Feb 22, 2022

14 min read

Blockchain Blog 16: Crypto Exchanges

We have covered the crypto wallets in the following: Blockchain Blog 06 — Cryptography, Security, and Crypto Wallets
Where we explored the cold wallets, hot wallets, and different types of crypto wallets. In this blog, we will cover the Crypto Exchanges.

Cryptocurrency exchanges are the digital marketplaces where you can buy and trade crypto.

You can’t just buy crypto from your bank or investment firm. Once you’ve decided you want to buy some Bitcoin, Ethereum, or another cryptocurrency, you’ll need to create an account on a crypto trading platform to exchange your U.S. dollars (or other currency) for digital assets.

You can use exchanges to trade one crypto for another — converting Bitcoin to Litecoin, for example — or to buy crypto using regular currency, like the U.S. Dollar. Exchanges reflect the current market prices of the cryptocurrencies they offer. You can also convert cryptocurrencies back into the U.S. Dollar or another currency on an exchange, to leave as cash within your account (if you want to trade back into crypto later), or withdraw to your regular bank account.

One of the main roles of an exchange is to provide liquidity in a secure and organized trading environment. Liquidity is simply a measure of how easily an asset can be bought or sold. Exchanges act as an intermediary for traders and investors, where users can easily buy and sell their assets on the exchange as opposed to having to find buyers/sellers on their own.

What to Look for in an Exchange

Accessibility

Your location may prevent you from buying and selling crypto on certain exchanges due to state or national regulations. Some countries, like China, have banned citizens from accessing crypto exchanges at all. In the United States, there’s a lot of regulatory uncertainty around cryptocurrency, and some states have instituted their own regulations. You can often find information about the geographic limitations of an exchange — as well as related accessibility factors, like national currencies accepted — on its website or within the terms of service.

Security

Cryptocurrency isn’t backed by any central institution, and your cryptocurrency holdings aren’t protected the same way as money in the bank or traditional investments. Some exchanges, like Coinbase and Gemini, keep any balances in U.S. Dollars you hold with them in FDIC-insured bank accounts. But FDIC insurance doesn’t apply to cryptocurrency balances.

Whether you plan to keep your crypto holdings within an exchange or only have it there for a short time before moving it into your own wallet, the exchange’s security should be top priority. For example, look into how much of its assets the exchange keeps offline, in hard storage.

You can also look for general online security measures you may already be familiar with on other platforms, such as two-factor authentication. That means, in addition to your username and password, you’ll have to verify your identity using an additional method, like entering a code you receive by text message, each time you log in.

In general, you may feel most secure sticking with more popular exchanges with an already-large customer base. You may be taking more of a risk doing business with smaller or newer exchanges that don’t have their security measures and offerings spelled out clearly online.

Liquidity

If you plan to buy, sell, or trade your crypto, the exchange you choose should have enough trade volume to ensure your holdings are relatively liquid, meaning you can sell them when you want. Again, this can be an instance where size matters. Often, the more popular exchanges are also those with the largest trade volumes.

When a lot of trades are happening within an exchange at any given time, it means you have a higher chance of buying or selling the crypto you hold at the best price, Montgomery says. Crypto prices move very quickly, so when you use an exchange that doesn’t have a lot of trade volume, you could end up paying a higher price than you would on more popular exchanges. For example, say you decide to buy Bitcoin once its price falls below $32,000. If you’re on an exchange with a low trade volume, you may end up actually paying a different price than you think, if your purchase doesn’t actually go through until the price has moved back up.

CoinMarketCap, a price-tracking site for cryptocurrencies, continually tracks the trade volume of hundreds of exchanges in operation. Currently, it lists Binance, Coinbase, and Huobi as the top exchanges by volume worldwide.

Market Makers and Market Takers

Trading exchanges such as Coinbase Pro and Kraken Pro use a fee structure called market maker fees and market taker fees.
A market maker is a user who places an order on an exchange that does not immediately get filled. If you wanted to buy BTC at a lower price than what it currently is, you can place an order for the exact price that you want to buy it for. If the price drops to that level, your order will be filled.
A market taker is someone who places an order that immediately is filled. They are essentially taking an order that was created by a market maker and fulfilling it. Exchanges will often charge fees that differ based on if your transaction is considered a market maker or a market taker.

Types of crypto exchange fees

Cryptocurrency exchanges charge fees on different types of user behavior:

Trading Fees — the primary source of revenue for exchanges. They are typically charged on both fiat-crypto trades as well as crypto-crypto trades.

While exchanges can offer a variety of services to cryptocurrency users, there are often fees attached to each individual service when using their platform. The exchanges charge a fee for every purchase, sale, or conversion (converting one crypto to another) of a cryptocurrency. Fees can be based on your location, payment method, the amount transferred, and other conditions. Fees can vary from exchange to exchange, so it is important to know the fee structure of each exchange you are using.

