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Bitcoin Exchange

What is a Bitcoin Exchange?

Understanding Bitcoin Exchanges

Bitcoin has proven itself to be one of the fastest horses in the financial arena. To keep up with the rising demand, countless Bitcoin exchanges have popped up to help supply meet that demand.

But what exactly is a Bitcoin exchange, and how does it work? What’s taking place behind the scenes to make sure that my dollars are yielding me an equivalent amount of bitcoin?

What Is A Bitcoin Exchange?

Simply put, a Bitcoin exchange is a marketplace where savers, investors, and traders alike can buy and sell bitcoin using fiat currencies or other assets. Much like traditional financial exchanges, a Bitcoin exchange only lists Bitcoin and skips all the various stocks, cryptocurrencies, and other assets available elsewhere.

By simplifying the product, Bitcoin exchanges can focus more on their customers rather than new trade listings.

A Bitcoin exchange is made up of three core components:

  • Trading: The backbone of any exchange – Bitcoin exchanges provide liquidity for people to easily buy and sell bitcoin
  • User interface (UI): Bitcoin exchanges aim to make buying and selling bitcoin easy, so they offer sleek UIs that simplify the experience for the user.
  • Custody model: Some Bitcoin exchanges offer an internal custody solution for users’ Bitcoin, meaning that it’s a custodial exchange. On the flip side, other exchanges let users keep the Bitcoin under their own control, hence why they are called non-custodial exchanges.

Types Of Bitcoin Exchanges

How we go about buying bitcoin can vary quite a bit depending on your own personal goals.Generally speaking, you can break Bitcoin exchanges down into three main categories: centralized, decentralized, and over-the-counter. How we classify each exchange depends on who is keeping custody of the assets traded on the platform.

Centralized Bitcoin Exchanges

Centralized exchanges (CEXs) are custodial exchanges. It’s the standard way that new holders begin buying bitcoin. A centralized exchange models the traditional financial exchange model we’ve all become used to: a third-party entity maintains full control of its marketplace, and users can sign up on the platform to use its services.

The key distinction that makes a centralized exchange centralized is that the exchange itself maintains custody of assets, and it requires Know-Your-Customer (KYC) verification from its users.

If you’re buying bitcoin on a centralized exchange, you don’t actually own any bitcoin at all; you just hold an IOU. To take custody of the bitcoin you’ve purchased, you have to withdraw it from the platform into a wallet that you control.

How Centralized Exchanges Work

Centralized exchanges operate similarly to traditional banks. They act as intermediaries, facilitating trades between buyers and sellers.

Users create accounts on these platforms, undergo a verification process, deposit their assets, and begin trading. Centrally controlled groups of people or companies control the direction and update implementation of the exchange.

The exchange controls the order book, and serves as the intermediary for facilitating trades. They take a percentage fee for this service from each trade placed on the platform.

Pros And Cons Of Centralized Exchanges

While giving up personal information isn’t ideal for maintaining privacy, centralized exchanges have their own benefits to offer, including:

  • User-friendliness: Centralized exchanges are designed to provide an easy trading experience for the users. They keep functionality simple and clear for newcomers and veterans alike to take advantage of the platform’s offerings.
  • High trading volume and liquidity: Since centralized echanges are the most popular means to buy and sell Bitcoin, they typically have the highest levels of volume and liquidity, which is ideal for large holders working with large amounts of capital.
  • Insurance policies: Centralized exchanges often come with insurance policies to make users whole in case of error. Unlike your private keys, if you lose access to your account for whatever reason, be it a forgotten password or malicious activity, centralized exchanges have protocols in place to help reconnect you with your funds.

However, centralized exchanges may not be right for you if you’re concerned about:

  • Privacy: Sharing KYC information with centralized exchanges is essentially the antithesis to privacy. You’re giving up your personal information in exchange for the convenience of centralized trading. While this may be a worthwhile compromise for some, others who wish to retain their privacy should seek alternatives.
  • Security: Centralized Bitcoin exchanges that attract the majority of people unfortunately means they also attract the most bad actors. Their large Bitcoin treasuries become primary targets for hackers to steal the honeypot. Just look back to the notorious Mt. Gox collapse to better understand what risks come with centrally stored honeypots of Bitcoin.
    Custodial services: You give up control of your assets when you trade on centralized exchanges, so they’re not ideal for long-term storage for your bitcoin.
  • Regulation: Bitcoin is a rapidly developing technology, and with it comes a dynamic regulatory environment that’s changing year after year. Centralized, law-abiding exchanges must follow these regulations, which may not be ideal for someone looking for a reliable, long-term onramp to convert their fiat to bitcoin.

