How Does the Crypto Market Work?

On the surface, a crypto market works like other financial markets. There are buyers, sellers, and an intermediary platform where the trading occurs. But the crypto market is versatile; there are many ways crypto moves and many moving parts.

Today we will examine the crypto market, its advantages, and some dangers investors must be aware of.

But first, it helps to understand the basics of blockchain.

In short, a blockchain is a collection of computers that record transactions of cryptocurrencies. Each blockchain only supports certain cryptocurrencies. Therefore, there are many blockchains, each supporting different cryptos.

Now let’s get started, shall we?

The Origins of Crypto Markets

Today, there are countless ways to buy Bitcoin or any other cryptocurrency – from cross-chain swaps to purchasing with PayPal. But this was not always the case.

The original use of cryptocurrency was digital cash. Other cryptocurrencies came before Bitcoin, but Bitcoin was the first to solve the double spending problem. This meant Bitcoin was the first to see huge adoption and is the oldest crypto still running!

Bitcoin was designed to be a digital peer-to-peer (P2P) payment network for permissionless and immutable transactions. This meant anyone, anywhere, at any time, could send or receive cryptocurrency, providing they had an internet connection.

Following the creation of Bitcoin in 2009, there were only two ways to get it. By mining it or arranging a P2P exchange. There were a couple of escrow services available, but options were limited.

Following this, the first cryptocurrency market was created. It was proposed on the Bitcointalk forum, where on January 5, 2010, user “dwdollar” said, “Hi everyone. I’m in the process of building an exchange,” he continued:

“I am trying to create a market where Bitcoins are treated as a commodity. People will be able to trade Bitcoins for dollars and speculate on the value. In theory, this will establish a real-time exchange rate so we will all have a clue what the current value of a Bitcoin is, compared to a dollar.”

The proposed exchange was named Bitcoinmarket.com and led to a consensus around the price of Bitcoin for the first time.

Other exchanges then followed. Namely, Mt. Gox. This new exchange once accounted for 70% of all Bitcoin transactions. However, its collapse in 2014 taught the community a valuable lesson on the importance of self-custody.

Shortly before the Mt. Gox collapse, the 19-year-old programmer and co-founder of Bitcoin Magazine, Vitalik Buterin, published the Ethereum white paper.

Ethereum was designed as a separate blockchain from Bitcoin, with a totally different goal. Instead of a decentralised payment network, Ethereum was to become the global decentralised infrastructure layer upon which other blockchain apps could be built; while leveraging the security and decentralisation of the network.

In simple terms, this allowed for the creation of a wide range of decentralised applications (dApps). This included the creation of decentralised exchanges (DEXs).

This new concept was celebrated after the collapse and loss of users’ funds from the Mt. Gox attack. Ethereum and its dApps quickly became some of the most popular cryptocurrencies.

But even with the collapse of Mt. Gox and the rise of Ethereum and other decentralised infrastructure blockchains, CEXs kept on popping up.

Centralised Exchanges Crypto Markets

The biggest concern with centralised exchanges is that they contradict the fundamental idea of cryptocurrency. This is because the origins of digital currency were to enable P2P, permissionless and trustless transactions.

But CEXs introduce a third party, so they are no longer P2P. They can ban or censor particular transactions or users, so they are not permissionless. And they hold your assets in their custodian wallets, so you must trust them.

Nonetheless, the trading volume on CEXs currently dwarfs that of DEXs.

Using A Centralised Exchange

To purchase crypto through a CEX, users can deposit funds from their bank or another cryptocurrency wallet directly into the exchange. They are then free to buy, sell or trade assets on the exchange without worrying about which blockchain each coin is on. This makes cryptocurrency investing simple and is an easy entry point for newcomers in the market.

This means for the average crypto investor, who does not have much time to learn how to create wallets on multiple blockchains, bridge assets and the difference between an ERC-20, BEP-2 and BEP-20 token, it is much easier just to use a CEX.

The other portion of users who continue to use CEXs are institutional investors. One of the main reasons for this is the higher and more efficient use of liquidity on CEXs compared to DEXs.

