Crypto Exchange

Crypto (cryptocurrency) is a digital currency designed and developed to work as a medium of exchange through a computer network that doesn’t rely on a central authority, such as a bank or government agency. It’s a decentralised system for verifying whether parties involved in a transaction have the funds they claim. It eliminates the need for conventional intermediaries when transferring money between two entities. Individual coin ownership is recorded and stored in a digital ledger, a digital database protected by strong cryptography to ensure secure transaction records, coin ownership verification, and additional coin creation. Despite their name, cryptocurrencies aren’t considered to be currencies by law. While various treatments have been applied to them, including categorisation as securities, commodities, and currencies, crypto is usually viewed as a particular asset class. Some cryptocurrency schemes use validators to maintain operations. In a proof-of-stake model, token owners put up assets as collateral. In exchange, they get authority over tokens in proportion to their stake. Furthermore, token stakers get additional ownership over time via network fees, different reward mechanisms, and newly released tokens. Crypto doesn’t exist in physical form (paper money or metal coins) and is usually not issued by a centralised organisation. When a cryptocurrency is issued, created, or minted, it’s generally considered centralised. However, it becomes decentralised as soon as it becomes part of a distributed ledger technology, typically a blockchain. The first decentralised crypto was Bitcoin. It was released as open-source software in 2009. As of March 2022, more than 9,000 cryptocurrencies are in the marketplace, of which more than 70 have a market capitalisation exceeding $1 billion.

Formal Definition

Cryptocurrency is a system that meets six conditions, according to Jan Lansky.

• It doesn’t require a central authority. Its state is regulated via distributed consensus;
• It keeps an overview of crypto units and their ownership;
• It defines whether new cryptocurrency units can be issued, created, or minted. If new units are to be released, the system determines their ownership and the circumstances of their origin;
• The ownership of crypto units can only be proved cryptographically;
• It allows transactions to be executed only when an entity can prove the current ownership of the cryptocurrency;
• It performs at most one set of instructions for changing the ownership of the same cryptographic units, even if two or more sets are activated;

Types of Cryptocurrency

Altcoins

Crypto units, tokens, and digital assets other than Bitcoin are collectively known as alternative cryptocurrencies (altcoins). Altcoins have fundamental differences when compared to Bitcoin. For instance, Litecoin aims to execute a block every 2.5 minutes, which is faster than Bitcoin’s 10 minutes. Another example is Ethereum. It has smart contract functionality that enables decentralised applications to run on its blockchain.

Stablecoins

Stablecoins are crypto units designed to keep a stable level of purchasing power. These cryptocurrencies are not foolproof, as several have lost their peg or crashed. Terra and Luna coins are an example of these units’ increased volatility.

Architecture

Cryptocurrency is generated collectively by an entire network at a rate defined during the system’s creation and which is announced publicly. Corporate boards or governments control the currency supply in centralised banking and economic networks. In the case of crypto, companies or governments cannot create new units. Moreover, they have yet to provide backing for other corporations, firms, and banks that hold asset value measured in cryptocurrency. In a proof-of-work system such as Bitcoin, the balance, integrity, and safety of ledgers are kept by a community of mutually distrustful parties known as miners. Miners use their computers to timestamp and validate transactions, adding them to the ledger per a particular timestamping protocol. On the other hand, in a proof-of-stake network, transactions are validated by owners of the associated crypto units, who are sometimes grouped in stake pools. Most cryptocurrencies are developed to decrease the production of that currency gradually. Placing a cap on the total amount of crypto units that will ever be circulated.

Blockchain

A blockchain provides the validity of each cryptocurrency coin. Blockchains are a continuously growing list of records called blocks. All blocks within a system are linked and secure via cryptography. Typically, each block features a hash pointer as a link to a previous block, transaction data, and a timestamp. By design, blockchains are resistant to data alternation. They are “open, distributed ledgers that can efficiently record transactions between two entities in a verifiable and permanent manner.” Blockchains are usually managed by a peer-to-peer network adhering to regulations for validating new blocks. Once recorded, the data in any given block cannot be changed without modifying all subsequent blocks. Blockchains are highly secure by design. They are a perfect example of a distributed computing system with considerable Byzantine fault tolerance. It’s safe to say that decentralised consensus is more than attainable with blockchains.

Nodes

A node is a computer connected to a cryptocurrency network. The node supports the system by either hosting a copy of the blockchain, relaying transactions, or conducting validations. Regarding relaying transactions, each computer has a copy of the blockchain of the crypto unit it supports. When a transaction is made, the node generating its broadcast details uses encryption to notify the network about the ongoing operation. Nodes are either hosted by the organisations responsible for developing the cryptocurrency blockchain network technology or by volunteers who host a node in exchange for rewards from the network.

Timestamping

Crypto units use different timestamping techniques to “prove” the validity of transactions added to blockchain ledgers, thus eliminating the need for third parties. The first timestamping scheme invented was proof-of-work. The most widely used proof-of-work procedures are based on scrypt and SHA-256. X11, CryptoNote, SHA-3, and Blake are other popular hashing algorithms used for this scheme. Proof-of-stake is another timestamping scheme. It’s a method of securing a cryptocurrency network and attaining distributed consensus by requesting users to demonstrate ownership of a certain amount of crypto. Unlike proof-of-work that runs complex hashing algorithms, this scheme mainly depends on the coin. Some crypto units use a combination of both schemes to secure their networks and execute transactions.