Decentralized Bitcoin Exchanges

Unlike a centralized exchange, a decentralized exchange (DEX) is a non-custodial exchange that enables direct peer-to-peer (P2P) trading between its users.

Decentralized Bitcoin exchanges don’t require KYC information from you, and they allow their users to maintain control over their own assets rather than custodying assets themselves for users to trade.

How Decentralized Exchanges Work

Decentralized exchanges eliminate the need for a centrally-located entity in between trades, allowing for automated P2P transactions.

Instead of having users deposit assets into an exchanges’ native wallet address, users keep funds within their own wallets and transfer them directly between one another’s.

Since they operate without a central authority or intermediary entity, decentralized Bitcoin exchanges rely on atomic swaps or their own proprietary tech to serve as the “intermediary” that enables trustless trading.

Pros And Cons Of Decentralized Exchanges

The key benefits of buying and selling bitcoin on a decentralized exchange include:

  • Non-custodial services: As mentioned, one of the greatest perks of decentralized exchanges is control over your own assets. In the spirit of Bitcoin, you don’t need to give up custody to a third party in order to use the platform.
  • Greater security: Since decentralized exchanges have no single points of failure, and data is distributed rather than consolidated, it makes them much more resilient to online attack vectors.
  • Greater privacy: Your personal information remains with you alone when buying and selling bitcoin on a decentralized exchange.

While more privacy-minded, self-custodial options sound great on paper, decentralized Bitcoin exchanges do come with their own set of tradeoffs:

  • Lower liquidity: Since they aren’t as popular as their centralized counterparts, trades may have a greater price impact, making it more difficult to enter and exit large positions.
  • Complex UX: Decentralized exchanges are a bit rougher around the edges. They sacrifice user experience for greater security; however, don’t let that discourage you. DEXs are becoming more user-friendly with each passing year, and it’s not hard to learn how to navigate them seamlessly.
  • Less regulation: Since they don’t abide by the same legal jurisdictions enforced by traditional financial services, their future is more uncertain. A Bitcoin DEX you’re trading on today may not be available forever.

Over-The-Counter (OTC) Bitcoin Exchanges

An often overlooked but critical component of Bitcoin exchanges is an over-the-counter (OTC) exchange.

Over-the-counter Bitcoin exchanges are essentially private marketplaces, often facilitated by brokers, where high-volume traders can execute trades without immediately impacting the broader market price. We call these traders “whales” – typically high net worth individuals or institutional investors who move around large amounts of bitcoin.

How OTC Exchanges Work

Instead of trading on a public order book, buyers and sellers transact directly in a private deal.

OTC trades typically follow a straightforward path:

  1. Initiation: A buyer or seller initiates a trade by reaching out to an OTC broker, where they then receive a quotation.
  2. Quotation: The broker quotes a price, which can come from a variety of sources, like exchange averages or specific exchange prices. Sometimes, trades on OTC markets can come with a premium.
  3. Agreement: The broker executes a transaction once each party agrees to a price. Settlement can be instantaneous or may take longer, depending on the terms of the trade.
  4. Settlement: The seller transfers the bitcoin from their own wallet to the buyer’s, while the buyer deposits fiat or other assets to the seller. The broker ensures both parties each fulfill their ends of the deal.
  5. Confidentiality: Throughout the process, the specifics of the trade remain private, ensuring the broader market is unaffected by these high-volume trades.

