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Trading Cryptocurrency: Exchange Basics

This article details the basic functions of cryptocurrency exchanges, how they operate, and what types of orders and trades you can execute.

Jan 14, 2020

An exchange is a marketplace for trading. This article details the basic functions of cryptocurrency exchanges, how they operate, and what types of orders and trades you can execute.

What is an Exchange?

An exchange is a marketplace where buyers and sellers come together to buy and sell assets at specific prices. The type you are most familiar with is likely a cryptocurrency exchange, where cryptocurrencies can be traded versus fiat or other cryptocurrencies. There are also other types of exchanges called token swappers, where one can buy or sell at prices determined by an algorithm.

Exchanges exist as a location where market participants can transact without the need to find a buyer or seller willing to trade with them. Trading through an exchange is highly preferable for traders since a large number of users are gathered in one place, which allows for more liquidity and better prices. We will describe these concepts later in this piece.

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Trading Pairs

Many exchanges and apps, including Crypto.com’s App, support crypto-fiat pairs, most often US dollars. A trading pair tells you which currencies you can exchange for one another. For example, BTC/USD allows you to buy bitcoin with US dollars, or sell bitcoin for US dollars. There are also crypto-to-crypto pairs, such as BTC/USDT, ETH/BTC, and so on. Below are some examples of the trading pairs our exchange supports.

Bitcoin-Crypto Pairs

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Crypto-USDT Pairs

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Executing Your Order

Once you have deposited fiat currency onto the exchange or input your credit card details (if the exchange supports credit cards), you are ready to execute your first trade. You can now place an order to buy your preferred cryptocurrency.

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Once you hit submit, the exchange will automatically match your order with the lowest priced offer(s) in its systems. It will then subtract the corresponding fiat currency from your account and credit you with ownership of the token you have just bought. Once the order is matched it is said to be filled.

Basic Order Types

When a market participant wishes to transact on an exchange, there are two major types of orders that are usually used: a market order or a limit order.

Market orders are done at market, meaning traders would like to execute their trade immediately, at whatever price is available at the time.

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Limit orders, on the other hand, allow traders to specify a price at which they would like to transact, and do not execute until they get matched with someone else’s order.

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In other words, the difference between market and limit orders is their level of urgency. Traders using market orders prioritise the immediacy and certainty of trade execution over the price, whereas limit orders allow traders to delay their order execution (accepting the risk that it might never be executed) in return for a better price.

Order Books

Most exchanges use order books, which is a collection of limit orders at which market participants are willing to buy or sell. The image below is an example of a bitcoin order book in action. Users on this exchange are willing to buy 2.006986 BTC at $5,885.80, 5.1803 at $5,887.91, while they are willing to sell 0.0002 units at $5,885.21, 0.009822 at $5,881.71, and so on.

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When a user wishes to buy 4 BTC at the market, they must first buy the 2.006986 units at $5,885.80, then the remainder of their order at $5,887.91. The average price paid is therefore $5,886.85.

The prices on top are called the offer or ask, as they represent tokens on ‘offer,’ or the ‘asking price.’ The green numbers represent the bid, where other traders are ‘bidding’ to buy.

Bid-Ask Spread

Notice that in the order book above, there is a difference between the lowest-quoted ask and the highest-quoted bid. This is called the bid-ask, or bid-offer spread.

Why does the bid-ask spread exist? Recall the example above, when the user bought 4 BTC at market, he had to buy the BTC on offer at the prices other traders had specified. If that same user had instead placed a limit order to buy 4 BTC at $5,885.21, he might have been able to buy BTC a little cheaper than the $5,887.91 they paid.

We can see that market orders are used by traders who demand immediate liquidity, paying the difference between the bid and ask price. Thus, the bid-ask spread represents the price of liquidity. In financial markets, using a market order is called ‘crossing the spread.’

Price Slippage

Coming back to the above example, our trader bought 4 BTC. After his trade, the order book has changed, since the limit order at $5,885.80 is now filled. If someone else were to come along wanting to buy immediately, they would have to buy at the next best offer of $5,887.91. In other words, our trader has moved the market while buying. The price movement that occurs during order execution is called price slippage.

Market Depth

What if there had been 5 BTC on the market at $5,885.80 instead? Our trader could have bought all 4 BTC at the lower price, limiting his price slippage. Conversely, what if there had only been 1 BTC on offer for $5,885.80, with the next highest offer being $5,900? In that case, our market order to buy 4 BTC would have been executed at a much higher price.

The effect of price slippage is why it is important for exchanges to have sufficient market depth, otherwise it becomes very costly for market participants to transact. The higher the market depth (i.e. the quantities on either side of the order book), the lower the slippage.

Market depth is typically represented by a chart showing the bids and offers at each price, like below. Charts like this allow traders to estimate how susceptible the price is to large buy or sell orders, and to gauge likely support and resistance levels.

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Market Makers vs. Takers

If ‘crossing the spread’ means paying the bid-ask spread, then someone must have profited. But who? Very simply put, this profit goes to the traders who use limit orders, known as market makers, while traders who use market orders are called market takers, or price takers.

Market makers get their name from the fact that their combined limit orders make up the entire order book, which represents the state of the market. Market takers, on the other hand, agree with the prices listed on the order book and execute their trade immediately.

