Lesson 6 — How a Crypto Exchange Actually Works

If you want to buy or sell crypto, you will normally use a crypto exchange. In this lesson, we will understand how an exchange works and learn the basic terms you will see while trading.

1. What Is a Crypto Exchange?

A crypto exchange is a platform where users can buy, sell and trade cryptocurrencies and other digital assets.

Some exchanges also provide futures and options trading, depending on the platform and the country where the user is located.

For Indian investors, CoinDCX is one example of a crypto exchange. Binance is another major global crypto exchange.

2. CEX vs DEX

There are two broad types of crypto exchanges: Centralized Exchanges and Decentralized Exchanges.

CEX means Centralized Exchange. A company operates the platform and manages the trading infrastructure, user accounts and other exchange services.

DEX means Decentralized Exchange. Trading is generally carried out through blockchain protocols and smart contracts rather than through a traditional company-operated order matching system.

3. What Is a Trading Pair?

A trading pair tells you which asset you are buying and which asset you are using to pay for it.

For example, BTC/USDT means you are trading Bitcoin against USDT.

If you buy BTC/USDT, you are using USDT to buy Bitcoin. If you sell BTC/USDT, you are selling Bitcoin and receiving USDT.

4. Base Asset

In a trading pair, the first asset is called the base asset.

In BTC/USDT, BTC is the base asset. The quantity of the trade is normally expressed in the base asset.

5. Quote Asset

The second asset in a trading pair is called the quote asset.

In BTC/USDT, USDT is the quote asset. It is used to express the price of Bitcoin.

For example, if BTC/USDT is trading at 100,000, one Bitcoin is priced at 100,000 USDT.

6. What Is an Order Book?

An order book is a list of buy and sell orders waiting to be matched on an exchange.

The buy orders are called bids. The sell orders are called asks.

When a suitable buy order and sell order can be matched, a trade takes place.

7. Bid and Ask

The bid is the price at which buyers are willing to buy.

The ask is the price at which sellers are willing to sell.

Normally, the best bid is slightly lower than the best ask. The difference between them is called the spread.

8. Spread

Spread is the difference between the best available selling price and the best available buying price.

A smaller spread generally means the market is more competitive and liquid.

A large spread can increase the effective cost of entering or exiting a trade.

9. Market Maker

A market maker provides buy and sell orders to the market.

Market makers help provide liquidity by continuously placing orders on both sides of the market.

10. Market Taker

A market taker is a trader who takes an existing order from the order book.

For example, when you place a market order and it immediately matches available orders in the order book, you are acting as a market taker.

11. Liquidity

Liquidity tells us how easily an asset can be bought or sold without causing a large movement in its price.

Bitcoin and other highly traded cryptocurrencies generally have much more liquidity than small, less-traded tokens.

12. Slippage

Slippage happens when the actual execution price of your trade is different from the price you expected.

Slippage can become larger when the market has low liquidity or when the order is very large.

13. Trading Fees

Exchanges normally charge fees for trading.

The fee can depend on factors such as your trading volume, order type and exchange account level.

Always check the current fee structure of the exchange before trading because fees can change.

14. Deposits and Withdrawals

Before trading, you may need to deposit money or crypto into your exchange account.

When you want to move your crypto away from the exchange, you can use the withdrawal function.

When withdrawing crypto to an external wallet, always check the blockchain network carefully. Sending an asset through the wrong network can result in loss of funds.

15. Spot Trading

Spot trading means buying or selling the actual crypto asset at the current market price or at a price you specify.

For example, if you buy Bitcoin in the BTC/USDT spot market, you receive Bitcoin in your exchange account after the trade.

16. Futures Trading

Futures trading is different from spot trading. You are trading a contract whose value is linked to an underlying asset.

Futures can allow traders to take long or short positions and may also involve leverage.

Because of leverage and other contract mechanics, futures trading can involve much higher risk than simple spot investing.

17. Options Trading

Options are contracts that give the buyer certain rights related to an underlying asset at specified terms.

Options involve concepts such as call options, put options, strike price, premium and expiry.

We will not go deep into options in this lesson. The important point is that options are different from simply buying and selling the underlying cryptocurrency.

18. Funding

Funding is mainly associated with perpetual futures contracts.

It is a periodic payment between traders holding long and short positions.

The funding rate can be positive or negative. It is designed to help keep the perpetual contract price close to the underlying market price.

19. Open Interest

Open Interest, or OI, represents the amount of outstanding futures or derivatives positions that remain open.

When traders open new positions, open interest can increase. When positions are closed, open interest can decrease.

Traders often study OI together with price and volume to understand market positioning.

20. Volume

Volume tells us how much trading activity has taken place during a particular period.

High volume can indicate strong market participation. But high volume by itself does not tell us whether the price will go up or down.

Key Takeaway

An exchange is much more than a place where you click Buy or Sell.

You should understand trading pairs, order books, bid and ask, spread, liquidity, slippage and fees before you start trading.

You should also clearly understand the difference between spot, futures and options.

In the next lessons, we will go deeper into contract specifications, leverage, margin, MTM, liquidation, order types, funding, open interest and volume.