How a Bitcoin Exchange Works

Jean Nichols | Updated: 26-07-2021 10:13 IST | Created: 26-07-2021 09:39 IST
How a Bitcoin Exchange Works
Image Credit: Pixabay

The primary purpose of Bitcoin is to allow people to exchange value via a peer-to-peer network, the same way fiat money does. However, Bitcoin has a digital realm. That means people can trade this digital currency for anything without involving intermediaries like payment apps and banks. For instance, a Bitcoin user can negotiate and send a specific Bitcoin amount as their payment after offering a service or delivering a product. And this may not be different from paying such a person using cash.

Conversely, people can purchase Bitcoin using an agreed cash amount. A person can also get Bitcoin as a payment for a service or a commodity. But because individuals don’t use this digital currency as an exchange medium every day, it’s generally not easy to get a peer-to-peer buyer or seller than when trading in a local currency. And this leads to the liquidity concept.

Liquidity Explained

Liquidity definition describes it as the ease of trading out and in of any asset. And this largely depends on the available market participants, particularly sellers and buyers. Typically, people consider cash as the most liquid asset because of its universal acceptance. In simple terms, exchanging cash for anything a person wants is relatively easy.

On the other hand, exchanging a car for something else is not easy. Thus, a car is a less liquid asset when compared to cash. That’s because you must put in some effort into finding a buyer. Meanwhile, high-end collector cars are less liquid assets because they have a smaller pool of buyers.

When compared to other cryptocurrencies, Bitcoin is a highly liquid digital asset. That’s because it has the highest number of market participants and the most significant exchange volume. People measure Bitcoin’s daily exchange in billions of dollars. However, Bitcoin may not seem liquid when people compare it to cash, especially when purchasing something. And that’s why crypto exchanges exist.

Bitcoin Exchange Defined

A Bitcoin exchange is a platform where a seller finds a buyer of this cryptocurrency. Essentially, this it’s a system that matches a seller and a buyer. A Bitcoin exchange like the bitcoin code makes this cryptocurrency a liquid asset for large-scale traders.

In most cases, people think about centralized or custodial platforms whenever they hear others mention crypto exchanges. The purpose of these platforms is to facilitate Bitcoin trade. Like the systems that people use to trade stocks, crypto exchanges match cryptocurrency sellers and buyers.

By definition, centralized crypto exchanges take custody of the users’ Bitcoins. However, the increased recent crypto exchange hacks have compelled many people to avoid keeping large Bitcoin amounts in crypto exchanges. Thus, most people opt to transfer their Bitcoins to digital wallets and back to crypto exchanges only when trading.

How a Bitcoin Exchange Functions

Here’s how a Bitcoin exchange functions from a user’s perspective:

  • Present your identity documents to sign up at a crypto exchange
  • Fund your crypto exchange account using an acceptable local currency or another digital currency.
  • Set a buy order to start trading Bitcoin

Crypto exchanges aggregate buy and sell orders into the order book that the platform maintains for automatic and efficient matching of sellers and buyers. Also, a crypto exchange allows the user to set limit buy and market buy orders.

A Bitcoin exchange makes money by charging its users some fees.

These charges can include:

  • Trading fees
  • Withdrawal fees
  • Liquidation/borrowing/interest fees

The amount users pay as fees vary from one crypto exchange to another. What’s more, each platform may sell Bitcoin at a different price. Nevertheless, Bitcoin traders and investors should choose reputable crypto exchanges to ensure better exchange rates and ensure your safety.

(Devdiscourse's journalists were not involved in the production of this article. The facts and opinions appearing in the article do not reflect the views of Devdiscourse and Devdiscourse does not claim any responsibility for the same.)

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