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Buying and Selling Bitcoins & Exchanges

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You can buy bitcoins from anyone who has them. Likewise you can sell
bitcoins to anyone who wants them. Fortunately, there are various places
where you are likely to find a group of people willing to trade at
competitive prices—exchanges.
Exchanges
Just like stock exchanges, Bitcoin or cryptocurrency exchanges are places
(usually websites) that attract traders. However, you don’t buy bitcoins
from the exchange itself. Just like a stock exchange, where you buy shares
from another user of the exchange rather than from the exchange itself, a
cryptocurrency exchange is the website that allows people to buy and sell
between themselves. The exchange itself is just the location that brings
together buyers and sellers, and people go there because they know they
are likely to get the best prices there.
In financial services jargon, the exchange is an order matching engine. It
matches buyers and sellers. It also acts as the central clearing
counterparty. All matched trades appear to be against the exchange
rather than between the customers directly, providing anonymity for
customers. Finally, the exchange is the cash and asset custodian. It
controls customers’ fiat money in its bank account and cryptocurrencies
in its wallet.
How Do Cryptocurrency Exchanges Work?
Exchanges are based in different countries and support different fiat
currencies and different cryptocurrencies. They all work roughly the same
way using the same four steps:
1. Create account
2. Deposit
3. Trade
4. Withdraw
Create Account
To use an exchange, just like a bank, you need to open an account.
Exchanges are coming under increasing regulatory scrutiny due to the
fact that they process large amounts of money. The top cryptocurrency
exchanges match billions of dollars of buys and sells per day. Most
legitimate exchanges follow a similar account opening procedure to
banks, where new customers submit details and evidence of their
identity, for example passport and utility bills147. The documentation
needed may become more onerous in proportion to the value of fiat or
cryptocurrencies you plan to transact, in a progressive risk-based
approach. Exchanges are now big business and take these processes
seriously.
Once the exchange is satisfied, your account is created. Then you can log
in and the next step is to deposit.
Deposit
Before you can attempt to buy or sell anything on an exchange, you need
to fund your account. This is like funding an account with a traditional
broker before being allowed to buy traditional financial assets.
Exchanges have bank accounts and cryptocurrency wallets. In order to
fund your account you click on ‘Deposit,’ then follow the instructions. If
you are funding your account with fiat currency (presumably in order to
buy cryptocurrency), then the exchange will display a bank account for
you to make a fiat currency transfer to. If you are funding your account
with cryptocurrency, (presumably to sell for fiat currency or trade for a
different cryptocurrency) then the exchange will display a cryptocurrency
address for you to make a cryptocurrency transfer to.
Once exchange has detected the transfer to their bank account or
cryptocurrency address, the balance will be reflected in your ‘account
balance’ on the exchange’s website, and you are ready to trade.
Trade
You can now trade up to the amounts you have deposited. For example, if
you have deposited USD 10,000, then you can buy up to $10,000 worth
of cryptocurrency. If you have deposited 3 BTC then you can sell up to 3
BTC for fiat or other cryptocurrency that is available at that exchange.
Prices are expressed in pairs that look something like this: BTC/USD or
BTCUSD with a number such as 8,000. The way to read this is, ‘One unit
of BTC costs 8,000 USD’. Not all currencies can be traded for each other
—it is really up to the exchange as to which pairs they enable. For
example you may see BTCUSD and BTCEUR as trading pairs, meaning
that you can trade BTC with USD and trade BTC with EUR, but you may
not trade USD with EUR directly if you don’t see EURUSD. In that case,
to convert USD into EUR, you’d need to sell USD for BTC then use the
BTC to buy EUR.
You will see a screen of other people’s bids and offers. These are the
prices at which they are willing to trade, and how much they are willing to
trade at that price. You can decide either to match their prices, which will
result in a matched trade, or submit your own orders which will rest in
the order book until someone matches your price (if they ever do).
This is a financial market—this means that the larger amounts you want
to buy or sell, the worse the prices will be. This is unlike a supermarket
where you get a discount for buying in bulk. This is confusing for some
people initially, but it is easily explained. When you buy something on an
exchange, the exchange will naturally match you off with the person who
is selling it at the cheapest price. When you’ve bought all that they have to
offer, you have to find the next best price, which will be slightly higher.
Selling uses the same logic: when you sell something, the exchange will
match you with the person who is willing to pay the highest price for it.
When you have sold as much to them as they want to buy, you will have
to go to the next highest price which will be slightly lower.
Here is an example screenshot of Bitfinex, a typical exchange:

