Naveen Saraswat

@naveen_saraswat

How do Cryptocurrency Exchanges Work? And What Technologies are Driving Disruption.

November 27th 2018
Source: SodioTech

Decentralized cryptocurrency exchanges have garnered a tremendous amount of attention in the crypto community, or as we like to call it — CRYPTOSPHERE. Our team has been working relentlessly to build robust and ready-to-scale decentralized cryptocurrency exchange solutions tailored to suit the requirements of cryptocurrency traders and even the general crypto enthusiasts. We have even built a white-labeled cryptocurrency exchange solutions (Centralized/Decentralized) that has been lauded by a lot of experts.

In my last post at Hackernoon, I discussed the whole process of implementing blockchain solutions to solve any given problem. From use-case analysis to commercializing the business value of blockchain, everything was discussed in that post. In this post, however, I am going to discuss a topic much closer to my team — Cryptocurrency Exchanges, What is a Cryptocurrency Exchange?, Making of a cryptocurrency exchange, and How do Cryptocurrency exchanges work? Here’s a list of things that I intend on covering with this post:

Why do we Need Cryptocurrency Exchanges?
What are Cryptocurrency Exchanges? And their Types.
How do cryptocurrency exchange work?

So, without any further small-talk, let’s get down to business.

Why do we even need Cryptocurrency Exchanges?

It was the year 2009.

Satoshi Nakamoto was hard at work writing the code for the world’s first cryptocurrency. For simplicity, let us refer to Satoshi Nakamoto as a guy, since we do not know what this name stands for. He, at the time of creating the Bitcoin, wouldn’t have thought that the currency he created would blow up right in everyone’s faces in the coming years.

In the process, he also created the world’s first blockchain database, as it is conceived today. In all fairness, Satoshi Nakamoto can be thought of as the father of cryptocurrency and the blockchain. An arguable statement, of course, with more recent times throwing up people like Vitalik Buterin and his Ethereum project, which is about to enter its second phase, Ethereum 2.0 as of now.

All that being said, the world of cryptocurrency is still a very intriguing sector to study, and even more intriguing to participate in. To understand how do cryptocurrency exchanges work completely, you need to have a background knowledge of these things.

With every currency comes a need to trade it. Whether it be for profit or for obtaining some other useful currency, trading has always been associated with currencies and is more commonly called by the concept known as forex (foreign exchange).

Due to the geographical restrictions of currency, the term foreign exchange has been coined to refer to all such aspects of currency trading. Bitcoin, and all other cryptocurrencies, of course, are not exempt from the concept. Trading occurs here too, although the manner and the processes are completely different.

Understanding the basic of trading, too, will help one to understand how do cryptocurrency exchanges work. Trading can also occur between fiat and cryptocurrency, that is not a problem. But the very nature of cryptocurrencies asks for a special platform to trade them, something different, built just to honor the very legacy that cryptocurrencies stand for.

Once you understand the concept of asset-digitization and how the cryptocurrencies are getting relevant, understanding the working of a digital currency exchange will be your cup of tea.

Enter cryptocurrency exchanges.

Source: Coincenter.org

Currencies bring with them a need to trade them, as discussed before. Picking up on the idea of traditional exchanges, cryptocurrency pioneers built platforms to trade cryptocurrencies, modified and optimized to help them do so in the fastest and most efficient ways possible.

Now that you’ll be reading about how do cryptocurrency exchanges work, decentralized as well as centralized, there are are some events that you must be aware of. Bitfinex and Mt. Gox are few of the popular cryptocurrency exchanges of recent times.

Our team has continuously been trying to make robust and made-for-scale cryptocurrency exchange solutions. You can have a look at some of the more technical posts like this one on Development of Decentralized Cryptocurrency Exchange if you have a somewhat clear idea of how do cryptocurrency exchanges work.

Exchanges are mainly of two types, classified on the basis of their nature. There exist centralized and decentralized exchanges, both differing in the hierarchies of operation and governance. In due course, we will get to essentially what constitutes centralized and decentralized exchanges both, but first, let us talk a little bit more about the concept.

Being an online platform, cryptocurrency exchanges are the easiest way to trade in crypto-fiat and crypto-crypto pairings. The pairings for these exchange govern a big portion of how do cryptocurrency exchanges work.

Visualized at the regular currency exchange at the airport or the stock exchange, these are usually viewed as an online marketplace for the entire crypto network. In this post, we are going to discuss everything about the cryptocurrency exchanges. From the classification of cryptocurrency exchanges to the whole process of creating a cryptocurrency exchange. We will also be discussing how do cryptocurrency exchanges work.

Say Hacks in the cryptocurrency exchanges? Have a look:

Classification of cryptocurrency exchanges

Based on their organizational hierarchy and their overall controlling bodies, cryptocurrency exchanges are usually divided into two, as discussed before. Let us dive into each one of them, and discover what secrets the world of cryptocurrency exchanges holds.

Centralized Exchanges — How do these Crypto Exchanges Work?

