How does bitcoin exchange work?
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Loading... - Karla Carbrera
- 20 Jul 2022
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Bitcoin is designed to enable peer-to-peer value exchange just like cash, but in the digital realm. This means you can trade bitcoin for anything you want, and you can do so without using intermediaries like banks or payment apps. For example, if someone paints your house, you could potentially negotiate to send the person an agreed amount of bitcoin as payment. This would be effectively no different than handing over cash in exchange for the house-painting service.
How does bitcoin exchange work?
Conversely, if you're looking to buy bitcoin, you could offer the seller an agreed amount of cash (or any other good or service) in exchange for the agreed amount of bitcoin.
Of course, since most people don't use bitcoin as a medium of exchange in their daily lives (at least not yet!), it's generally harder to find peer-to-peer sellers/buyers than it is to, for example, trade in local currency. This brings us to the concept of 'liquidity.'
What's liquidity?
Liquidity refers to the ease with which you can trade in and out of an asset - and it depends largely on the number of buyers and sellers (market participants) there are for an asset. Cash is typically considered the most liquid asset, as it's almost universally accepted. In other words, it's easy to exchange cash for practically anything you want. A car, by contrast, is generally a less liquid asset than cash, since it requires some effort to find a buyer. A high-end collector's car, meanwhile, would be an even less liquid asset, since the pool of potential buyers is smaller.
Bitcoin is the most liquid of all cryptocurrencies as it combines the highest number of market participants with the greatest volume of exchange. The daily exchange of bitcoin is measured in the tens of billions of dollars! Still, compared to cash, it's not liquid, particularly when it comes to using it to buy something in the real world. For this reason, there's a need for bitcoin exchanges.
What's a bitcoin exchange?
A bitcoin exchange is any service that matches buyers of bitcoin with sellers. Exchanges are what make Bitcoin a liquid asset for traders at large scale.
When most people speak of bitcoin exchanges, they're referring to centralized 'custodial' platforms like Coinbase, Kraken, and Binance. These platforms facilitate the trade of bitcoin and many other cryptocurrencies. Similar to platforms for trading stocks like Robinhood and Charles Schwab, cryptocurrency exchanges match buyers and sellers.
Critically, by definition, a centralized cryptocurrency exchange takes custody of your bitcoin. This has a number of implications relating to security, but also relating to the freedom you have to use your bitcoin as you wish.
How do centralized bitcoin exchanges work?
From a user's perspective, the typical flow is as follows:
Sign up to the exchange and present identity documents.
Fund your newly created account with bitcoin, another cryptocurrency or, if the exchange allows it, local currency.
Make a trade by setting a 'buy order.'
Buy and sell orders are aggregated into an 'order book' which is maintained by the exchange for the purpose of efficiently and automatically matching buyers and sellers. Most exchanges allow you to set both 'market buy' orders and 'limit buy' orders. When you create a market buy order, you only need to indicate how much bitcoin you'd like to buy (you don't set the price). The exchange will automatically match you with the seller(s) currently offering the lowest price, and execute your trade. Market orders are, by and large, instantly completed, meaning the moment you submit the order, you'll receive your bitcoin in your exchange wallet/account. When you create a limit buy order, you're indicating how much bitcoin you'd like to buy and the price you're willing to pay for it. If and when there are sellers willing to accept the price you've set (your 'limit'), your order will complete, meaning your bitcoin will show up in your exchange wallet and your money (or other cryptocurrency) will disappear.
What's a banked exchange?
Cryptocurrency exchanges that allow you to transfer local currency to and from them are known as 'banked exchanges.' Some exchanges allow you to transfer local currency to start buying (typically in the form of credit card or payment app like PayPal), but don't allow you to withdraw local currency back to your credit card or payment app. These are known as 'partially banked' exchanges. A fully-banked exchange will allow to you fund your account via bank transfer and send local currency back to your bank account. Read More...