On the left-hand side is information about your balances in each currency
(not shown here as this is a demonstration account). The main part of the
screen shows a price and volume chart—Bitcoin’s price and how many
bitcoins have been traded. And the bottom third shows your open trades,
i.e. your orders that haven’t been matched yet, and the full order book,
i.e. everyone’s orders to buy and sell bitcoins and their amounts and price
levels. A ticker is shown on the bottom right which streams the prices and
amounts of matched trades in real-time.
Withdraw
Finally, you will want to withdraw fiat currency or cryptocurrency. To do
so you have to instruct the exchange where you want it to go. If you are
withdrawing fiat, you will need to tell the exchange your bank account
details for them to make the transfer to you. If are withdrawing
cryptocurrency, you need to tell the exchange your cryptocurrency
address so that they can make the cryptocurrency transaction. Usually
cryptocurrency withdrawals are faster for the exchange to process than
fiat withdrawals because most exchanges have ‘hot wallets,’ as described
fiat withdrawals because most exchanges have ‘hot wallets,’ as described
earlier, which automate the process of sending small amounts of
cryptocurrency back to users.
How Do Exchanges Make Money?
Exchanges make money by charging fees, just like your stock broker.
Different exchanges charge different fees in different ways. Some charge
withdrawal fees (e.g., if you withdraw $10,000, then they might send you
$9,950, and you would receive even less than this because of bank fees).
Others charge by taking a small fraction of every trade you do, usually by
reducing the amount of whatever you are receiving. For example, if you
have $8,000 in your exchange account and use it to buy BTC at a price of
$8,000 per BTC, then you will receive slightly less than 1 BTC, say 0.995
BTC. Trading fees are usually determined by how much trading you do,
so if you trade more, the fee rate decreases according to a published fee
schedule.
Pricing On Different Exchanges
The price of any asset at a cryptocurrency exchange depends on the
participants using the exchange. Different exchanges can have different
prices for each cryptocurrency, because of the different participants using
the exchange and the different levels of supply and demand on those
exchanges. Usually the prices are within a few percent of each other. If
they get too out of line, arbitrageurs step in and buy the bitcoins from the
exchange where they are cheap and sell them where they are trading at a
premium.
The extent to which arbitrageurs can keep doing this profitably affects
how aligned the prices will ever become. To complete the circle of a
successful arbitrage you need to move the fiat, and sometimes this will
have costs and time delays. To buy bitcoins on the cheap exchange, you
need to move fiat currency there, buy bitcoins, withdraw the bitcoins and
send them to the more expensive exchange, then sell them, withdraw the
fiat, and repeat the cycle. Each step has a financial cost and may not be
instant. Some countries have currency controls, which hinder cross
border exchange arbitrage. This is why there can be price differentials
between exchanges for some time.
In late 2013-14, the exchange Mt Gox traded at a premium to its
competitor Bitstamp, because people found they couldn’t withdraw fiat
from Mt Gox, so instead they had to buy bitcoins and withdraw the
bitcoins instead. This created artificial demand for bitcoins on Mt Gox,
and the arbitrage of buying cheap bitcoins on Bitstamp and selling them
on Mt Gox didn’t work because you couldn’t get your fiat out of Mt Gox!
Regulation
Cryptocurrency exchanges perform activities that may be regulated in
their operational jurisdictions. The fact that the instruments involved are
cryptocurrencies does not necessarily mean that the exchanges escape
local trading and tax disclosure requirements. However, depending on
how the legislation is written, and owing to regulatory uncertainty, the
classification of cryptocurrencies, exchanges currently operate in a legal
grey area, especially crypto-only exchanges who allow trades between
cryptocurrencies but not fiat.

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