Market mechanics – Part 2, Functions of an exchange

Part of a 6-part series on market mechanics:

  1. Introduction
  2. Functions of an exchange
    1. Custody
    2. Settlement
    3. Tax reporting
    4. Matching
    5. Market data
  3. Types of exchanges
    1. Order book
    2. Over-the-counter (OTC)
    3. Derivatives
  4. How order books work
    1. Mechanics
    2. Types of orders
      1. Market
      2. Limit
      3. Stop
    3. Matching
  5. What’s in a price?
  6. Market pitfalls
    1. Slippage
    2. Market cap
    3. Hidden supply
    4. Flash crash

If you ask “How do I get started investing in crypto?”, somebody will usually point you towards an exchange like Coinbase or Binance. These are businesses that make their money facilitating trading in cryptocurrencies. Most of the big ones serve as a one-stop shop for five major services that they provide to customers:

Custody

Bitcoin and other cryptocurrencies are digital assets. At least according to the IRS, cryptocurrencies are considered property. You can own them, transfer them, sell them, and so on.

There is nothing in the Bitcoin protocol that requires the existence of an exchange or any other custodial institution. You receive Bitcoins by advertising your Bitcoin address, which is a public key. (Technically, it’s multiple rounds of hashing of the public portion of an ECDSA keypair, followed by Base58 encoding.) You send them by digitally signing a message with your private key. You can generate Bitcoin addresses yourself, on your local computer, and also store them on paper, on a hardware device, or even just on your hard disk. Once you receive funds, they’re stored in a distributed ledger across thousands of computers worldwide, and encrypted so that those computers can’t tamper with the ledger.

If the previous paragraph made your eyes glaze over, you understand why most exchanges offer custodial services.

The exchange handles all the details of creating an address and performing transactions with it, and the only time you have to interact with them is when you’re sending and receiving funds from other organizations. They give you a nice, small bit of text you can copy & paste into other applications to send cryptocurrencies, and you don’t need to think about it otherwise. The exchange just shows your current balance and holds the funds for you until you need them.

The downside of offering another institution custody of your property is that they have full control over your funds, and so you better trust that institution. Custody of funds is an area that is extensively regulated by governments; most of the Big-10 comply with regulations, but cryptocurrency exchanges are an industry that have had prominent failures.

It is not strictly necessary for custodial functions to be bundled in with an exchange. There are decentralized exchanges (DEX for short) that perform only the settlement, matching, and market-data functions of an exchange while letting you keep custody of your cryptocurrency in whatever wallet you prefer. (A full discussion of decentralized exchanges is out-of-scope for this article, but a later blog post will cover them.) Conversely, there are Bitcoin wallets, custodial services, and even ordinary brokerages that let their customers hold cryptocurrency.

Settlement

Settlement is the process of physically delivering the assets to the buyer after a trade has occurred.

Most centralized exchanges allow you to trade only with other users of that exchange. This makes settlement trivial: the exchange updates the balances of the buyer and seller to reflect that the trade has occurred, and they’re done. In some cases they may need to perform a transaction on the blockchain to update these balances, but they handle that transparently.

Settlement is much more complex when trades are allowed between participants on different exchanges. The 0x Project provides a protocol to do this for DEXes, and it’s frequently an issue for non-cryptocurrency assets like the stock market. This is why, when you make a stock trade, you often don’t actually own the stock shares until 3 days after the trade occurs.

Tax Reporting

For U.S. customers, the IRS has ruled that cryptocurrency transactions are taxable as capital gains, and must be reported (over a certain limit) on Form 1099-K. Many exchanges keep an automatic record of your trades and send you this form at tax time if you’re subject to the reporting requirements.

Most other jurisdictions have similar reporting laws for cryptocurrency transactions, and one of the reasons exchanges ask for your address is to identify the relevant jurisdiction for tax & Know-Your-Customer laws.

If your exchange doesn’t do this, you should keep a careful record of every trade you make, including the date and price you bought a currency, the date and price you sold it, the specific assets traded, and if you’re not directly trading for US dollars, the dollar value of the trade at current prices. Various third-party services can help you prepare the required tax forms.

Matching

The most important function of an exchange is to actually exchange assets. All markets have some way to match up buyers and sellers, so that people can advertise that they want to buy or sell cryptocurrencies and then find someone advertising the asset they want to match and settle up.

The rest of this blog series will go into detail about how the matching process works and how different exchanges handle it. As the most important function that exchanges perform, it’s also the one with the most subtleties and unexpected interactions.

Market data

Finally, most exchanges publish information about trades that have recently happened on them and orders that are pending, so that other traders can execute particular trading strategies.

The exchange itself will usually have a variety of charts, tables, and other graphics detailing the recent history of trades that happened on it. They reflect only trades that happened on that particular exchange; for obvious reasons, exchanges do not have information about trades that happen on their competitors.

It’s often worthwhile to use a separate market data service like Cryptolazza for market data, because:

  • They can aggregate data coming off of many exchanges at once.
  • They handle the details of connecting to all the different exchanges, which all use different protocols for their market data and generally require a professional programmer if you want to process data on individual trades or orders.
  • They can process and present data in real-time, while if you tried to keep 10 different tabs open to view what was happening in the market at once, you likely would not be able to react before some other trader takes advantage of any market opportunities that open up.

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