Mining

Mining is the validation of transactions on a blockchain. Miners are incentivised to contribute to the processing power of networks by getting rewards. Specialised machines such as FPGAs and ASICs are used to increase the rate of generating hashes. They run complex hashing algorithms such as scrypt and SHA-2256 to raise effectiveness. Mining is measured by hash rate, typically in TH/s. Generating hashes for validation has become challenging as more people are venturing into crypto. Miners are forced to invest increasingly large funds to improve computing performance. Consequently, the reward for discovering a hash has diminished and rarely justifies the investment in equipment, cooling, and electricity. Some miners pool their resources, sharing their processing power to split the reward equally. “Shares,” on the other hand, are awarded to network members who can present a valid partial proof-of-work. Popular mining locations include regions with a cold climate, inexpensive electricity, and jurisdictions with favourable and transparent regulations. Currently, Iceland and Kazakhstan are regarded as hot spots for cryptocurrency miners due to their cheap electricity rates and lax laws. Quebec and Texas are also incredibly popular, especially among Chinese miners, as China halted virtual currency trading in 2018.

Wallets

Cryptocurrency wallets store public and private “keys” or seeds that can be used to spend or receive crypto units. Private keys enable users to write in public ledgers. Private keys, however, are used to send cryptocurrency to wallets. There are different ways to store keys or seeds in a wallet. These methods are:

• Paper wallets
• Hardware wallets
• Digital wallets
• Hosting wallets on crypto exchanges

Anonymity

Unlike popular opinion, crypto unit ownership isn’t anonymous. It’s pseudonymous. The cryptocurrency in a wallet is not linked to a person but to one or more keys. Crypto owners aren’t immediately identifiable, but all their transactions are publicly available in their respective blockchain networks. Furthermore, cryptocurrency exchanges often require by law the gathering of the personal information of their users.

Crypto Exchange

A Digital Currency Exchange (DCE), more commonly known as a cryptocurrency exchange, is a platform or business that enables clients to trade crypto units for other assets like other digital currencies or fiat money. Exchanges may accept wire transfers, card payments, and other forms of payment. Crypto exchanges can be market makers or matching platforms that traditionally take the bid-ask spreads or charge a fee as a transaction commission for their service. Some brokerage services that focus on other assets, such as stocks, like eToro and Robinhood, allow users to purchase but not withdraw cryptocurrencies to wallets. However, dedicated crypto exchanges like Coinbase and Binance allow cryptocurrency withdrawals. Crypto exchanges do NOT guarantee that investors make purchases or trades at optimal prices. As a result, since 2020, it has been possible to arbitrage to find the difference in price across different markets.

Operation

Crypto exchanges can send cryptocurrency to users’ wallets. Some businesses and platforms can convert digital currencies into anonymous prepaid cards to withdraw funds from ATMs worldwide. The creators of cryptocurrencies are usually independent of crypto exchange platforms and businesses. Digital Currency Providers (DCPs) aren’t creators. They are businesses that keep and administer accounts for their customers but generally do NOT issue crypto units to those clients directly. People buy or sell cryptocurrency from digital exchanges, which then transfer the funds into or out of the users’ DCP accounts. Some crypto exchanges are subsidiaries of DCP, but in general, many are legally independent organisations. The denomination of funds kept in DCP accounts can be real or fictitious currency. Digital currency exchanges can be both brick-and-mortar or digital businesses. The former is known to work with traditional payment methods and digital currencies, while the latter exchange electronically transferred money and cryptocurrency. Usually, digital currency exchanges operate outside Western countries to avoid specific regulations. However, they work with Western fiat money and maintain bank accounts in different countries to streamline deposits in various national currencies. IDEX, Etherdelta, and HADAX are decentralised (DeFi) exchanges that do NOT store user funds on the exchange. Instead, they facilitate peer-to-peer cryptocurrency trading. DeFi exchanges resist most security problems affecting centralised exchanges but can suffer from low trading volumes.

Legislation

By 2016, several crypto exchanges within the European Union (EU) obtained licenses under the EU Electronic Money Directive and the EU Payment Services Directive. Since the adequacy of such permissions wasn’t judicially tested at the time, the European Parliament and the European Council announced they would issue regulations to impose stricter rules for exchange platforms and businesses. In 2018, the U.S. Securities and Exchange Commission stated that “if a platform offers the trading of digital assets that are securities and operates as an “exchange,” as defined by the federal security laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.” Since then, the Commodity Futures Trading Commission has enabled crypto derivative trading publicly. In Asia, Japan is more forthcoming than other local countries, and its regulations mandate the need for a special license from the Financial Services Authority to operate a cryptocurrency exchange. China and South Korea remain ill-disposed, with China banning miners and freezing their bank accounts. Australia is yet to announce its final regulations on crypto units. However, Australian citizens must disclose their digital assets for capital gains tax.

Crypto Exchange Methods

Atomic Swap

Atomic swap is a method where one crypto unit can be exchanged directly for another without the involvement of a trusted third party.

Automated Teller Machines

The first Bitcoin ATM was launched in the United States on 20 February 2014 by Jordan Kelley, the founder of Robocoin. The kiosk was installed in Austin, Texas, and is similar to conventional ATMs used by banks. The main difference is that it features scanners to read government-issued identification like passports and driver’s licenses to confirm users’ identities. There are two types of Bitcoin ATMs:

• Unidirectional – Used for one-way transactions involving cryptocurrency selling or buying.
• Bi-Directional – Use for the selling and buying of crypto units.