A beginner's guide to on-ramping into cryptocurrency
Do I need a crypto exchange?
In short, yes. If you want to buy and sell Bitcoin or any other cryptocurrency, you will need an exchange account, i.e. an ‘On-Ramp’. Once you have decided to buy some cryptocurrency, step one is to transfer your funds to a platform that will enable you to buy crypto. Transferring your everyday money - such as US dollars, Euros or Pounds - into and out of the crypto-economic system requires the use of cryptocurrency on-ramps and off-ramps. These are the cryptocurrency exchanges that allow the depositing of funds, the transfer into and out of cryptocurrency, and the subsequent withdrawal of those funds.
What is a cryptocurrency exchange?
A cryptocurrency exchange is a platform for the exchange of cryptocurrencies. Crypto exchanges provide the functionality for customers to trade cryptocurrencies for fiat money or between digital assets. As a rule, crypto exchanges are online businesses that exchange both fiat money and digital currencies transferred electronically. Some cryptocurrency exchanges operate as market makers, taking the bid-ask spreads as transaction commission. These exchanges help create a market for investors to buy or sell cryptocurrencies, whilst other exchanges are simply matching platforms who charge fees for trades.
A large number of cryptocurrency exchanges operate outside the major Western countries to avoid regulation and prosecution. You would be well advised to consider the domicile of each exchange as a factor in making your choice of which provider to go with. However, most prominent exchanges accept deposits in major fiat currencies, facilitating fiat to crypto on-ramp. Exchanges usually accept credit and debit card payments, wire transfers or other forms of electronic payment scheme in exchange for cryptocurrency.
What is a market maker in crypto?
A market maker helps create a market for investors to buy or sell securities. In the crypto markets, a market maker is an exchange that is actively quoting two-sided markets in a cryptocurrency, providing both bids and offers/asks along with the market size of each. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
What is the bid-ask spread?
A bid-ask spread in cryptocurrency is the amount by which the ask price exceeds the bid price for a particular coin or token in the market. In simple terms, the bid-ask spread is the difference between the highest price a buyer is willing to pay for a cryptocurrency and the lowest price that the seller is willing to accept. The seller will receive the bid price and the buyer will pay the ask price.
How does a crypto exchange work?
Cryptocurrency exchanges enable customers and investors to trade cryptocurrencies for fiat money or between digital assets. There are numerous types of exchanges, offering a variety of functions. Some are geared for professional or institutional traders, whilst others simply offer the ability to exchange crypto and fiat currencies. Crypto exchanges set the rates of the cryptocurrencies on offer. Just like the forex markets, cryptocurrencies are quoted in trading pairs. On crypto exchanges, traders use these currency pairs to profit from the volatility in cryptocurrency rates. A number of crypto exchanges, especially those designed for regular traders, only allow transactions in cryptocurrency and avoid the use of fiat money altogether by offering crypto only pairs. Popular crypto-to-crypto pairs include: BTC/ETH, ETH/BTC, BTC/LTC and LTC/BTC. These platforms charge lower commission fees than on crypto-to-fiat exchanges.
What are trading (currency) pairs?
A trading or currency pair is a term to describe two currencies coupled for trading on an exchange or marketplace. Both currencies will have exchange rates on which the trade pricing is based. All trading within the forex market, whether selling, buying or trading, takes place through currency pairs. On crypto exchanges, coins are offered and traded as fiat/crypto (e.g. USD/BTC) or crypto/crypto (BTC/ETH) pairs.
Why do crypto exchanges have different prices?
Crypto exchanges are independent businesses, so rates and prices will vary depending on the buying and selling activity on each exchange. Exchanges calculate the price of cryptocurrencies based on supply, demand and their own trading volumes. Generally, the bigger the exchange, the more market-aligned the price will be. There is no absolute standard price for Bitcoin or any other cryptocurrency; prices are determined by the market at any moment in time. Pricing feeds and major news channels use an aggregate price of Bitcoin and other coins/tokens. Some calculate their own price index for BTC, ETH and other currencies, which is calculated as an average value based on the prices of over 25 leading exchanges.
What fees do cryptocurrency exchanges charge?
As you would expect, cryptocurrency exchanges charge fees for a range of products and services on their platforms. This is a broad and topic, but a brief summary of the fees and fee types charged by exchanges is as follows:
Trading fees are the primary source of revenue for cryptocurrency exchanges and are charged on both fiat to crypto trades as well as crypto to crypto trades.
Deposit and withdrawal fees
A number of exchanges will charge fees for deposits and/or withdrawals of fiat currency. You are more likely to see withdrawal than deposit fees as exchanges would not want to discourage customers from funding their account or looking elsewhere for a cheaper provider. Exchanges often limit fees to any incurred blockchain transaction costs, which may be a minimum flat fee, whilst others charge additional fees depending on currency, location and particularly if you are withdrawing fiat rather than crypto.
Margin trading fees
Some exchanges offer margin trading. Margin trading is when an investor borrows additional funds from the exchange to leverage their positions and trades. Aside from the significant increase in risk and exposure when margin trading, these exchanges will charge additional fees based on the amount borrowed on margin and the interest rate. There may also be liquidation fees for exiting a trade that has moved against the investor.