As the name suggests, centralized exchanges are run by a third-party or an organization, i.e. trusting someone else to handle your money. Much like you trust banks to handle your fiat currency, centralized exchanges consist of the same ideology. By the term centralized, we mean that a middleman takes care of whatever assets that are being traded on the network. In a conventional sense, people think this is safer than handling all their money themselves. It is true in many regards since these organizations consist of trained professionals equipped to handle large amounts of money. Other services like loans and savings also make people go for the centralized architecture. Now that you’ve understood how do centralized cryptocurrency exchanges and their underlying principle, let’s discuss the various type of centralized cryptocurrency exchanges.

When it comes to centralized exchanges, they can be further classified into two more types of exchanges.

Synchronous exchanges are such where the customer’s request is granted by a single transaction. They are small-scale exchanges and are thus prone to failures and scaling issues when large-volume transactions are executed.

Asynchronous exchanges consist of interfaces to take user requests and add them to a queue. These are then processed independently using various layers, and the status of the request is then communicated to the interface. This exchange has no scaling issues and can handle a large volume of transactions, unlike synchronous exchanges.

Centralized cryptocurrency exchanges are no different to banks in the conventional sense. Storing their money on the exchange, logging in with security features such as two-factor authentication, and other services make cryptocurrency exchanges popular among the masses. One point to note here, however, is that all cryptocurrency exchanges do not provide fiat-crypto pairings, there are just a few popular ones that do so. Some of these include Gemini, Coinbase, Robinhood and Kraken.

Volume on centralized exchanges.

After you understand how do cryptocurrency exchanges work and the technology behind them, it is important to understand the dynamics of volume in these exchanges. It is a universal fact that the more volume there is on an exchange, the fewer chances of volatility and market manipulation exist. On low volume sites, buying would result in eating up of all sell orders, thereby making the price of the cryptocurrency go up and making the person lose their money. A high volume is thus essential to keep the exchange ticking and keep the profits for traders rolling in. Looking at some popular exchanges with high volumes and number of pairings, we have-

a. Binance- Launched only last year, Binance now trades the highest volume of any exchange. They offer two levels of verification, with level 1 offering a withdrawal threshold of 2 BTC per day, while level two ups the ante to 100 BTC per day withdrawal capabilities.

b. GDAX- It stands for the Global Digital Asset Exchange. An extension of Coinbase, it is now one of the most popular exchanges in the world. What’s unique is that users are insured for up to USD 250000 by the Federal Deposit Insurance Corporation of the USA. Focused on serving professional and sophisticated customers, it may not be suitable for beginners. It does, however, prove to be a very good option for margin trading and trading in both crypto-fiat and crypto-crypto pairings.

Related: Cryptocurrency Exchange Development

The security aspect for Centralized Cryptocurrency Exchange.

No centralized exchange is immune to hacks. In fact, due to their structure, they are much likely to be affected by hacks and scams than decentralized exchanges are, about which we will discuss further on. Speaking of centralized exchanges as of now, the possibility of people with malicious intent breaking down the security of the network and stealing the money of all users is quite high. For instance, an Ethereum hacker stole about 20000 ETH, worth about USD 17 million, from the Coinbase cryptocurrency exchange. Although the hacker later returned the amount in full, this showcases the vulnerability of centralized exchanges. Due to their very nature, they are most susceptible to thefts and hacks.

As the data is stored on a central, single datacentre, hackers need only to infiltrate this level of the network to gain access. On a personal front too, there have been reports of users having their passwords and private keys to their wallets stolen, thus losing access to all their money stored online. These security concerns, albeit worrying, are very rare. Nowadays, all centralized exchanges boast of high-security transactions, data storage, and other services, and the incidents of exchanges being hacked or people losing their money have reduced drastically. Gone are the days when Bitfinex and Mt. Gox were being scammed of hundreds of millions of dollars, now, exchanges are better equipped to handle such attacks.

CEXs are Suitable for beginners — Because of simplicity in How these cryptocurrency exchange work!

A centralized cryptocurrency exchange presents itself as the best bet to trade for beginners and investors who do not know much about the business. It is still preferred by seasoned traders as well, but if you are a novice in the field of cryptocurrency trading, you should definitely go for a centralized cryptocurrency exchange. While choosing the best exchange for yourself, keep in mind different factors such as which pairs are traded on the exchange, security measures, and the volume being traded. All these are paramount to making the decision of picking a centralized crypto exchange for yourself.

If centralized exchanges are so wonderful, safe, and secure, then what was the need to create a whole other type of cryptocurrency exchange?

The need for a Decentralized Exchange

In all honesty, centralized exchanges do not adhere to the whole essence of a cryptocurrency, being a decentralized virtual currency. When one of the biggest purposes of cryptocurrency is to eliminate the middleman, to eradicate the governing, centralized bodies, then why use centralized exchanges? Why not create something that follows the notion of what cryptocurrencies are made of?

Thus the crypto industry gave birth to decentralized cryptocurrency exchanges. Exchanges that are built on the exact principle that the cryptocurrencies stand for- no middlemen, and put trust back into the system. Rather than trusting a company to keep your funds safe, you do it for yourself. All of your money remains in your hands, for as long as you want it to. Trading and other transactions are all done by you and you only, making decentralized exchanges perhaps the most personal experiences in cryptocurrency trading out there.