So that’s the surface-level explanation of how a CEX works. But it does not really explain how the crypto market works. To understand that, we have to dig a little deeper.

How CEX Crypto Markets Work

A CEX is an intermediary between a buyer and seller which facilitates funds. They use a traditional record-keeping method for transactions: an order book.

An order book is a live record of the bids (buyers’ orders) and asks (sellers’ orders) currently waiting to be filled on an exchange platform. For an order to be filled, the opposing party must place an order at the same price.

Centralised exchanges use market markets (large financial institutions), which add opposing bid and ask orders to provide liquidity to the market. This creates seamless, user-friendly trading.

All orders are carried out from within the exchange’s wallet, which stores separate addresses for each user. And all CEX transactions are done off-chain.

To regulate the price difference between exchanges, arbitrage traders will sell assets on an exchange if a price gets too high or buy if it gets too low, compared to the market price.

*Did you know every asset swap in the crypto market in UK is classed as a taxable event? Get help with your crypto tax today.*

 

Decentralised Exchanges (DEXs)

DEXs are close to the total opposite of CEXs. From the underlying philosophy to how orders are filled. But this comes with advantages and disadvantages.

First, DEXs follow the underlying cryptocurrency philosophy of P2P, permissionless and trustless transactions.

Using A DEX

Users need to import funds into their crypto wallet to use a DEX. In the past, users would need to either be paid in crypto or deposit fiat to a CEX, swap it to cryptocurrency and send it to their on-chain wallet. But now, there are more ways to do this, and it has recently become more common for non-custodial wallets to offer fiat on-ramp.

Once users have funds in their wallet, they can visit a DEX website, connect their wallet, and trade crypto assets. For security, we recommend having a separate wallet for long-term storage of cryptocurrency to the one you use to trade!

DEXs are decentralised applications only supported on select blockchains. So users must ensure the wallet they are trying to connect is supported by the DEXs blockchain. This creates confusion in using DEXs, particularly for newer users.

Users must also ensure that if they transfer crypto between wallets, the wallets support that cryptocurrency. If not, the crypto may be lost in the blockchain forever.

Another area for improvement with DEXs is the fragmented liquidity. This is something we will explore further in the next section.

How DEX Crypto Markets Work

Although some DEXs use order books, the majority of new and most popular ones use automated market makers (AMM).

An AMM is a software algorithm that automatically determines the price of an asset based on its fluctuating supply and demand. The supply of assets for an AMM comes from liquidity pools. These are decentralised versions of market makers where anyone can deposit cryptocurrency into trading pair pools and receive a share of its commissions.

This solves two issues:

• No more wait times for orders to be filled, as the market price is automatically calculated.
• Does not rely on a centralised 3rd party market maker. So it fits better with the cryptocurrency ideology.

However, AMMs also come with two main issues:

• Fragmented liquidity. Each token pair needs its own pool, and liquidity is spread across DEXs and chains – often leading to slippage.
• Liquidity providers risk impermanent loss when the price of the deposited tokens is volatile.

When it comes to crypto markets, DEXs automatically calculate the price of a currency based on supply and demand in liquidity pools. In contrast, CEXs use traditional order books where orders queue to be filled.

*One final note about DEXs is that transactions are all on-chain. This goes part in parcel with the crypto philosophy mentioned earlier, but does mean users must pay a gas fee on transactions. This is not an issue on some chains, like the Binance or Avalanche chain, as they have higher bandwidth (although this has other tradeoffs).

But on the most popular, secure and decentralised chain, Ethereum, gas prices to execute trades can become immensely high during bull markets or times of high usage. This is another reason some people prefer to use CEXs.

Whether you choose to use a CEX, DEX or P2P transaction ultimately depends on your circumstances. However, if you are holding long-term, we always advise you to send your crypto to a hardware wallet and store it offline for security.

When it comes to moving, trading or swapping cryptocurrency, there are a lot of tax implications. Check out Cryptiony today, and let us do the hard work for you.