How Cryptocurrency Markets Function: Exchanges, Prices and Trading

What’s a Cryptocurrency Market?

We assume you already have a basic idea of what cryptocurrency is all about. If you don’t, it’s simply a form of digital currency that exists on the internet and is secured using cryptography. Unlike traditional currencies issued by governments, cryptocurrencies typically operate on decentralised networks, meaning no single bank or authority controls them. A few of the more widely known examples are Bitcoin, Ethereum, and Solana.

A cryptocurrency market, as you might have guessed, is simply the place where these digital currencies are bought, sold, and traded. It functions similarly to traditional financial markets like the New York Stock Exchange. In both systems, buyers and sellers come together to trade assets, and the interaction between supply and demand ultimately determines their prices.

The key difference, however, is that crypto markets are largely decentralised. There's no single exchange that controls the entire market, no central authority approving every transaction, and it operates 24/7.

Crypto Exchanges

When it comes to markets, there must be an actual location or platform where the buying and selling take place. In crypto, that platform is known as a crypto exchange. When someone places an order to buy a cryptocurrency at a certain price, the exchange looks for another user willing to sell at that price. When those two sides match, the trade is executed.

Beyond matching buyers and sellers, exchanges also provide the infrastructure that enables trading. They list coins for sale, maintain records of all available buy and sell offers, and, in many cases, hold users' funds securely.

Broadly speaking, exchanges fall into two main categories: centralised exchanges (CEXs) and decentralised exchanges (DEXs).

• CEXs: CEXs are run by organisations that act as middlemen between buyers and sellers. Popular examples include Binance, Coinbase, and Kraken.
• DEXs: In a decentralised exchange, there’s no middleman holding your funds, and no central point of control. Instead, they operate through smart contracts that allow buyers and sellers to trade directly with each other. Examples include Uniswap, PancakeSwap and dYdX.

Now, while centralised and decentralised exchanges differ in structure and approach, they both function on the same core mechanics. In the following sections, we shall break down exactly how they function, feature by feature.

Trading Pairs

Every trade on a crypto exchange involves swapping two assets. The first asset in the pair is the base currency, while the second is the quote currency. Using BTC/USDT as an example: BTC is the base currency being bought or sold, and USDT is the quote currency being used to price or pay for it.

Trading pairs generally fall into a few common categories. They include:

Stablecoin Pairs

A stablecoin is a type of cryptocurrency designed to maintain a stable value, usually pegged to the US dollar. USDT (Tether) and USDC (USD Coin) are the most popular examples. Examples of stablecoin pairs would then include:

• BTC/USDT
• ETH/USDT
• SOL/USDC

Because stablecoins hold a steady value, they're usually the preferred choice for most traders. It also makes it easy for them to track gains or losses in familiar terms.

BTC Pairs

Historically, Bitcoin served as the primary quote currency across most crypto exchanges because there weren't many stablecoins available, and Bitcoin was the most widely held asset. So while stablecoin pairs have largely taken over in terms of popularity, BTC pairs are still widely used, particularly by traders who are already holding Bitcoin.

Some examples of this pair include:

• ETH/BTC
• ADA/BTC
• SOL/BTC

The idea is, in a crypto market, you’re never just buying or selling a cryptocurrency on its own. Instead, you’re exchanging one asset for another. A trading pair simply shows which two assets are being traded against each other. For example, in a pair like BTC/USDT, it means Bitcoin is being traded against USDT. In this case, you would use USDT to buy Bitcoin, or sell Bitcoin to receive USDT.

Order Books

Once a trading pair is selected, the next thing users typically see on an exchange interface is the order book. An order book is essentially a real-time list of all the buy and sell orders for a particular trading pair. It shows what prices buyers are willing to pay and what prices sellers are willing to accept at any given moment.

The order book is usually divided into two main sides: buy orders and sell orders.

• Buy Orders: Also known as bids, buy orders show the price a buyer is willing to pay and the amount of the asset they want to buy.
• Sell Orders: Sell orders or asks show the price sellers are asking for and how much of the asset they are offering.

The exchange constantly updates this list as new orders come in. When a buy order and a sell order meet at the same price, the exchange matches them, and the trade is executed.

Because the order book records every active order, it also gives traders a snapshot of market demand and supply. If there are many buyers placing bids at certain price levels, it signals strong demand. If there are many sellers offering large amounts of an asset, it may indicate a strong supply.

Order Types

There are also different types of orders. Each one is practically telling the exchange how a trader wants their trade to be executed. Most commonly, there are market orders and limit orders.

• Market Orders: A market order tells the exchange to execute the trade immediately at the best available price in the market. For example, if you decide to buy Bitcoin using a market order, the exchange will instantly match your order with the lowest available sell orders in the order book.
• Limit Orders: Limit orders allow you to set a specific price at which you want to buy or sell an asset. For instance, if Bitcoin is trading at $60,000 but you only want to buy it at $58,000, you can place a limit order at $58,000. That order will then sit in the order book until the market reaches your specified price.

Liquidity

Now that we understand how orders are placed into the system, the next important concept to understand is liquidity. In simple terms, liquidity refers to how easily an asset can be bought or sold without significantly affecting its price. A market is considered liquid when there are plenty of buyers and sellers actively placing orders. In such markets, trades can be executed quickly and smoothly.

