Cryptocurrency exchanges operate as platforms where users can buy, sell, and trade various cryptocurrencies, similar to how stock exchanges operate for traditional assets. Here’s a breakdown of how they work:
1. Types of Exchanges
Centralized Exchanges (CEX): These are managed by a central authority or company, such as Binance, Coinbase, or Kraken. They hold users’ funds in custodial wallets, handle security, and facilitate trading.
Decentralized Exchanges (DEX): These operate without a central authority. Instead, they use smart contracts and allow peer-to-peer trading directly on the blockchain, like Uniswap or SushiSwap.
2. User Accounts and Verification
Users sign up, create accounts, and, for regulated exchanges, complete Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures. Verification typically includes providing identification and contact information.
3. Deposits and Wallets
After registration, users deposit funds, which can be in fiat currency (like USD) or cryptocurrency. For fiat, exchanges often use traditional bank transfers, credit cards, or payment gateways.
Funds are stored in wallets managed by the exchange (custodial for CEX) or user-controlled wallets (non-custodial for DEX). Exchanges manage both hot wallets (connected online for active trading) and cold wallets (offline for security).
4. Order Matching and Trading
Order Book Model: In CEXs, user orders are matched through an order book, where buy and sell orders are listed at various price points. The exchange matches orders and executes trades.
Automated Market Maker (AMM): DEXs use AMMs, where liquidity pools replace order books. Users provide liquidity, and prices are determined by algorithms (e.g., Uniswap’s “constant product” formula). Trades are directly with the pool, not another trader.
5. Transaction Fees
Exchanges earn revenue by charging fees on each trade. CEXs often have tiered fee structures based on trading volume, while DEXs may split fees with liquidity providers.