Exchanges are online marketplaces where users can buy and sell cryptocurrencies. In this post we will take a closer look at how traditional exchanges work, what services they offer and how to avoid risk as much as possible. For other types of exchanges see Types of Exchanges.
Basics of How an Exchange Works
Buying and Selling
Exchanges offer a platform for buying and selling of cryptocurrencies. They do this by matching potential buyers and seller. Most exchanges offer different types of orders. The easiest to understand are market and limit orders which work in the same way as with buying shares of stock. Some exchanges offer more advanced order types that are not recommended for new users.
When you execute a market or limit order on an exchange a transaction will happen as soon as a buyer and seller are matched. But what happens behind the scenes when you make such a transaction via an exchange?
Transactions on Exchanges
One interesting thing to note about exchanges is that when you make a trade on an exchange the transaction is not recorded in the blockchain. This makes sense from two points. First recording something in the blockchain takes time and second it costs a mining fee. So exchanges do off blockchain transactions. The easiest way to imagine this is that they hold a table with each user’s account and their current balance of each cryptocurrency tradable on the exchange. So somewhere in the exchanges database it would say “Cryptohelp – 500 BTC” (I wish), “Cryptohelp – 20 ETH” and so on. If I then sell some of my BTC this internal ledger would simply be updated to reflect the new balance. As you can easily see, using an exchange requires you to trust it to keep this internal ledger correctly and to protect it from attacks.
How do Exchanges Earn Money?
Traditional Exchanges earn most of their money from transaction fees. These are usually clearly listed somewhere on their website. Different exchanges have different fee structures which can get rather complicated. For example Bistamp starts with a fee of 0.25% for all trades, but as your trading volume increases the fee gets lower. Kraken combines this approach with different maker and taker fees. A maker is someone that adds to the order book, whereas a taker is someone that removes something from the order book. Maker fees are lower as they add liquidity to the market which is favored by exchanges. With a market order you should always get the higher taker fee, which is undesirable. So if the exchange distinguishes between maker and taker fees it is best to only use limit orders.
In addition to earning from transaction fees many exchanges also have additional fees. This is covered in a separate post about the Different Types of Fees.
Can I Trust an Exchange?
Since the majority of exchanges are centralized authorities, meaning that the whole process is controlled by one entity, it is necessary to put a lot of trust into the exchange you are using. Actual risks involved when dealing with an exchange are the following:
- Hackers – as we will see this is one of the largest risks.
- Owners Steal Money – the entity controlling the exchange might simply walk away with your money.
- Bank run – this is exactly the same as a bank run on a traditional bank. It could happen when a large amount of users wishes to withdraw their funds since they believe the exchange may cease to function in the near future and that exchange only keeps a fractional reserve (Note: in theory each exchange should keep a full reserve of all coins stored on the platform, but this is difficult to verify). With more and more people withdrawing the likelihood of the exchange actually becoming insolvent increases which will cause more people to withdraw.
- Bugs / Data Loss – the program running the exchange is likely not perfect and will have some bugs (as all software does). From simple bugs that lead to the user having to pay the higher taker fee instead of the maker fee, transactions that aren’t recorded properly in the ledger or larger bugs that lead to temporary trading stops anything is imaginable.
- Seizure from government – if the exchange is acting illegally it could be seized by government.
- Bankruptcy – the exchange can also simply go bankrupt due to for example mismanagement.
Your assets might not necessarily be completely gone in all of these cases, but it will certainly give you an uneasy feeling for a certain time as you won’t really know what is happening to them and you will most likely not be able to access them. It is also likely that if one of these risks becomes apparent with one exchange another might follow.
So there are quite a couple of things that can go wrong and in the past many exchanges have actually ceased to exist due to some points or several mentioned above.
Here are a couple of examples of hacks that have happened in the past:
- One of the first disasters was Mt. Gox which was the leading Bitcoin Exchange in 2013 handling over 70% of all transactions. In February 2014 all trading suspended. WizSec, a volunteer independent investigation into MtGox, found that in September 2011 the private keys for the hot wallet of Mt Gox were stolen. This is how the hacker managed to steal 630’000 BTC – worth 460 million USD – from MtGox. If you are interested in more details read the article here.
- In January 2018 NEM (XEM) worth over 500 million USD were stolen from Coincheck. Apparently the XEM funds were not stored in cold wallets, but online in hot wallets. This made it much easier to hack.
- In 2016 another hack occurred where roughly 120’000 BTC were stolen from Bitfinex’s customer’s accounts, or about 72 million USD. This is also a rather interesting story if you are interested.
- Seoul-based Youbit filed for bankruptcy in December 2017 after hackers stole around 17% of their assets.
- There are more examples of hacks, such as the DAO hack that affected Ethereum and resulted in the currency ultimately being split into Ethereum Classic and Ethereum.
If you are interested about more details I found this article very interesting.
But hackers aren’t the only risk involved when dealing with an exchange, the exchange could be seized by government (see BTC-e) or walk away with your money (claiming to have been hacked). In an article from October 2015 36 bitcoin exchanges that had to close for various reasons are listed.
So you see, it isn’t that easy to successfully run a cryptocurrency exchange. There are many ways in which you can attempt to minimize the risk you expose yourself to when using an exchange. The most important one is to Google the exchange and to never ever leave any fiat or cryptocurrency on the exchange. For details see How to Minimize Risk Exposure When Using a Traditional Exchange.
Now one can ask oneself what the legal situation with exchanges is and whether this helps protect customers. We will explore this topic in another post.