Exchanges will usually offer discounts in the form of lower trading fees to regular and high-volume traders to incentivise exchange liquidity. However the most common form of discount is that provided by the use of exchange tokens. Exchange tokens are essentially utility tokens and have been issued by some cryptocurrency exchanges since 2017. Exchange tokens are a growing class of digital tokens and have the underlying credibility of being issued by genuine infrastructure projects and existing companies. There are 4 exchange tokens in the top 20 cryptocurrencies (by market cap), with Binance Coin in the top 10. Exchange tokens are issued for the benefit of the users of an exchange. These tokens are designed to provide a number of advantages to the token holders, most commonly to reward market makers who create liquidity in the exchange and to lower trading fees for users. Some provide exchange users with limited governance rights and airdrops. Often the benefits to the holder of a token are linked to the amount of tokens they hold – larger balances accrue increased benefits.
Are crypto exchanges regulated?
Whilst cryptocurrency exchanges do not yet pose concerns from a systemic financial stability perspective, they are integral to the crypto-economic system and are very much in the spotlight of regulators with regard to consumer protection, money laundering and the prevention of financial crime.
The United Kingdom’s approach to cryptocurrency regulation is developing but despite the fact that the UK has no specific cryptocurrency laws, exchanges have registration requirements. Cryptocurrency exchanges in the UK generally need to register with the Financial Conduct Authority (FCA) although some crypto firms may operate with an e-license. Although the FCA does not make special provisions for exchanges, their guidance stresses that entities engaging in crypto-related activities which fall under existing financial regulations for derivatives (like futures and options) require authorisation. As regards cryptocurrencies in the UK, they are not considered legal tender and crypto assets (such as Bitcoin and other cryptocurrencies) are only regulated in the UK for money laundering purposes.
The EU’s Fifth Anti-Money Laundering Directive (5MLD) is a significant milestone in the regulation of cryptocurrency in the EU as it has now brought virtual currency exchange platforms and custodian wallet providers within the scope of the EU's anti-money laundering requirements. 5MLD defines custodian wallet providers as an "entity that provides services to safeguard private cryptographic keys on behalf of their customers, to hold, store and transfer virtual currencies."
In the United States, trading of crypto assets is regulated by many different agencies at both the federal and state levels. Laws governing exchanges vary by state and federal authorities define the term ‘cryptocurrency’ differently.
The US Treasury Department's Financial Crimes Enforcement Network (FinCEN) does not consider cryptocurrencies to be legal tender but since 2013 has considered exchanges as money transmitters. deems businesses involved in buying and selling of cryptocurrency to customers or transferring cryptocurrency on behalf of customers to be money services businesses required to register with FinCEN and maintain AML compliance programs and follow other US federal AML requirements.
Crypto assets that meet the definition of a security are subject to regulation by the Securities and Exchange Commission (SEC) under US securities laws. The SEC regulates securities transactions, broker-dealers, investment advisers and other securities market participants. If a cryptocurrency or a product that is linked to a cryptocurrency is determined to be a security, the offer and sale of such cryptocurrency or product must comply with the US federal securities laws, including registration as a security under the US Securities Act or compliance with an exemption from such registration.
To the extent a crypto exchange permits certain regulated commodities transactions or swaps in crypto assets, it will be subject to regulation by the Commodity Futures Trading Commission (CFTC).
Both the SEC and the CFTC have advised the public on taking caution when investing in cryptocurrencies and to consider the risks involved. This advice included the fact that many of the systems and exchange platforms on which trading occurs are not registered or are located outside the United States and therefore outside the jurisdiction of US regulators and the protection of US law.
Are crypto exchanges safe?
Centralised cryptocurrency exchanges are an essential cog in the wheels of the cryptocurrency market and provide their customers with the critical functionalities of crypto trading and storage. The exchanges are the intermediaries for the majority of trading activity and as such, we must rely on the exchanges to in a similar fashion to how we regard banks with our fiat money.
Centralised cryptocurrency exchanges offer the feature of exchange-hosted wallets, in which your cryptocurrency is stored and from where you trade. Exchange-hosted wallets operate in the same fashion as other software-based cryptocurrency wallets but require the exchange to ensure your private key is secure. When you hold cryptocurrency on a centralised exchange, you will never even see or have access to your private key. The exchange acts as custodian, just like a bank.
Many crypto fans and cypherpunks would argue however that holding your coins in a centralised exchange negates the security features inherent in using cryptocurrency in the first place. You are placing full trust in the exchange to protect your private keys in the same way you trust your local bank to keep your money safe. If you recall the 2012-13 Cyprus bank run, you will understand the counter argument clearly. That was a key milestone in the rise of Bitcoin as a credible alternative to the traditional centralised financial system. The only way to have total control over your crypto holdings is to transfer your cryptocurrency to an off-exchange wallet and store your wallet’s private key somewhere safe and secure.
Many of you will ask whether you should leave your crypto on an exchange? It cannot be forgotten that a number of cryptocurrency exchanges have been vulnerable to hacking attacks and theft in the past (think Mt. Gox, Bittrex, Bithumb) but most of the major exchanges, who offer online wallets, have since enhanced their security significantly and now boast industry leading standards of security. Many hold the majority of their funds in cold storage and others, such as Coinbase, also offer insurance of up to £250,000 in the event of a hack. This increased security does mean you’ll be paying slightly higher transaction costs, but many customers are willing to pay for the peace of mind.
What is cold storage?
In the context of centralised cryptocurrency exchanges, the term cold storage refers to the storing of cryptocurrency offline, without the private keys controlling the assets ever being online. This preventative measure mitigates the threat of theft by hackers and malware. Major exchanges see this as a necessary security precaution for their reserves. Exchanges will be keeping the majority of the reserve in cold storage, with only the trading day’s expected liquidity requirements being online. Offline storage of cryptocurrencies – either by individual investors or institutional custodians – is an important safety measure to look for in your choice of wallet and exchange.