A Lawyer Beginner’s Guide to Cryptocurrency Exchange

A cryptocurrency exchange is a platform that allows users to exchange various currencies and cryptocurrency types

A crypto exchange has a similar interface to a bank or investment firm, but it differs in a few notable ways. The exchange acts as a central platform connecting buyers and sellers of various cryptocurrencies. Its main value is that it offers almost instant liquidity 24/7 for many crypto asset pairs.

Popular exchanges like Coinbase and Gemini hold billions of dollars worth of cryptocurrencies, some of which are directly owned by the company and some of which are owned by users using the exchange. exchange cryptocurrency wallet.

There are a few notable distinctions within the realm of cryptocurrency trading, each of which we will go into detail about.

  1. Is the cryptocurrency exchange centralized or completely decentralized?
  2. Is the exchange custodial or non-custodial?

This is what any lawyer, and frankly anyone who interacts with the financial world, needs to know about why selecting the right cryptocurrency exchange makes all the difference.

Is the cryptocurrency exchange centralized or completely decentralized?

As you may have learned by reading The Legal Examiner’s Blockchain: A Guide for Lawyers series, cryptocurrency like Bitcoin is completely decentralized.

This means that there is no central company or entity in charge of Bitcoin– there’s no fancy tech startup office in San Francisco, nor is there a 1-800 number you can dial if things go awry.

This is in contrast to a centralized exchange, which is a formally established entity that must comply with guidelines and regulations. Of course, there are rogue centralized exchanges that do not meet the definition of “formally established”, per se, but the point is still valid.

A centralized exchange, such as Coinbase or many of its direct alternativeshas chiseled out its value proposition of making cryptocurrency much more accessible to the average person.

Instead of two people having to agree to send each other different coins (ie BTC for ETH), a centralized exchange handles the transaction and takes a small cut. This fee, often called the maker-taker fee, gives the centralized exchange (or liquidity provider, as we’ll see later) an incentive to participate in the market. The makers are the market makers who create the two-sided markets (the exchange), and the takers are the ones who trade at the prices set by the market makers.

If you’re curious about how much money an exchange like Coinbase can make with these relatively small fees, check out their Statement S-1 it launched before going public in 2021.

Now, imagine taking the centralized exchange out of the equation. With without intermediary, The trading parties would be responsible for setting the prices at which they are willing to trade the assets and trusting that the other party will send their fair share of the deal.

As you can imagine, without structure, this is an incredibly inefficient and unreliable way to trade digital assets on a large scale.

That is where decentralized exchanges (DEX) come into play.

A DEX is basically a decentralized platform that allows users to trade directly and instantly through pre-programmed contracts. The DEX routes the request and doesn’t complete it until both parties sign the transaction, and the entire ordeal is validated by the blockchain.

Companies like change of form Y metamask make it possible for users to instantly exchange their funds with each other without having to give an intermediary custody of their assets.

How do DEXs make money? They sometimes charge fees (not to be confused with actual blockchain network fees, which exist every time a transaction takes place, centralized or not), which can be distributed to token holders of that exchange token.

the DEX model gets a little hairybut it is a fascinating journey to learn about it, especially as it serves as a portal to the world of decentralized finance (DeFi).

Is the exchange custodial or non-custodial?

As mentioned in the previous section, centralized exchanges (CEXs) are different from decentralized exchanges (DEXs) in that they take custody of users’ assets, while DEXs do not.

To be technically more precise, CEXs keep their private keys, since they do not “coins” or “tokens” They exist in a vault somewhere. A DEX allows you to trade without requiring you to reveal your private key to the DEX or the receiving party.

Custody exchanges pose significant risk. For one thing, if the exchange were to be hacked or revealed to be an elusive scam, your private keys are at risk.

The hacking of Mt. Gox, one of the first popular exchanges, posed an existential threat to the nascent Bitcoin. In February 2014, hackers stole a whopping 840,000 bitcoins from Mt. Gox customers and the company itself, with only 100,000 belonging to the company, which is equivalent to about $33.6 billion today .

Other notable centralized exchange hacks and mishaps include Bithumb ($30 million), Coinrail ($37.2 million), BitGrail ($195 million), Coincheck ($534 million), with each value set to the time period it was hacked.

While today’s exchanges have hopefully learned from the mistakes of the past, the threat still exists. These exchanges use a combination of hot and cold storage to ensure that a Mt.Gox level catastrophe does not happen again.

If you are using a DEX, the biggest threat to your funds is… well, you. Since you retain custody of your assets at all times, you are the number one potential point of failure. If you lose your device and can’t recover your account, or if someone points directly to your wallet, you can lose your funds indefinitely.

However, these events can be almost completely avoided with proper digital security hygiene.

Final Thoughts: How To Choose The Right Crypto Exchange For You

Your crypto exchange selection ultimately comes down to convenience, given that you are choosing from a handful of vetted and reputable companies.

If you fall into the archetype of absolute crypto beginner, it is worth creating a Coinbase account and checking out the beginner platform. It lacks much of the advanced trading functionality, but it accomplishes what you’re after: buying your first bitcoin, ether, or other cryptocurrency.

Coinbase Learn also has some options for you to learn about certain cryptocurrency projects and earn a small amount of your tokens.

If you choose to buy crypto on Coinbase, you’ll likely soon outgrow the comparatively steep fees – they’re nothing to lose sleep over, but they do add up and there are cheaper options.

The good news is that you don’t need to leave the Coinbase ecosystem to escape the high fees. Coinbase Pro is the Coinbase “Pro” Version and is owned by the same company. Not only does it have much lower fees across the board, it also has a lot more asset pairs and the ability to deposit and buy crypto directly with USD.

Other Coinbase alternatives include: Gemini, krakenY BlockFi.

However, all of the options listed above are escrow platforms, meaning you escrow your private keys in your own cryptocurrency wallet. This removes (although waives) the responsibility of maintaining your private keys, making it much easier for a beginner in the ecosystem.

For those aligned with the “Be Your Own Bank” cryptocurrency ethos, you may want to consider a non-custodial exchange platform, such as ShapeShift, MyEtherWallet, or Metamask. You still keep custody of your private keys, but you can exchange them for other assets, likely paying much lower fees than on a centralized exchange.

Non-custodial platforms also tend to make it easier to interface with the decentralized finance (DeFi) world. However, if you’re just starting out, we don’t recommend jumping in here just yet!