Deposit/Withdrawal Fees — some exchanges charge fees for deposits and/or withdrawals. Deposit fees vary based on the type of deposit but are less common than withdrawal fees since exchanges want to incentivize users to fund their account. For cryptocurrency withdrawals, many exchanges limit fees to any blockchain transaction costs (usually a flat fee regardless of the amount withdrawn), but some will take an additional fee based on your country or the type of withdrawal (crypto vs fiat)

Most of the time there is no deposit fee. For example, Binance does not charge deposit fees. For each withdrawal, a flat fee is paid by users to cover the transaction costs of moving the cryptocurrency out of their Binance account.
Check this source to know more about different exchanges deposit and withdrawal fees.

Withdrawals rates are determined by the blockchain network and can fluctuate without notice due to factors such as network congestion.

Interest/Borrowing/Liquidation Fees — some exchanges like Kraken, Poloniex, and Bitfinex offer crypto margin trading: the ability to borrow or synthetically borrow additional funds to increase your position and create leverage. These exchanges typically charge additional fees based on the amount borrowed on margin and an interest rate determined by the supply of funds available. Additionally, if your trade goes upside down and the position is liquidated you may be charged an additional fee.

Funds on hold

Funds on hold refer to the fiat currency value of your recent deposits and the crypto purchased with those deposits. Some exchanges may allow you to instantly deposit money to the account and allow you to instantly use those funds to buy crypto but may put a hold on those funds/crypto until the transaction has been fully confirmed and settled. This means that while you may be able to instantly buy and trade crypto with the newly deposited funds, you may not be able to send it off your account as the exchange may place a hold until they clear the purchase.

KYC (Know Your Customer)

KYC is a process that exchanges use to verify a customer’s identity and location. KYC is a mandated practice for all asset classes and regulated institutions and is a part of the broader Anti-Money Laundering (AML) policies taken by governments around the world. KYC practices may vary from exchange to exchange, but generally, they all include these policies:
Customer Identification Program: Identity verification that can include a user’s full name, date of birth, address, social security, driver license, and passport.
Customer Due Diligence: Background checks can be performed on new users to evaluate any risk that the exchange could take on by doing business with them.
Ongoing Monitoring/Risk Management: Financial services continue to monitor and oversee its user’s actions and transactions over long periods of time.

Taxes in the U.S.

The IRS has classified cryptocurrency as property, not as currency. This results in the use of tax rules that apply to property transactions such as factoring in the appreciation of value over time. Some examples: selling a vintage car or a vintage comic book collection. If you have sold, converted, donated, made payments of, or earned income of any amount of crypto and are subject to U.S. taxes, you are mandated to report your gains and loses to the IRS for that year. The IRS holds every individual responsible for reporting all of their income and transactions. Some exchanges may offer to send a tax form of total gains/losses for the year to U.S. residents. Other exchanges may simply provide a total history of transactions that can be used for these purposes as well.

Taxable Events

Taxable events are actions that are recorded that could result in taxes owed to the government.
Here are some examples of taxable crypto events:
○ Selling crypto for cash
○ Paying for goods or services
○ Buying one crypto with another crypto
○ Receiving mined crypto
○ Being paid in crypto by an employer
○ Airdrops (Airdrops are similar to free money in a giveaway)
○ Receiving staking and interest rewards

Non Taxable Crypto Events

Non taxable events can include:
○ Donating crypto to a qualified tax exempt charity or a non profit
○ Buying crypto with cash and holding it
○ Transferring crypto between wallets/address
○ Transferring crypto between exchange accounts or from a wallet to an exchange

Coins offered

Not every exchange offers each of the thousands of cryptocurrencies that exist.

If you’re interested in a popular coin like Bitcoin or Ethereum, you’ll probably find it on any given exchange you’re considering. But newer altcoins, coins with a very small market cap, or meme coins may require a bit more shopping around.

Just remember, these types of coins are often even riskier gambles on top of already highly speculative, more established cryptocurrencies. That’s why many experts recommend sticking with the big names like Bitcoin and Ethereum. With any crypto coin you’re considering buying on an exchange, only trade in a cash value you’re prepared to lose.

Educational tools

A big priority for crypto beginners when it comes to choosing an exchange is the opportunity to learn more about different coins, digital assets, and blockchain technology. Coinbase, for example, offers rewards for learning about new coins through its Coinbase Earn program. In exchange for watching videos and completing quizzes related to different coins, Coinbase will reward you with a small portion of the crypto, which you can then hold or convert to something else. Others offer courses and articles on site to help you learn about crypto markets, history, and innovations, such as Gemini’s Cryptopedia or Binance Academy from Binance.

