Crypto Exchange: Process, Misconceptions and Risks

Now, that we have a good grasp on Wallace and Key Management. Let’s go ahead and get us some crypto. Again, you can always do a direct transaction with someone you know, but by and large the vast majority of the investor are going to acquire and trade cryptocurrencies on one of the hundreds of crypto exchanges. Now, we’ll look at how this process works. We’ll dissect the crypto exchange and the trading process, dispel some common misconceptions and uncover some unique risks. After this module, you should be relatively comfortable with the process of buying and selling cryptocurrencies on crypto exchanges.

Now, the first thing you need to know is that buying and selling on crypto exchanges is very different than buying and selling on say stock exchanges. To buy stocks you don’t actually interact with the exchange yourself. You just get an account with a brokerage firm, say Charles Schwab or Fidelity, you place your order with them and the broker executes the order for you on the exchange. The trade settles within two days and after that you own that stock. The exchange transfers the actual ownership of that stock from someone else to you. And in practice these stocks are held at outside custodian banks in your name. And your brokerage pay these custodians to keep your stocks secure.

None of that happens when you buy crypto, there’s only one entity the crypto exchange serving all three rules of the bank, the exchange and the broker. Let’s see how this works. Suppose we have a buyer who wants to buy Bitcoins with $10,000. We also have a seller who wants to sell his three Bitcoins and get dollars. You need two other parties in this transaction the Bitcoin blockchain for Bitcoin movements and the bank payment rail $4 movements. The first key difference between this and the stock transaction is that well, there’s no brokerage firms here. Instead both the buyer and the seller will sign up for accounts directly with the exchange. They can do that on the exchanges websites.

Second difference instead of held at custodian banks both the dollars and the Bitcoin have to be transferred to the exchange before the transaction could happen. This makes the exchange, the custodian bank for both the dollar and crypto assets. Say the buyer deposits $10,000 to the exchange using an ACH transaction, transferring the money from his bank to the exchange’s bank account. Then the exchange credits the buyers account with a virtual balance of $10,000 and 0 Bitcoins. kind of like the PayPal process that we talked about in the Big Tech course. Same goes for the seller, he has to transfer the three Bitcoins that he wants to sell to the exchange.

In practice the exchange will give you the address to send the coins to. You then have to use your wallet to generate and broadcast the transaction to the blockchain as usual. For larger exchanges like coinbase, which also operate their own wireless services, this could be streamlined a bit more. Once the coins are deposited the exchange credits the seller’s account with a virtual balance of 3 Bitcoins and 0 dollars. Once these accounts are established and funded the exchange then takes on the role of the broker. If you log into their websites, you’ll see an interface similar to an online stock trading account, which allows you to place various buying and sell orders like market order, limit order, etc.

Now, suppose the buyer and the seller’s orders are matched at a price of $3,500 per coin for 2 Bitcoins. Maybe the buyer placed a limit by order at $3,500 and the seller placed a limit sell order at $3,500. Then once the order is matched the exchange can simply reduce the virtual dollar balance of the buyer by $7,000. That is to Bitcoins at $3,500 each and increase his virtual Bitcoin balance by 2. At the same time the exchange will increase the virtual dollar balance of the seller’s account by $7,000 and decrease his virtual Bitcoin balance by 2. The transaction is now complete and critically you can see another key difference. This transaction did not involve the blockchain at all.

Nothing is broadcast or recorded on the blockchain, and it’s all done using the virtual balances in the exchange accounts. And because these are virtual balances they can be traded instantly as opposed to waiting for an hour for the confirmation on the blockchain. This allows trades to occur at a much higher frequency. So to correct a common misconception, if you are quote-unquote trading Bitcoins the majority of the time you’re not actually trading the actual coins on the blockchain, but are trading your virtual balances with the exchange. The Bitcoin prices that you see online are actually the prices of the Bitcoin exchange balances.

To give you an example suppose the buyer who now has 2 Bitcoins in its virtual balance once to sell one of them. Suppose the price has since gone up and another buyer who has deposited $10,000 into his account is willing to buy a Bitcoin at $5,000. Then the exchange can immediately adjust the virtual balances here again increasing the previous buyers dollar amount by $5,000 and decreasing his Bitcoin virtual balance by 1. And decreasing the new buyers dollar amount by $5,000 and increasing his Bitcoin virtual balance by 1. And this could go on and on and on without ever involving the Bitcoin blockchain or the bank rails.

The blockchain only gets involved when you want to withdraw, that is converting your virtual Bitcoin balance into the actual proof on the blockchain. To do that you need to have a wallet and an address to receive these coins. And once you sent the withdrawal request, the exchange will generate and broadcast a Bitcoin transaction sending the Bitcoins from the exchange’s address to your wallet address. Similar process for money withdrawal, the exchange will generate ACH transaction pushing the dollars from their bank account into the bank account that you specify.

So let’s reflect on this a bit. It’s quite a complicated process that has some key differences from stock trading. And it could all be boiled down to the greatly increased rule of the crypto exchanges. In a stock trade there are multiple outside parties such as the custodian banks and brokers that facilitate the trade and safeguard the asset. Here in a crypto transaction these intermediaries don’t exist and you’re relying on the exchange to do all these functions. First of all, the exchange is like a custodian Bank. They hold your assets both in fiat and in crypto and gives you virtual balances instead, which are just promises that if you want to withdraw the amount will be there.

Second, because all your trades are entered directly on the exchange, the exchange is also your broker. Finally, in most cases the exchanges are directly crossing the orders of the buyer and the seller accounts without involving the blockchain at all. So it acts like an electronic trading platform where trades can be done in relatively high frequency and not subject to the technical limitations of the Bitcoin blockchain. If you think about it, you really got to place a lot of trust on the exchange to carry out all these intermediary functions that are traditionally done by regulated financial institutions.

By assuming the triple role of exchange broker and custodian bank, crypto exchanges expose the traders to risks from all three components, which we’ll elaborate in the next video.