Pros And Cons Of OTC Exchanges

Over-the-counter Bitcoin exchanges certainly aren’t for everyone. However, you may enjoy buying and selling OTC if you care about:

  • High-volume trading: If you have a large stash of capital to deploy, buying bitcoin directly on a traditional CEX or DEX may negatively influence the price. Instead, OTC markets sidestep the greater market to connect buyers and sellers directly on their own terms.
  • Privacy: Since trades aren’t listed on a public order book like a CEX or DEX, you can keep the details of your own transactions out of the public eye, which may be important for companies or entities with larger influence.
  • Personalized, direct customer service: If you have specific requirements for the deal, trading OTC gives you the flexibility to enforce those agreements with willing buyers/sellers.

If you don’t have a lot of capital to throw around or aren’t operating a large financial institution, though, buying and selling Bitcoin over-the-counter may not make the most sense for your situation.

The downsides to over-the-counter Bitcoin exchanges are that they’re:

  • Not suitable for small traders: An OTC exchange’s design favors large whales, not small fish. Oftentimes, an OTC exchange requires higher capital thresholds that smaller traders can’t meet.
  • Not as transparent: While you’ll probably have to give up KYC information to the platform, you may not learn much about the counterparties you’re working with. Additionally, it’s more difficult to find the specific details of each transaction.
  • Delayed finality: OTC exchanges move a bit slower, as it requires mutual agreement between all three parties (buyer, seller, broker). If you’re in a hurry to enter or exit a position, then OTC exchanges probably aren’t for you.

Why Do We Need Bitcoin Exchanges?

Bitcoin exchanges are critical infrastructure for onboarding newcomers to the Bitcoin network. Without them, we wouldn’t have an outlet to exchange fiat currencies and other assets for Bitcoin. In this light, Bitcoin exchanges are the bridges between legacy finance and Bitcoin.

Exchanges help supply (Bitcoin) meet demand (buyers/sellers). There wouldn’t be any liquidity to trade without them, and thus no price discovery. As with the traditional economy, we need these entities in place to help Bitcoin realize its potential as a technology and catalyze mainstream adoption.

Best Bitcoin Exchanges

Here’s a brief list of some of the best Bitcoin exchanges available:

Centralized Bitcoin Exchanges

 Decentralized Bitcoin Exchanges
Cash App RoboSats
Swan HodlHodl
Strike Bisq
River

Relai

Buying Bitcoin With ATMs (Or BTMs)

Bitcoin ATMs, commonly termed BTMs, offer a physical interface to buy bitcoin with fiat currencies. Much like traditional ATMs, they are spread across cities, but instead of dispensing cash, users can buy (and sometimes sell) bitcoin with them. All that’s typically required is a Bitcoin wallet and cash to deposit.

Keep in mind that while Bitcoin ATMs provide convenience when looking to convert spare cash to BTC, Bitcoin ATMs often come with large premiums and fees that net you less bitcoin than buying through standard online exchanges.

The benefit is that you can buy bitcoin completely anonymously this way; they don’t require any sign ups, accounts, or other personal information.

Final Thoughts

Bitcoin is a rapidly developing technology, and thus, so are the applications and financial services being built to support it.

As you look for the best place to buy or sell bitcoin, consider trying out different platforms and determining which best suits you. While you may care about convenience and ease of use, the privacy protection that comes with decentralized exchanges may be just what you’re looking for, depending on your needs.

Everyone has their own personal preferences, so it’s important that bitcoiners provide a range of options for newcomers and veterans alike.

FAQs About Bitcoin Exchanges

Q: Are Bitcoin exchanges safe?
A: While many exchanges prioritize security, they are not immune to risks. It’s important to use reputable exchanges and employ personal security measures, like two-factor authentication or FDIC protection on assets.

Q: Why does price differ between Bitcoin exchanges?
A: Differences in trading volumes, liquidity, regional demand, and the presence (or absence) of specific regulations can lead to price discrepancies across exchanges. To capitalize on the difference in prices, traders can conduct “arbitrage” where they buy bitcoin on one exchange to sell for a higher price on another, for example. Arbitrage helps maintain a balance between prices on exchanges. Once the price discrepancy becomes too wide between exchanges, it economically incentivizes traders to step in and realign prices with arbitrage.

Q: Can I trade other assets on Bitcoin exchanges?
A: This depends on the exchange. While some platforms are Bitcoin-exclusive, others offer various trading pairs.