LeoGlossary: Exchange

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An exchange is a marketplace where investors and speculators can trade securities.

Some are:

Most exchanges have certain hours of operation. For example, the stock market is open from 9:30 AM to 4 PM Monday through Friday. There are extended hours trading sessions although volume tends to be a lot less. This means that those operating that time see increased volatility. This is also known as after hours trading.

History of Exchanges

Trillions of dollars is traded each day on exchanges all over the world. The advancement of technology, especially when it comes to communications, aided in the massive growth over the last few decades. Digital networks are so powerful that people can trade anywhere in the world, as long as they are connected to the Internet and have a trading account.

Despite the present advancement, exchanges are nothing new. They date back hundreds of years, with all kinds of materials and assets traded.

  • As early as the 1300s, Venetian money lenders began to sell debt issues. This could be considered an early debt market.

  • In the Middle Ages, people got together to trade crops, livestock, clothing, and even land (early real estate markets).

  • Belgium starts an exchange in the 1500s for promissory notes and bonds.

  • One of the earliest financial revolutions in modern Europe was created by the wartime demands of Emperor Charles V and the Habsburg Netherlands in 1542. The monarch used the Amsterdam exchange to issue and sell debt.

  • In the 1600s, the emergence of various East India companies that issued stock led to a financial boom, which was followed by a bust.

  • The Buttonwood Tree Agreement was signed in 1792 and is agreed to be the formation of the New York Stock Exchange.

Like today, exchanges are often a way for organizations to raise money. This can be done as a debt or equity offering. Providing access to capital is one of the primary function of exchanges.

Centralized Exchange (CEX)

Most exchanges are centralized. This was true throughout history and remains so today.

An exchange is owned by a centralized entity that adhere to all regulation. In modern times, they are tasked with ensuring trading is in line with the KYC and AML laws that were passed. Brokerage firms, as a requirement for gaining access, has to compile this information on each customer.

The idea of a centralized exchange (CEX) did not become a concept until cryptocurrency came around. This is a class that is not created through the same venues as other assets. Instead, blockchains have this as part of their coding, releasing coins based upon a particular block reward scheme. This can be done through the Proof-of-Work (PoW) mining mechanism, used by Bitcoin, or a Proof-of-Stake (PoS) which like Ethereum.

As coins and tokens were distributed, people wanted to distribute them. This caused the formation of exchanges within the cryptocurrency industry. Many of these were centralized, as compared to decentralized.

Centralized cryptocurrency exchanges mirror most others. The interfaces tend to be user friendly since they are familiar in look. Often, the exchange provides liquidity by acting as a market maker in an effort to ensure buyer and sellers can move in and out of positions. Transaction fees are charged which enables the exchange to generate revenue.

Unlike traditional exchanges which go through brokerage firms and other financial institutions, cryptocurrency is traded with the exchange itself. Firms such as Coinbase and Binance are two large exchanges servicing this market.

Centralized exchanges provide customers with the ability to access the services using fiat currency. This is obvious for traditional assets but a major point for cryptocurrency. These are the on and off ramps between crypto and currencies such as the USD, JPY, or EUR.

Most non-fungible tokens (NFTs) are traded on CEX although it is possible for decentralized exchanges to facilitate the transactions.

Decentralized Exchange (DEX)

Cryptocurrency brought with it the idea of a decentralized exchange (DEX). The idea here is that no company or single entity is behind the exchange. Instead, it is an application, often open source, that people utilize to conduct their trading.

DEX provides trading between cryptocurrencies. There are no other currency or assets involved (at least up to this point). These are peer-to-peer exchanges with no intermediary. This means that all private keys are held by the individual, requiring no custodian. It also provides full ownership rights while removing the counterparty risk that is often present with CEX.

After the fall of FTX, the idea of decentralization is gaining more attention. One of the key tenets of cryptocurrency is not your keys, not your crypto. Many were burned as they put their assets on the exchanges only to find out withdrawals were shut down. This was further enhanced when it filed for bankruptcy, making the depositors creditors in the case.

DEX bring buyers and sellers together through the use of smart contracts. Customers start the process by using a wallet such as Metamask. This allows coins and tokens to be swapped.

There are a few different types of decentralized exchanges. Many are tied to liquidity pools. These are pre-funded pools that provide liquidity. Owners place their assets in the pool, seeking to gain a return via the transaction fees.

Some DEX will use an aggregator to trade using different liquidity pools and even CEX. This is done to reduce the number of failed transactions while also lowering fees. Larger orders can be serviced while eliminating much of the slippage that could come from a single source.

The exchange is a centerpiece to Wall Street and the entire financial world. Likewise, the DEX is the main component for decentralized finance (DeFi). This seeks to remove financial intermediaries from the process such as the banks. Again, this is done to reduce costs as well as counterparty risk.

Exchanges could see a rise in DEX especially within cryptocurrency. Bitcoin was created by Satoshi Nakamoto supposedly in response to the actions of the banks leading up to the Great Financial Crisis. The idea of risk associated with a counterparty was eliminated by the creation of the Bitcoin network. This provided a ledger system where nobody was in control of the money. It is a decentralized monetary system.

As issues arise within the banking system, we could see DEX start to gain favor if people are continually at risk of losing their funds.

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