How Do Crypto Exchanges Work? Everything You Need to Know

If you're considering dipping your toe into the world of cryptocurrency, a crypto exchange is key. Crypto exchanges work by allowing you to buy and sell these digital currencies—essentially, it's a digital marketplace. 

Read on for the rundown on exactly how crypto exchanges work as well as details on some of the biggest crypto exchanges out there and how you can choose one that's right for you.

A crypto exchange is an online platform where you can buy and sell cryptocurrency. The platform effectively acts as the intermediary in transactions, making it possible for users to swap different fiat currencies (think U.S. dollars), Bitcoin, or altcoins (like Cardano and Dogecoin).

So, for instance, you could use a crypto exchange to trade one type of cryptocurrency for a different one, or you could use it to buy crypto with fiat currencies. Another option is to switch your cryptocurrency back to fiat currency.

Crypto exchanges work in much the same way as exchanges for other types of assets, like a stock exchange. In other words, the exchange matches up buyers with sellers.

Before you can start trading cryptocurrency, you'll need to register and fund your account. From there, you can create different order types to buy or sell, or even speculate on, cryptocurrencies. These orders are then compiled in what's known as an order book, which lists the amounts of cryptocurrencies that users want to buy and sell as well as their desired price. Pairs of buyers and sellers are then matched up by the exchange based on this information.

There are two main types of cryptocurrency exchanges, and it's important to understand the differences when you're choosing a crypto exchange. The most common type is a centralized crypto exchange, which is overseen by a third party that's responsible for monitoring the platform and making sure transactions run smoothly. While these exchange operators can make it easier to buy and sell cryptocurrency, there's a price to pay—typically, centralized crypto exchanges charge an additional exchange operator fee. Examples of popular centralized crypto exchanges include Binance, Coinbase, Kraken, Gemini, and Crypto.com.

A decentralized crypto exchange (DEX), on the other hand, doesn't have a central figure overseeing transactions on the platform. Instead, the platform relies on blockchain technology or distributed ledgers, and transactions are done through peer-to-peer trading. These exchanges, which are generally less common than their centralized counterparts, are typically a bit more challenging to use, requiring greater technological knowhow and knowledge of cryptocurrencies. Plus, there's no central authority to turn to if an issue arises. Examples of popular decentralized exchanges include KLAYswap, Uniswap, dYdX, and PancakeSwap.

Crypto exchanges that are centralized (i.e., run by exchange operators) primarily make money through fees. Specifically, they may earn money from the following types of fees:

• Withdrawal fees: As you may have guessed, this fee is charged to withdraw crypto or other currencies from the platform. It's usually charged as a flat fee to cover the cost of moving your crypto out of the platform.
• Deposit fees: Deposit fees may apply to either crypto or cash deposits, though sometimes there is no cost for this action.
• Trading fees: These fees apply whenever an order is executed on the platform. The fee is generally a percentage of the trade value, with your rate varying depending on whether you are the maker or the taker.
• Fees for trading using margin: Some platforms offer margin trading, in which case additional fees would apply. You may pay fees based on how much you borrowed, as well as interest. An additional fee may apply if your position is liquidated.

In addition to fees, crypto exchanges may also be able to make money off of the growth of the cryptosphere, such as by charging a new cryptocurrency a fee to list it or by offering a unique crypto pairing on their exchange.

According to CoinMarketCap, a price-tracking website for cryptoassets, the top three crypto exchanges that allow U.S. residents to trade on the platform are Binance, Coinbase and Kraken, as of December 2021. Rankings are based on traffic, liquidity, trading volumes and confidence that the reported trading volumes are legitimate.

Binance is the world's largest crypto exchange by trading volume. In the version available to users in the U.S., Binance.US, you can trade over 50 cryptocurrencies. The platform, which boasts competitive transaction fees, is best-suited to more experienced investors, featuring advanced charting capabilities. It is not currently available in all 50 states though.

Coinbase is one of the largest U.S.-based crypto exchanges, known for its easy-to-use platform. On Coinbase, you can buy, sell and store "hundreds" of cryptocurrencies. For those more advanced, there's also Coinbase Pro, which builds on Coinbase with more offerings when it comes to charts and indicators. However, you may find the fees to be higher with Coinbase compared to some other exchanges out there.

Founded in 2011, Kraken bills itself as one of the "largest and oldest Bitcoin exchanges in the world." The crypto exchange allows you to buy over 50 cryptocurrencies, and it places an emphasis on strong security. Though the platform boasts some advanced trading features that might appeal to the more experienced, beginner crypto investors may find the platform a bit complicated.

When you're trying to figure out which crypto exchange is right for you, there are several things to consider, including:

A big determinant of whether you can start trading on a particular crypto exchange is whether the platform is available in your country and your state. Not all platforms are accessible everywhere due to regulations and restrictions, so it's important to check. You can usually find this information on a platform's website or within its terms of service.

A crypto exchange is one instance where the lowest fees might not always be the best choice. Often, platforms that offer greater security or more ease of trading charge higher fees, so if you're still learning the ropes of trading crypto it could be worth the cost (though keep in mind, that could cut into your returns). Those who expect to trade frequently will especially want to keep an eye on trading costs.

Whichever route you go, just make sure you understand what fees may be involved and how much they run.

Because cryptocurrencies aren't backed by a central institution nor are they generally covered by SIPC insurance, it's your job to keep security in mind when choosing a crypto exchange. See if the exchange has its own insurance policy in place, as well as how much of its assets are generally kept offline. Also look at more general security factors like two-factor authentication and consider a platform's overall reputation and recognition.

You'll also want to take a look at what coins are available for the platform, particularly if you're interested in less popular or newer coins. Consider what coins you'd like to invest in ahead of choosing a platform, and then shop around with an eye to whether or not those are among the platform's offerings.

Another thing to keep in mind is whether you'll be able to sell your cryptocurrency when you want to. In general, larger, more popular platforms tend to have higher trade volume that allows for easier liquidity. This can give you a better chance of buying and selling at the best price if you're able to trade more quickly.

To start trading, you'll first need to open an account on a crypto exchange of your choosing. This generally requires entering some basic information, such as your name, birthday, mailing address and Social Security number. You also may need to submit a picture or scan of a government-issued I.D. in order to verify your account.

Once your identity is verified, you'll need to fund your account, which can usually be done by connecting your bank account or a debit or credit card (keep in mind that cards may incur an additional fee). After that is set up, you can buy cryptocurrency.

Once purchased, it's recommended to store your cryptocurrency somewhere safe, such as a cryptocurrency wallet (some exchanges may offer these to their users). You can also keep your crypto in the crypto exchange vs a wallet if you plan to actively trade.

Once you really dive into investing in crypto, it's also worth getting one of the best crypto tracking apps. This will help you keep track of all your investments and manage your crypto in one place.