Account statements

An account statement is a summary of your activity on your account. This can be based on a specific range of dates of your choosing. Statements can include information about your transaction history, prices paid for crypto, and whether or not you sold your crypto for a gain or loss. Account statements can be very useful for keeping records of your transactions for tax purposes and other reasons. It is always recommended to keep your own self-made statements to compare to the built-in statements recorded in your exchange.

Crypto Custodianship

When you store your money in a bank, the bank is technically in control of your funds. The bank can limit how much you withdraw per day, and can halt transactions if they deem it necessary to do so. If you are trying to buy something or send money to someone and the bank does not want you to do so, they can and will stop the transaction. Coin custodianship refers to full ownership and control of a coin. You are in control of your funds, and can withdraw and send as much as you like without limitations from a 3rd party.

Control

The world of cryptocurrencies and decentralization is based on the concept of financial independence, where users are in total control of their assets. Users can act as their own banks, utilizing funds whenever and wherever appropriate without needing to ask for permission or use a third party. While full control over your account can be enticing, it can also be dangerous as full responsibility over the account security resides over you. There is no customer service available to call if you lose your private keys

Centralization

Most cryptocurrency exchanges are based on a centralized system, where a private company such as Coinbase or Binance acts as an intermediary and is responsible for overseeing all trades, transactions, and holdings. If you choose to keep your cryptocurrency on an exchange, you are trusting that exchange to keep your cryptocurrency secure on your behalf. They are keeping custody or holding your currency with their own holdings along with funds from all their customers.

Benefits of storing your coins on an exchange

Some of the benefits of storing your coins on an exchange include:
Ease of use - Many exchanges are designed with easy-to-use user interfaces that make it clear for anyone to use
Liquidity/liquid markets - Users who may want to buy, sell, or exchange their coins for another cryptocurrency will find that major exchanges typically have large amounts of various coins and users to trade with. This makes it easier to buy/sell/trade the coins you already have, as there are more users to trade for coins at reasonable prices. In illiquid markets, there are less coins available to trade for and the prices that sellers may ask for may not be reasonable.
Customer Service - Major exchanges typically have robust customer service operations where if there are issues with payment services, trades, or transactions, you can speak with a customer representative to assist you with your issue.

Downsides of storing your coins on exchanges

Coin Custody: “Not your keys, not your coins”. For most cryptocurrency users, leaving their funds on a trustworthy exchange is not an issue. But for those who want to truly own their assets, leaving their crypto on an exchange can be problematic. Exchanges hold your cryptocurrency keys until you opt to send them off of the exchange. Some exchanges such as Robinhood do not even give the ability to transfer crypto funds off their exchange.

Blockchain Explorers

All transactions on public blockchain networks such as Bitcoin and Ethereum are visible for anyone to browse through. Block explorers such as https://www.blockchain.com/explorer and https://etherscan.io/ allow you to search for various on-chain information (on-chain metrics) such as:
○ Historical prices
○ market capitalization
○ recently mined blocks
○ mempool size of unconfirmed transactions
○ data for the latest transactions (size, timings, addresses, etc.)
○ hash rate
○ gas prices
○ mining difficulty

How to look up a transaction on the blockchain

Block Explorers give users a visually appealing and an easy-to-use way to navigate a cryptocurrency blockchain. To look up a bitcoin transaction, users can go to https://www.blockchain.com/explorer and use the search bar to look up a specific address, transaction hash, or block number.

Sending/Receiving Cryptocurrency

Sending and receiving cryptocurrency off of an exchange account can be relatively straightforward as long as you are careful with what information you are entering. In your exchange account/portfolio you should see an option to deposit/withdraw funds. From there you should see an option to select specifically what kind of asset you wish to deposit/withdraw such as BTC, ETH, or USD.

Network Fees

Network fees are transaction fees from sending a cryptocurrency from one address to another. These fees are paid out to miners and validators who help maintain the integrity of the network by processing and validating transactions. Fees will vary according to the network/crypto being sent. Certain networks such as the Stellar Lumen (XLM) network are known for having low transaction fees and fast processing speeds compared to Ethereum (ETH) which can often have slower processing speeds and high gas fees due to congestion.

Bottom Line

There are additional factors you can consider based on your own preferences, Boneparth adds, like customer support, how well you like the platform’s mobile app, and how easy the exchange is to use overall. But like we hear from experts time and again when it comes to crypto, taking the time to learn as much as you can before you put money into crypto is one of the most useful things you can do.

Think about the fee structures and security measures you’re comfortable with, what additional steps you’ll take to store your coins, and your goals.

“You probably should spend more time learning about the space,” Boneparth says. “You’re putting risk on your money in a pretty wild environment. It’s one thing to haphazardly put money into more stable markets, it’s a completely other thing to throw money into volatile markets. So it’s important to get educated, especially when you’re going to deal with something that’s perhaps more volatile than other risky assets.”

Entire Series: 28 Blogs on Blockchain and Cryptocurrency

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