How does a crypto exchange work?

In the old days, if someone needed their cash, they would head down to the bank, fill out a form, stand in a long line, hand the form over, wait while someone counted the money, then counted it again, before they tucked the crisp bills into a neat white envelope and handed it over.

And if someone wanted to buy stock back then, the process likely involved paper forms and maybe even a phone call. While these processes took plenty of time, they were pretty straightforward and standardized.

The new world of cryptocurrency is a different story.

Want to buy some Bitcoin? How about some Ethereum? What if you want to convert your Bitcoin into a fun new altcoin you just heard about that’s based on a forum you spend way too much time on?

It can be a little more complicated and confusing than writing your account number, the date, and a dollar amount on a form down at the community bank or calling your broker.

In some cases, you’ll have to engage with a cryptocurrency exchange platform, you may need a digital wallet and want a basic grounding in the cryptocurrency landscape — because you won’t have access to a charming bitcoin teller with a green visor to answer your questions.

That said, there are opportunities where the company or firm handling the purchase will provide a secure platform, digital wallet and a learn-as-you-go education in cryptocurrency. However, it’s important to note that cryptocurrency is volatile and comes with risk.

Related: What is considered a good return on investment?

What’s the deal with cryptocurrency wallets? lists more than 2,800 cryptocurrencies as of October 2019. There’s a good chance that number has increased by the time you read this since new cryptocurrencies seem to pop up by the day. Bitcoin and Ethereum are still two of the most popular cryptocurrencies —Bitcoin being the first and still holding the highest market cap and value.

But there are coins and crypto projects built out for myriad weird and interesting niches, like the DogeCoin that started on Reddit, multiple coins themed around cats and one for buying Burger King Whoppers in Russia.

What most of these currencies have in common is that they have a piece of software — some are online — called a wallet where you can store your cryptocurrency.

Buyers can set up a wallet before buying their first coin. That way, they can move their crisp new cryptocurrency off of the exchange when it’s purchased.

The official Bitcoin site lists no fewer than 22 wallets that you could use to store Bitcoin. This is likely a product of Bitcoin’s place as the first cryptocurrency and still one of the most popular. More people have been using Bitcoin longer, so it makes sense that there are more options for wallets.

Many smaller cryptos, like Litecoin, will have their own wallet and additional wallets you can use from other developers. There are even hardware wallets if you want to be really secure. 

The hardware wallets usually look like a USB stick and can be more secure because once you remove them from your computer they’re not on the internet, and they can be built around secure chips and can have encryption. You can also get mobile apps on most iOS and Android devices as well.

Your options for choosing a wallet that works for you are basically those made by the coin developers themselves or those made by a third-party developer. In some cases, wallets made by the original developers might need a little more technical know-how and may require more computer processing power than the third-party applications that seem to be aimed toward a general audience.

For instance, Bitcoin Core, the wallet application from the developers of Bitcoin, needs a ton of hard-drive space. If you want to use this application you’ll need a minimum of 200 GB free on your hard drive. Bitcoin will take up this space because it’s going to download the entire blockchain.

Basically, your computer will end up having a record of every Bitcoin transaction that has run across the blockchain. Pretty cool, but may not be necessary if you’re just looking to purchase some cryptocurrency.

A third-party application might make it a little easier for most end users who want to buy and trade cryptocurrencies without taking such a deep dive into the technology under the hood.

These applications often require fewer resources from your computer, might be a little easier to use, and some of them are mobile apps so you can take your crypto portfolio on the go.

Crypto exchanges: Like Wall Street on code

Once you’ve found the wallet that could work for you, it might be time to head to an exchange to get some crypto you can store in it. After all, what’s the point of having the wallet if you’re not going to use it? But you might be wondering what an exchange actually is.

An easy way to think about cryptocurrency exchanges is to imagine the stock market. Instead of trading and selling small bits of companies in the form of stocks, futures, or bonds, crypto exchanges do the same thing, but with cryptocurrencies.

Many of these exchanges will show prices of a single coin/token, usually against the U.S. dollar, and they may have charts that show the performance of a particular cryptocurrency over time.