Crypto.com has a VIP tiering system which offers lower fees for makers at the first VIP level, so you can save on fees by using limit orders. Users can move up VIP tiers by reaching monthly volume milestones. Additional discounts can be gained by staking CRO tokens on the platform. The full fee table can be seen below or on our Trading Fees page.

Advanced Order Types

Now that we understand the basics of exchanges, let’s go through a number of more complex order types you may come across or even use in your trading.

Stop orders

Stop orders are conditional orders to execute a market order when the bid or ask price reaches or crosses a certain level. Stop orders are useful because they do not show up on the order book and are invisible to other market participants, while still allowing traders to specify a price. Be careful when using stop orders, however, especially when the trade quantity is large or if the market is illiquid – stop orders convert into market orders once the price reaches a certain level, so there could be substantial slippage. Stop orders are most often used to set stop-losses, since they prioritise order execution over getting a better price.

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Stop-limit orders

Stop-limit orders are similar to stop orders, except a limit order is placed when the specified price is reached. This gives market participants further control over execution price. Like limit orders, however, there is no guarantee that the order will be filled, especially if the price moves quickly past your stop-limit price level.

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Iceberg orders

Iceberg orders mean an order is broken down into smaller limit orders, each executing after the prior one has been executed. Iceberg orders are particularly useful when trading large quantities to hide the true order size from the market. Some exchanges even allow users to set iceberg orders with random variation in the quantity of each batch and the upper and lower price limits.

Here’s an example of an iceberg order to sell 630 BTC over six smaller batches:

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All the above order types give traders the ability to mask their intentions to buy or sell, especially for larger orders, which would encourage other traders to buy or sell knowing that there is an outsized order pending in the market.

Another type of order which is useful is the One-cancels-the-other or OCO order. An OCO order is made up of two stop or limit orders at different prices, where the first order to execute will cancel the other. This might be useful if a trader sees resistance and support levels above and below the current price, and wishes to either buy the token if the price breaks out to the upside, or sell if the support level is broken. In this case the trader would place an OCO order with a buy stop just above resistance and a sell stop just below support.

Measuring Liquidity

Back to the topic of liquidity and market depth, how do we know whether an asset is liquid or illiquid? Liquidity is the ease with which market participants can trade with minimal price slippage, given a certain trade size.

So how do we measure liquidity? The most commonly used metric is trading volume, the quantity of a security transacted over a specific period of time (typically daily). There are other methods, but for now we will focus on volume.

Volume is the most direct way to measure a market’s activity, which is a reliable proxy for liquidity. For one, higher trading volume is associated with more market participants and a correspondingly greater number of market makers. In this way, increased competition among market makers will generally lead to more competitive prices on the order book, narrowing the bid-ask spread and increasing the capacity of the market to absorb large transactions. All else equal, higher volume equates to more liquidity and better price discovery.

Volume and liquidity in crypto

Like in traditional markets, volume for cryptocurrencies is one of the most important metrics to consider. Volume tells us how many buyers and sellers are interested in trading the token, and indirectly, gives us a clue as to how many market makers there are, the price impact of any given order size, and how likely we are to be receiving a fair price on any given coin.

The most widely available tool to track token volumes is on CoinMarketCap, which lists publicly available token liquidity metrics.

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Just as important as token volume is exchange volume. All else equal, an exchange with more volume will be able to execute your trades at better prices. Solely relying on CoinMarketCap statistics, however, won’t give you the full story.

Wash trading

Wash trading is the practice of manipulating the volumes on an exchange. This is when the exchange facilitates trades where tokens do not actually change in beneficial ownership, i.e. the exchange trading on its own platform, or incentivising others to do so. The tokens do not actually change hands and are simply passed through the exchange to boost volume numbers as a marketing ploy. This practice is so widespread among many exchanges – a report submitted to the SEC by Bitwise concluded that 95% of trading volumes on unregulated exchanges are fake.

The headline volume figures on CoinMarketCap are reported without any adjustments to remove the effect of wash trading, so traders must be careful before drawing conclusions about the liquidity of a certain exchange or token.

Measuring true liquidity

With the prevalence of wash trading and unreliable volume numbers, how can traders in the crypto community measure true liquidity?

There are a number of ways:

1) We can sort through and eliminate volume numbers given by exchanges suspected of employing wash trading on a large scale

2) Use other metrics such as the % price impact of a $1 million order, like in this dashboard by Messari

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In response to criticisms on data quality, CoinMarketCap deployed two additional metrics to measure liquidity: adjusted volume and liquidity. Although the methodology used to adjust these figures is unclear, we can clearly see that the adjusted volumes are lower than the uncleaned volume statistics.

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Conclusion

Now that you have a basic understanding of the mechanisms at work behind an exchange, what liquidity is, and how to measure it, we hope you can take this knowledge into trading. Sign up at Crypto.com Exchange if you haven’t yet and put theory into practice.

References

1. Lesia Dubenko(May 2019). 95% of Trading Volumes Are Fake. Nothing to Worry About, says Bitwise. Retrieved from https://www.altcoinbuzz.io/cryptocurrency-news/finance-and-funding/95-of-trading-volumes-are-fake-nothing-to-worry-about-says-bitwise/

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