How do these Decentralized Digital Currency Exchanges work?

Atomic Swaps

Our team has been working on building solutions for decentralized exchange in the last few months. The solutions based on 0X protocol, Stellar and Bitshares being the one ready for implementation, I would be explaining the working of these only. In a future update to this post, I might update the readers about the DEX based on the EOS blockchain. So, let's discuss the DEXs based on 0X and Bitshares:

Off-Chain Orderbook and On-Chain Settlements with 0X Protocol

The 0X Protocol

This is perhaps the most popular protocol/stack to build a DEX upon. A number of relayers have been built based on this protocol. This includes Paradex and RADAR RELAY. These exchanges work upon the Ethereum smart contracts. This means that listing of the ERC-20 tokens would be streamlined. In exchanges built upon the Ethereum blockchain, all the order functions and trades are taking place within the smart contracts and the users will always be in the possession of their tokens. However, this also means that the traders and even the general users have to execute transactions on the blockchain every time they want to manage their funds, whether that be for depositing funds into an exchange’s smart contract or placing, canceling, or filling an order.

By building decentralized cryptocurrency exchanges on top of 0X, using the off-chain orderbooks and the on-chain settlements using the trading logic, it can be fixed, however. This makes the process of P2P payments using these decentralized exchanges extremely streamlined as everything else other than actual transfer happens off-chain. This cuts down the “gas-cost” as in the ethereum based DEXs to an extremely low level and makes the process of trading tokens extremely fast. Now, let’s have a look at some of the common terminologies used in the 0X protocol.

Relayers: 0x uses what it calls “relayers”. Relayers are responsible for broadcasting orders through public or private order books. They bring liquidity to the network by hosting its order books, acting effectively as an exchange. But unlike an exchange, it cannot execute any Trade but rather broadcast a maker order on the network,

Maker: The Maker is an address which originated the buy/sell order and using the help of relayer instead of pushing the order on the chain which charges a gas price it lists the Order on the network for a suitable Taker to make a request.

Taker: A Taker is an address which has been permitted to fill an order that a Maker has listed. For a trade to be executed the Taker has to submit the Maker’s signature along with his own signature to the DEX’s smart contract. To facilitate the transaction the relayer needs to be paid a fee as compensation in ZRX which is a native currency for 0x.

Point-to-Point Orders: 0x also accommodates Point-to-Point Orders, which are orders transmitted by makers with a specific taker in mind. Understanding the concept of point-to-point orders can be really helpful towards the development of this protocol and understanding how do cryptocurrency exchanges work. These orders allow two users to directly transfer funds through a variety of messaging mediums or even on social media. When a maker address sends an order relay, only the specified taker address can fulfill it, protecting funds from being hijacked by malicious third parties.

Transactions getting faster and cost-effective with the Stellar Blockchain.

Stellar Blockchain

In this part, we are going to discuss the considerations for making a DEX based on the stellar blockchain. The Stellar blockchain and the protocol to build decentralized exchange upon is an open-source internet protocol developed by a non-profit organization which is aimed at enabling people to move money faster and cheaper. It’s working is quite similar to that of how emailing works, with protocols based on the Simple Mail Transfer Protocol. Since the network is open source, it allows for a frictionless transfer of money from one party to other at an inexplicable transaction duration of 3–5 seconds having transaction charges as little as $ 0.000005. Given the popularity of Stellar blockchain and dApps based on them, understanding how do cryptocurrency exchanges work when built on top of stellar blockchain can be instrumental.

The Stellar DEX protocols take the decentralized nature of the blockchain to a whole new level. Independent servers with fault tolerance systems participate in the network, adding security to the whole network. The Stellar DEX essentially acts as a database for storing data of each and every account on the network, with a complete copy being hosted on each and every node on the network. To aid ease of conversion between currencies, Stellar has its own currency, Lumens. It acts as a bridge between other currencies to aid in the conversion process. This was another compelling reason for you to go ahead and make a cryptocurrency exchange on the stellar blockchain.

Accelerated Asset Digitization with Bitshares

Bitshares

This is a financial smart contracts platform which is aimed at making a transfer of digital assets simpler and much more streamlined. Bitshares can be used to create an asset-backed token, and listed in the market to be traded by any user. This is something that has the potential to make the case of a tokenized economy as it makes tokenization of assets a cakewalk.

The bitshares platform provides an interface which can be used by normal users to create their own asset-backed token or else a development company can use the bitshares API for their graphene technology to create their own exchange by creating tokens and listing them on the bitshares market for trade. Assets issued on Bitshares exchange are pegged to their native token, BTS so in case you want to run a full node of Bitshares client and trade multiple BTS pegged assets you can take leverage of interoperability of the Bitshares network just like any other blockchain.

Concluding.

In this post, I tried to explain how do cryptocurrency exchanges work and discussed the working of various protocols on which decentralized cryptocurrency exchanges are being built. If you want to discuss further about cryptocurrency exchanges, feel free to get in touch with me via LinkedIn or via any of the following.

Get In touch with us:
E-mail: contact@sodio.tech
Twitter: Sodiotech
Website: Sodio Technologies

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