If you’ve ever looked at a stock ticker tape or a finance site with stock prices, you can probably already imagine what a crypto exchange looks like, except with cryptocurrencies like Bitcoin and Ethereum listed instead of blue-chip, Fortune 500 companies.

There are three kinds of digital currency exchanges: centralized exchanges, decentralized exchanges and hybrids. Here’s how they shake out.

Centralized cryptocurrency exchanges

A centralized cryptocurrency exchange is a lot like what it sounds like: a central platform where cryptos are bought and exchanged. These exchanges have a third party that helps conduct transactions to make sure they go through as intended — sort of like a bank.

This might seem counterintuitive since one of the founding tenets of Bitcoin was a decentralized network, but exchanging fiat currencies for cryptocurrencies can require a third party to help make everything go as smoothly as possible. (“Fiat currency” is just a fancy term for traditional, established currencies like U.S. dollars.)

A centralized cryptocurrency exchange can make it easier to buy your intended crypto with real money and might give you some security that the transaction will go as intended. Also, they can make it easy to link your bank account or debit card in order to buy crypto.

Once you own cryptocurrency, you can usually trade it on centralized exchanges, too. So, if you have some Bitcoin and you want to buy some Litecoin, you can make that happen on a centralized exchange. Centralized exchanges are more common than their decentralized cousins.

Decentralized cryptocurrency exchanges

A decentralized cryptocurrency exchange, or DEX, lacks the third party found in centralized exchanges. You could say decentralized exchanges are closer to the spirit of the blockchain that started the cryptocurrency world, because they are open source and depend on users to trade peer to peer.

In theory, a decentralized cryptocurrency exchange could be more secure than a centralized exchange. Because there’s no central entity or server to hack, it might make it harder to steal cryptocurrency. Fees might be lower and your transactions might also process faster in a DEX.

DEX has some drawbacks compared to their centralized counterparts. You might have to be a little more skilled with tech because DEX doesn’t often offer easy transfers from bank accounts or debit cards to buy crypto.

Some DEX doesn’t offer fiat currency changes at all and your only option might be to trade one cryptocurrency for another. Your funds aren’t insured and there’s nobody to call if you run into a customer service issue, as there’s no central authority.

Hybrid cryptocurrency exchanges

Hybrid cryptocurrency exchanges are exactly what they sound like: an attempt to blend the best of both worlds from centralized and decentralized into one exchange. Their aim is to give end users the convenience of a centralized exchange while also giving them the security and freedom of a decentralized exchange.

Hybrid exchanges have yet to see the adoption that centralized exchanges have realized, but they may be laying a roadmap for a middle ground that might keep consumers and crypto enthusiasts happy in the future.

Now what?

Remember that wallet you learned about? Well, now that you’ve got a handle on how exchanges work, and what they do, you can combine the two and move your fancy new cryptocurrency from the exchange to your personal wallet.

Here’s how a transaction like this might go down. Let’s say you want to buy one Bitcoin:

•   First, you can find a Bitcoin-compatible wallet you like.

•   Then, you might find a centralized exchange (because they can be easier).

•   You could then create an account at the exchange and add some funds, usually from a bank account or debit card.

•   Then you could buy your one Bitcoin.

You could keep your Bitcoin on the exchange, but some crypto folks might suggest you move it to a personal wallet if you’re going to hang on to it for a while. That’s because the exchange could get hacked and you could lose your shiny new Bitcoin.

Or the exchange might suddenly close up shop and your Bitcoin might go right along with it — such as what happened with Polish cryptocurrency exchange, Coinroom.

Moving your Bitcoin from the exchange to your wallet is almost like taking cash from the bank and putting it in your safe at home. It might be a good idea to help keep your cryptocurrencies secure.

Get ready to trade

Finding the cryptocurrency, exchange and wallet that works for you and your goals is a personal choice. It may also depend on something like your operating system and if the wallet and exchange are available on mobile. It might even depend on the cryptocurrency you’re trying to buy. Please note that while the crypto industry is evolving, it is still nascent and volatile — so be careful!

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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRAthe SEC, and the CFPB, have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments.

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