How Crypto Exchanges Work

Most people buy their first crypto on a centralized exchange: a company that takes your dollars, matches you with someone selling, and records the result. It feels like a brokerage app, and in some ways it is one. The differences, especially around what happens to your money, matter a great deal.

Matching buyers and sellers

An exchange keeps an order book for each trading pair, such as BTC/CAD:

• Bids are offers to buy at a stated price.
• Asks are offers to sell at a stated price.
• The gap between the highest bid and the lowest ask is the spread.

A market order buys or sells immediately at the best available prices. A limit order waits until the market reaches your chosen price. On thinly traded coins, a large market order can “walk the book”, filling at progressively worse prices.

The “price of bitcoin” you see quoted is simply the most recent trade on some exchange or an average across several. Different exchanges can show slightly different prices at the same moment.

What you actually pay

Costs often add up to more than the headline fee:

• Trading fees, usually a percentage of each trade.
• The spread, which some “zero fee” apps widen to make their money.
• Deposit and withdrawal fees, including the network fee when you move coins off the platform.
• Currency conversion, if you deposit in one currency and buy in another.

Simplified “buy” buttons in apps are often the most expensive route. The advanced trading screen on the same platform is frequently cheaper.

What happens to your deposit

When your coins sit on an exchange, you usually don’t hold them on the blockchain in your own name. The exchange holds a pool of coins in its own wallets and keeps an internal record of how much it owes each customer. You are trusting that the records are accurate and that the pool is really there.

Well-run exchanges keep customer assets separate and fully backed, and some publish proof of reserves reports. But proof of reserves usually shows assets, not the full picture of debts, so it is a partial check rather than a guarantee.

Why exchanges fail

The history is long. Mt. Gox, once the largest bitcoin exchange, collapsed in 2014 after losing hundreds of thousands of bitcoins. In Canada, QuadrigaCX collapsed in 2019 owing customers about 215 million dollars. FTX, one of the world’s largest exchanges, went bankrupt in November 2022 after customer funds were misused. Common causes:

• Hacks of the exchange’s hot wallets.
• Misuse of customer funds, such as lending them out or using them to cover losses.
• Fraud or poor record-keeping.
• Runs, where too many customers try to withdraw at once.

When an exchange fails, customers become creditors in a bankruptcy that can take years, often recovering only part of what they were owed.

Regulation in Canada and the US

In Canada, crypto trading platforms serving Canadians are expected to register with the provincial securities regulators that make up the Canadian Securities Administrators (CSA), and they must register with FINTRAC as money services businesses. The CSA publishes a list of registered platforms. In the US, rules come from several federal and state agencies and have been changing. Registration is a meaningful check, but it does not make crypto itself safe or insured.

Questions worth asking before you deposit

• Is the platform registered where you live?
• Can you withdraw to your own wallet, and what does it cost?
• Does it publish proof of reserves, and does that include liabilities?
• What are the total costs of a buy, including the spread?
• What happens to customer assets if the company goes bankrupt?

The short version

An exchange is a matching engine plus a custodian. The matching part is simple. The custodian part is where the risk lives, so choose carefully and don’t leave more there than you have to.