What is a Currency Exchange Market?
To better understand What in the World a Cryptocurrency Exchange is, let’s first discuss the fiat currency exchange market. As we know, there are hundreds of different global currencies, which are all impacted by various macroeconomic, political, monetary, and fiscal forces. As of 2019, the United Nations recognizes 180 such currencies across 195 countries. Under this currency paradigm, if swapping one US Dollar, for say, the equivalent amount of Mexican Pesos is one exchange possibility, then there are over 16,000 such possibilities at any given moment! Furthermore, if we allow the currency amount and time to vary, then there are a near infinite number of unique exchanges possibilities. Due to the inherent complexity and enormous workload required to directly make these markets, a coordinated, decentralized (now termed over-the-counter) exchange network developed, promising a more efficient system of market-making and transaction facilitation. Over time, globalization, free trade agreements, and lucrative investment opportunities have ballooned the currency exchange (also known as Forex) market into the largest - $2T in daily volume - most liquid market in the world. Today, businesses, investors, funds, foreign travelers, and governments across all major global financial hubs and time zones actively participate in this multi-trillion dollar market.
What is a Currency Exchange?
Alongside the decentralized Forex market, centralized, customer-facing currency exchange outlets, such as Western Union and OFX, formed. These for-profit businesses, known as currency exchanges, have the legal right to facilitate (“broker”) the exchange of currencies between parties. Operationally, these exchanges work much like New York’s NYSE or London’s FTSE, where licensed funds, brokers, investment banks, and other institutions hold shares of publicly traded companies in “inventory”, standing ready to exchange securities for cash or other securities as orders come in (known as market-making). Like these security market-makers, currency exchanges help make currency markets by maintaining an inventory of global currency reserves, then exchanging the reserves for the offered currency at a fixed exchange rate as requests (“bids”) comes in.
Okay, time for a more relatable Currency Exchange example...
Say, for instance, you’re a US traveler preparing for a four week, $10,000 trip to the European Union. You’ll pay half by credit or debit, but need $5,000 in Euros to fund your trip. You may stop into a Western Union or unbranded currency exchange at the airport and ask to exchange your $5,000 US dollars for Euros (i.e. place a bid). Based on economic, political, and fiscal conditions of both the US and the Europen Union and the relative competition amongst currency exchanges for your business, the exchange will offer you a fixed exchange rate that tends to run 1% - 3% below the market exchange rate (the exchange’s profit margin). Now let’s assume one US dollar buys 0.9 Euros. If the exchange charges 3% for the transaction, then you’d receive about $5,000 * 0.9 * 97% = €4,365 for your $5,000. Although it’s tempting to think the 3% profit margin is completely arbitrary, the exchange must hold excess cash reserves in inventory to virtually guarantee that you’ll be able to leave with €4,365 on the spot. Since it could be investing these €4,365 at 3% (or more) instead of keeping it reserved for you at effectively 0%, the exchange charges you an “opportunity cost” fee of -- in this example -- 3%. After you leave the airport for Europe, depending on currency supply and demand levels, the exchange may keep the $5,000 proceeds as US Dollars, exchange it with another exchange for €4,365 to replenish its inventory, or even trade it for some “undervalued” third currency.
What is a Cryptocurrency Exchange?
The underlying operations of a cryptocurrency exchange closely resemble fiat currency exchange operations. In general, the largest global cryptocurrency exchanges -- Binance, Coinbase, Bitfinex -- hold (or have unfettered access to) excess domestic cash, cryptocurrency, and other in-demand tokens. As these exchange platforms receive bid orders, they normally exchange digital asset reserves at the prevailing market rates (ex, 1 BTC = 33.05 Ether), then retain a fixed percentage transaction fee as revenue. Although the operations are similar to fiat currency exchanges, there are a few important non-operational distinctions worth discussing:
- Cryptocurrency exchanges only hold digital currencies. Unlike fiat exchanges, which hold physical cash, cryptocurrency exchanges do not hold any physical assets. With only a digital presence, cryptocurrency exchanges exclusively hold digital assets (or rights to digital assets) using the blockchain to record-keep. The purely digital model has advantages -- it is easier to scale, cheaper to maintain, and economically efficient. However, because cryptocurrency exchanges don’t hold physical assets, they may face heightened cybersecurity, liquidity, and currency risks, and may also have more difficulty arbitrating disputes.
- Cryptocurrency exchanges introduce...cryptocurrency. Apologies if this is stating the obvious, but as the name suggests, most large, reputable cryptocurrency exchanges hold fiat currency alongside cryptocurrency reserves. To most of us, this is probably the most obvious distinction between crypto and fiat exchanges. Broadly speaking, crypto exchanges specialize in crypto-to-crypto swaps (ie. Bitcoin for Ether), but also offer fiat-to-crypto (ex USD to Bitcoin) or crypto-to-fiat (ex Ether to Euro) functionality. Therefore, if you want to swap crypto for fiat, own a supported fiat and want crypto, or want to swap crypto for crypto, you’ll be entirely out of luck at Western Union, the Forex market, or any other exclusively fiat market...sorry!
- Cryptocurrency exchanges feature personal storage “wallets”. Also unlike fiat exchanges, cryptocurrency exchanges generally offer accompanying storage of your digital assets and management of your private keys. Since fiat currency exchange aren’t banks, you won’t be able to keep your money with them. Instead, you must deposit your money at a licensed bank (hot storage in crypto-speak) or in your physical wallet or mattress (cold storage in crypto-speak). By contrast, cryptocurrency exchanges offer virtual wallet services, which act as your own personal hot storage devices. For instance, if you purchase $100 of BTC at Coinbase, you have the option of allowing Coinbase to store your Bitcoin on your behalf in a virtual wallet, which you can access anytime with a password and private key combination.
- Cryptocurrency exchanges are mostly unregulated. Unlike fiat currency exchanges, which are gently regulated at both the state and national level in the US, cryptocurrency exchanges fall almost entirely within the unregulated (known as shadow banking) sub-sector within the financial services industry. Like cryptocurrency itself, since cryptocurrency exchanges are so recent, pseudonymous, and purely digital, no coordinated system of global oversight and regulation has emerged. Instead, the immense regulatory burden has landed on the individual countries in which the exchanges primarily operate, resulting in the formation of wildly inconsistent and patchwork regulatory frameworks. Some governments, such as the US, have taken a more guarded approach, while others, such as China and Japan, have more actively encouraged innovation through policy.
And the grand finale...Integration of Crypto Exchanges with Portfolio Tracking Apps!
Now that we (hopefully) better understand the similarities and differences between fiat and cryptocurrency exchanges, we’re now prepared to discuss how crypto portfolio tracking apps utilize these exchange networks to your benefit. Once given API permission (see detailed discussion here), these apps automatically retrieve your crypto holdings across all crypto exchanges and display the results in a comprehensive interface. For an example, suppose you’re an Indian crypto holder, and hold Bitcoin in Biance and Ether in Bitfinex. Instead of keeping track of your holdings manually using a spreadsheet (see Benefits of Automated Portfolio Tracker here), your favorite crypto portfolio tracking app - Blockfolio, duh - automatically retrieves and averages BTC and Ether prices across 300+ partner crypto exchanges in real-time on your behalf. Furthermore, because you’ve enabled Binance and Bitfinex integration (see API discussion here), Blockfolio automatically computes your up-to-date holdings of BTC and Ether across these exchanges by netting all your historic buy and sell orders. Lastly, it multiplies your BTC and Ether holdings by BTC and Ether prices to calculate you “Holdings”, then adds all your Holdings up to reveal how crypto rich you really are.