Popular cryptocurrencies like Bitcoin and Ethereum typically have very high liquidity because thousands of traders constantly buy and sell them across multiple exchanges. As a result, it's relatively easy to enter or exit a position without causing major price movements.

On the other hand, smaller or lesser-known cryptocurrencies may have lower liquidity. In these markets, there may be fewer buyers and sellers available at any given moment. This means it can sometimes take longer to execute trades, and large orders may move the price more noticeably.

Liquidity also directly affects the spread. The spread is the difference between the highest price a buyer is willing to pay (the highest bid) and the lowest price a seller is willing to accept (the lowest ask). In highly liquid markets, this gap is usually very small because many traders are competing to buy and sell at similar prices. In less liquid markets, the spread can be much wider.

Price Discovery: How the Price of a Cryptocurrency is Determined

One thing we’ve established in this article is that the price of cryptocurrencies is constantly changing. But then, how exactly is the price of a cryptocurrency determined? Or simply put, what is price discovery?

In simple terms, price discovery is the mechanism through which the market continuously figures out what a cryptocurrency is worth at any given moment. And like most markets, it ultimately comes down to one basic principle: supply and demand.

As you might have guessed, supply represents the amount of a cryptocurrency that sellers are willing to offer, while demand represents the amount buyers are willing to purchase. When more people want to buy a cryptocurrency than sell it, demand exceeds supply, and the price tends to move upward. On the other hand, when more people want to sell than buy, supply exceeds demand, and the price usually moves downward. This constant tug-of-war between buyers and sellers is what drives price movement in the crypto market.

Now, in the cryptocurrency market, prices are not updated at fixed intervals. Instead, the price changes every time a trade occurs. This is why crypto prices can change so rapidly.

Volatility in Crypto Markets

You've probably heard people say that crypto is extremely volatile. Some people even cite volatility as the very reason they've chosen not to trade or invest in crypto at all. But then, what exactly is volatility?

In simple terms, volatility refers to how much and how quickly the price of an asset moves over a given period of time. All financial markets experience some degree of volatility, but cryptocurrency markets are widely regarded as some of the most volatile in the world.

Several factors contribute to this, including:

Market Sentiment

In simple terms, this refers to how traders and investors collectively feel about the market at a given time. If the sentiment is positive, meaning traders are optimistic about the future of a particular cryptocurrency, buying activity tends to increase. This can push prices upward. On the other hand, if sentiment turns negative, perhaps due to uncertainty or fear, many traders may rush to sell their holdings, which can quickly drive prices down.

News and External Events

Crypto markets are highly sensitive to news. Positive developments, such as a major company announcing it will accept Bitcoin as payment, or a country adopting crypto-friendly regulations, can trigger sharp price increases almost instantly. On the flip side, negative news like a government announcing a crackdown on crypto, or a major exchange getting hacked, can send prices tumbling just as quickly.

Regulation

Cryptocurrency is still a relatively young and evolving space, and the regulation around it remains uncertain in many parts of the world. When governments or regulatory bodies make announcements about how they intend to treat crypto, whether they are introducing new restrictions, banning certain activities, or conversely, providing clearer legal frameworks, the market tends to react strongly.

Liquidity Levels

Liquidity also plays an important role in volatility. As mentioned earlier, in highly liquid markets, there are many buyers and sellers placing orders at various price levels, which tends to stabilise prices.

However, in markets with lower liquidity, even moderately large buy or sell orders can push prices up or down more significantly. This is why smaller cryptocurrencies often experience more dramatic price swings compared to larger assets like Bitcoin.

Speculation and Trading Activity

How the majority of traders are trading at a given moment also affects volatility. For example, when traders collectively rush to buy during a rally or sell during a downturn, price movements can accelerate quickly.

Basic Risk Concepts Every Crypto Person Should Know

At this point, you have a solid understanding of how cryptocurrency markets work. And if you paid attention, you’d have seen the level of risk associated with it.

For example, since the crypto market is highly volatile, it can create opportunities for profit, but it can also result in significant losses. An asset you buy today could be worth considerably less tomorrow, simply because market sentiment shifted or a piece of news triggered a wave of selling.

Now, apart from volatility, there are also other types of risks involved. These include:

Liquidity Risk

Liquidity risk is the risk that you won't be able to buy or sell an asset as quickly or as smoothly as you'd like. As we covered earlier, not all cryptocurrencies have the same level of trading activity. Lesser-known cryptocurrencies, especially, may have far fewer buyers and sellers at any given moment.

So, if you're holding such low-liquidity assets and you need to sell quickly, particularly during a market downturn when everyone else may be trying to do the same, you might struggle to find a buyer at a reasonable price, or at all. The lower the liquidity of an asset, the higher this risk becomes.

Slippage

Slippage occurs when a trade is executed at a slightly different price than expected. This can happen because the market is moving quickly or because there aren’t enough orders available at a specific price level in the order book.

What to Remember About the Crypto Market

The crypto market, as we’ve gone through it, is not nearly as complicated as it might seem at first glance. You access the market through a crypto exchange, choose a trading pair that shows which two assets you want to swap, and then place an order to buy or sell. Of course, there are a lot of nuances between, but then the foundation, as you've now seen, is simpler than most people think.

One thing you should keep in mind, however, is that the market has risks, so you have to approach it with your eyes open. But then the biggest risk is approaching the market without properly understanding it. And we believe that to a large extent, this article has helped remove that risk.