Any asset class, including crypto-assets, needs a marketplace where they can be bought and sold. Equities are traded on exchanges like the New York Stock Exchange or the London Stock Exchange, and the crypto-asset Ecosystem has its equivalent service providers in many shapes and sizes but is broadly separated into two categories: centralised exchanges and decentralised exchanges.
Centralised Crypto-Asset Exchanges
Centralised exchanges operate in a way not dissimilar to the operations of an international stock exchange, matching buyers and sellers of crypto-assets and acting as a middleman for all trades without revealing the identity of the buyer or seller. In many cases, they may also serve as the custodian of the assets.
A question that often comes up is how many people have accounts at crypto exchanges. A study by the University of Cambridge estimated that a total of up to 101 million unique crypto asset users across 191 million accounts had an account at a crypto exchange as of the third quarter of 2020, with the total number of user accounts at crypto exchanges increasing tremendously from only five million five years ago. That number increased significantly following the bull market of early 2021, reaching over 200 million with users from around the world entering the crypto Ecosystem.
When looking at centralised crypto exchanges, it’s important to note there are two main types of centralised exchanges: fiat-to-crypto and crypto-to-crypto. There are also crypto derivative exchanges that are generally part of the crypto-to-crypto exchange family.
Fiat-to-Crypto Exchanges
A fiat-to-crypto exchange allows a user to deposit fiat funds in their account (e.g., USD, EUR, JPY) and convert that into the desired crypto asset. For most individuals, a fiat-to-crypto exchange will be the first on-ramp to the crypto industry.
Fiat-to-crypto exchanges play an essential role in the Ecosystem as they’re often the first entry point for someone entering the crypto space. The dominant fiat-to-crypto exchanges are also often different from the dominant crypto-to-crypto exchanges. For example, in November 2021, the crypto exchanges with the most significant market share for fiat-to-crypto were Coinbase, FTX, Upbit, Kraken, and Bitfinex, quite different from the top five crypto-to-crypto exchanges, which were Binance, OKEx, Huobi, Gate.io, and Kucoin.
Key differences between centralised and decentralised exchanges broken down by levels of regulatory compliance, user accessibility, liquidity, and fee structures; Source: Henri Arslanian, “The Book of Crypto: The Complete Guide to Understanding Bitcoin, Cryptocurrencies, and Digital Assets,” Palgrave Macmillan (2022)
Crypto-to-Crypto Exchanges
A crypto-to-crypto exchange does not touch or handle fiat currencies and only facilitates the exchange of one crypto-asset for another. In order to use the service, a user must send a crypto-asset to the exchange, say Bitcoin or Ether or stablecoins (which they may have gotten from a fiat-to-crypto exchange), and use that crypto-asset to buy other crypto-assets. However, crypto-to-crypto exchanges play a big role in the crypto Ecosystem, especially in the early days, as these exchanges were often home to a broader range of crypto-assets as they tend to not fall under the same level of regulatory scrutiny as fiat-to-crypto exchanges.
Crypto Derivatives Exchanges
Derivatives also exist in the crypto space, and as is the case in the traditional financial services industry, volumes in crypto derivatives are pretty significant. For example, since January 2021, the monthly volumes of Bitcoin futures alone have been over $1 trillion a month, many times the volume of spot Bitcoin. Data shows that the ratio between spot Bitcoin and Bitcoin futures is between 0.2 and 0.4, and whilst there are now regulated Bitcoin futures offered by players like the CME, the reality is that the majority of Bitcoin and crypto derivatives take place in crypto-to-crypto exchanges like Binance, FTX, or BitMEX.
Decentralised Exchanges
One area seeing tremendous growth is the Ecosystem of decentralised exchanges, with some popular exchanges like Uniswap, SushiSwap, Curve, and Balancer seeing tremendous growth.
But how do such decentralised exchanges work?
Decentralised exchanges achieve the same goal of letting you buy or trade digital assets, but they do so in a different way as there is no central counterparty. Trades are made peer-to-peer between two users using smart contracts, and each user custodies their own assets in their own wallet.
These exchanges are normally suited for more advanced traders as individuals new to the crypto world tend to first dip their toe in using a centralised exchange. Whilst most crypto trading has taken place on centralised exchanges, the trading volumes on decentralised exchanges started rising rapidly in the summer of 2020.
A big development happened with the rise of a decentralised exchange called Uniswap. Whilst its decentralised exchange offering is nothing new, Uniswap popularised an innovative concept called automated market making (AMM). The AMM concept was previously used by other decentralised exchanges like Bancor, but Uniswap is what made it popular in the summer of 2020.
Automated Market Makers (AMMs)
In a traditional centralised exchange, traders can see the liquidity (what is available to trade and at what price) by looking at the order book. Market makers (who are professional firms that provide such liquidity by buying and selling those assets at certain prices) need to actively and continuously manage their orders (although it’s done in a fully automated way using sophisticated trading infrastructure and algorithms).
Whilst this continues to work quite well in centralised exchanges, it has challenges in a decentralised world as there is no centralised entity to host and maintain the order book and match buyers and sellers. Also, becoming a market maker is not something that is possible for a small or retail trader due to the costs and trading infrastructure required, thus allowing only large and well-funded entities to participate.
Such decentralised structures are not regulated, which can be complicated for some large funds or trading firms who prefer or are required to trade with regulated exchanges. The liquidity pool model has many benefits on its own as well. The major benefit is that it allows anyone to be a “market maker” by providing tokens to the platforms and receiving a fee. In addition to generating a yield on crypto assets that would otherwise remain idle, they can get involved in yield farming.
This article is an extract from Henri Arslanian’s latest book, “The Book of Crypto: The Complete Guide to Understanding Bitcoin, Cryptocurrencies and Digital Assets” (Published by Palgrave in May 2022)