders are incentivized to lessen their risk associated with the asset  or gain exposure to the upside of the underlying asset. With respect to cryptocurrency exchanges – investors exchange fiat currencies for cryptocurrencies and trade those coins among themselves. 

How Do Exchanges Operate?

Traders deposit fiat money or cryptocurrency into the exchange to fund their account. The exchange itself provides traders security, liquidity, and order matching to those who are utilizing their trading platform. In return, exchanges earn fees for each transaction they facilitate. There are different fees for different types of orders. Maker-Fees are for traders who provide liquidity to the market, setting their trades execution price price above or below the current market price. Taker-Fees are for traders who trade against the resting liquidity by executing trades at the market price. Recently, stock exchange brokers have seen these commission fees transition to zero-fees. Fees eat into the traders’ gains so lower fees give more incentive for traders to join an exchanges’ platform. 

Exchanges’ value proposition will continue to change as technology makes it easier for traders’ orders to be matched and liquidity to be provided. Exchanges have a range of market data and analytical tools that are useful and sold to experienced traders. Exchanges will always have a role in the way value is transferred from one another. Cryptocurrency, and the exchanges that support them, are in the early stages of innovation. While value proposition changes for all other secondary markets, so will cryptocurrency exchanges. Security, liquidity, and order matching management to ensure tight spreads between bid and ask is still the most important aspect of an exchange. Fees associated with cryptocurrency exchanges will trend closer to zero as traders find advanced platforms with lower fees. Learn more about CrossTower’s high-end security, liquidity, and maker-taker fees that help our exchange create tight bid-ask spreads and unlock value for traders. 

Types of Exchanges

With respect to cryptocurrency exchanges, there are two distinctly known types of exchanges. Centralized exchanges are currently the most common. These exchanges are maintained by a private company and their proprietary centralized systems. The company acts as an intermediary for every order that is placed on the exchange. The centralized exchange is responsible for ensuring legality and fairness for transactions that take place on their platform. Customers enjoy deep liquidity on these exchanges since most traders and institutions prefer a responsible third-party entity executing their trades. Security is the foremost important quality for centralized exchanges because if anything goes wrong their company is liable. Centralized exchanges are the most popular types of crypto exchanges and provide the best experience for traders. 

An alternative to centralized exchanges are decentralized cryptocurrency exchanges (also known as DEX). DEX are automated market matching protocols that replace the middleman with code. A DEX executes trades and transactions with smart contracts rather than proprietary market making technology. Since they are far less popular than centralized exchanges they tend to have less liquidity so larger market orders experience price slippage. Smart Contract risk is the main focus in terms of security since vulnerabilities in the code can lead to hackers receiving millions of dollars worth of cryptocurrency. DEX also cannot be used with fiat currency due to the fact you need to interact with a smart contract. Paying gas fees to the smart contract for executing each transaction is another reason DEX has a hard time gaining traction with active traders.

CrossTower Inc. provides this content for general information purposes, to better inform you on your digital asset investment journey. We do not provide investment recommendations or provide tax advice. Please consult your investment professional or tax advisor if you require assistance in these areas.

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