What are Cryptocurrency Exchanges?
Discover what cryptocurrency exchanges are, in addition to their differences and similarities.
Cryptocurrency exchanges are places on the web where you can buy, sell, and trade crypto assets. Some of these exchanges include the ability to purchase crypto with fiat currency by connecting either a bank account or a credit card.
There are three main types of cryptocurrency exchanges: Centralized Exchanges (the most commonly used), Decentralized Exchanges, and what is called “Pseudo” Exchanges.
If you’ve ever traveled to a foreign country, you probably went to a local currency exchange when you arrived to exchange your US Dollars for the native currency. You may also have attempted to day trade stocks to (hopefully) a degree of success at some point in your life. These two concepts underpin the question “What is a centralized cryptocurrency exchange?”
The most common type of cryptocurrency exchange is what is referred to as a “cryptocurrency broker.” Cryptocurrency brokers (Coinbase is arguably the most well-known example) function exactly as the foreign currency exchanges commonly used while traveling abroad. You give your currency to the broker, and the broker exchanges one currency for another, generally at a small premium.
Centralized cryptocurrency exchanges work the same way. When you go to purchase bitcoin, on Coinbase, you pay the current market price of bitcoin (plus a small premium) and in exchange for your dollars, you receive bitcoin.
For more experienced cryptocurrency users, many exchanges also have a trading platform. Coinbase has a “pro” feature in addition to the simple broker function. On these platforms you generally pay smaller fees and have more autonomy to set limit orders among other trading options. These trading platforms function very similarly to a stock trading platform.
Centralized exchanges are the most popular and widely used exchanges for several reasons. The biggest reason is the simple user experience and convenience. It takes just minutes to download an app like Coinbase (or Gemini, Binance, Kraken etc.), verify your identity, connect a bank account or debit card, and purchase crypto. The other reasons include regulations, customer support, and especially attractive for new users: no need to set up a wallet.
Cryptocurrency is predicated on the strength of decentralization. It’s important to highlight this notion when understanding decentralized exchanges. Centralized entities (centralized crypto exchanges, banks, governments, social media apps, among many others are considered centralized entities) have a central point of failure.
You’ve probably read about hackers stealing customer data from companies and governments, or crypto exchanges getting hacked for sometimes hundreds of millions of dollars. Decentralization is still in its infancy, but it is where cryptocurrency (including exchanges) derives such immense value. There are two types of decentralized exchanges, which I like to refer to as “Traditional decentralized exchanges” and “Ecosystem decentralized exchanges.”
Traditional Decentralized Exchanges
Two good examples of traditional decentralized exchanges are Shapeshift and Exodus Exchange. On these platforms, you can exchange bitcoin for any other cryptocurrency available and vice versa. Decentralized exchanges function similarly to centralized exchanges, but instead of relying on a centralized entity, an algorithm functions as a “market maker” to provide the exchange rate for cryptocurrencies.
By removing the centralized middleman, you trade directly, peer-to-peer, with no central point of failure. If you recall the uproar when Robinhood suspended trading on GameStop stock, decentralized exchanges are the solution to those who don’t want to find themselves unable to trade because a corporation pressed a button.
Decentralized exchanges are also attractive to those who value privacy. The creation of cryptocurrency was motivated by several reasons: an unfair and antiquated banking system, a way to give the power of money back to the people, and to provide more privacy to those who value their privacy. Decentralized exchanges often will not require identity verifications, providing a more private alternative.
It is important to note that you need to have a self-custody wallet to use decentralized exchanges. Self-custody is the bedrock of decentralization. When the proper precautions are taken, self-custody provides you with complete control of your cryptocurrency: out of reach from malignant governments, institutions, and hackers.
If you want to explore self-custody wallets, Exodus Wallet is a great option. For more experienced users or those with more than $1,000 worth of cryptocurrency, a hardware wallet such as Trezor or Ledger are a worthwhile investment, as they are the safest wallet options.
Ecosystem Decentralized Exchanges
Ecosystem decentralized exchanges are functionally identical to traditional decentralized exchanges, but they are narrower in scope. Ethereum is what we call a “Platform or Layer 1” token. As a “platform” or “ecosystem”, other cryptocurrencies and protocols can be built on the Ethereum platform. Think of Ethereum as an IOS or Android operating system, and everything built on the platform are the apps, making an “ecosystem.”
If you hold Ethereum, you can use an ecosystem decentralized exchange to instantly swap any cryptocurrency built on Ethereum. The exchange is usually called a “DEX”. Uniswap is a popular decentralized exchange for Ethereum.
To draw an analogy, imagine American Airlines and Delta both built applications on Ethereum, and their tokens are what you know today as “airline miles or rewards miles” Unlike the present situation, if these Airlines built applications on Ethereum, you could seamlessly swap your American Airlines miles for Delta miles at the click of a button, and use them to purchase a more desirable flight.
Pseudo Cryptocurrency Exchanges
Pseudo cryptocurrency exchanges are, hopefully, going to fade out quickly. A Pseudo cryptocurrency exchange allows you to “buy” cryptocurrency, but it does not actually give you any ownership of the currency. You cannot withdraw your crypto from a Pseudo cryptocurrency exchange to a self-custody wallet, only sell it back to the exchange you purchased it from.
You might be thinking, who would use something like that? Why would you buy something you have no real ownership of? The answer is simple: lack of education, and ease of access. You’re likely very familiar with the most prolific Pseudo cryptocurrency exchanges: Venmo, Robinhood and CashApp. These applications make buying cryptocurrency very easy because the average consumer already uses them often.
What the average consumer doesn’t realize, is that they aren’t buying cryptocurrency at all. If you can’t withdraw a cryptocurrency to a self-custody wallet, you have no ownership over it. This is important to keep in mind when exploring exchange options to make your first purchase.
- Avoid Pseudo Exchanges
- Centralized exchanges are generally ok, but there is a risk of hacks or insolvency (“not your keys, not your crypto”) as private keys are the “password” for a self-custody wallet
- Decentralized Exchanges are likely to rise in prominence in the future, but there is a larger learning curve to navigating these exchanges.
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Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.