We’ve written about cryptocurrencies (CCs) before at CityFALCON, and that piece was largely focused on the technological aspects of them and how they can be related to real commerce and trade. In another article, we wrote about Initial Coin Offerings (ICOs), which are fundamentally new cryptocurrencies used for crowdfunding. In this article, we will discuss the mechanics of buying and trading CCs: where, how, and what.

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Obtaining Coins

People may know about CCs, but where can they actually purchase some? One of the most influential platforms is “Ethereum” and its coins are termed “ether”. It may sometimes seem as if all CCs are exactly that: a concoction born out of ether and largely unobtainable. There are, however, platforms where billions of pounds worth of CCs are traded daily. The published data includes a high-level overview of the exchanges and a more precise volume per specific pair.

There are several ways to obtain CCs. The easiest way is to set up a CC wallet (there is plenty of software available for storing and tracking various CCs) and receive an incoming transaction of the CC. This can be done on a peer-to-peer basis, such as between friends or local shops and meetings.

Other available methods are brokers and the aforementioned exchanges. The latter are set up much like a Forex exchange, where currencies, both national and crypto, are paired in a stock-market style order book and trades occur between buyers and sellers without the need to personally know each other. Brokers are people or organizations that exchange CCs for national currencies (NCs) and vice versa.

Exchanges

Some exchanges deal directly with national fiat currencies and allow participants to purchase CCs after depositing USD, GBP, or any other supported currency. Many offer cross-CC pairings, too, so exchange participants can trade Bitcoin for Ether or whatever else the exchange offers.

Exchanges are designed for traders. While they can serve as a means to purchase CCs, their main intention is to trade CCs. Margin trading is usually possible, as well as common order types such as limit and stop orders. Exchanges offer common trading tools like charts for technical analysis, which traders can leverage to profit from price movements between pairs. There are order books that list the most recent transactions and historical information for testing trading strategies. Liquidity can be of concern, but with the larger exchanges transacting tens or hundreds of millions of pounds worth of CCs, it is not any more of a liquidity risk than a regular stock exchange.

Here is a table of a list of exchanges from CryptoCoinCharts. These are as of 11 September 2017 around 13:00 UTC.

Exchange Last Update # Trading Pairs Main Currency (if any) 24 Hour USD Volume 24-hour BTC Volume BTCTrade 2 min, 44 sec 6 CNY $2,920,632,186 699,067 Coinone 1 min, 35 sec 5 KRW $554,697,694 132,77 Bitfinex 2 min, 21 sec 35 USD $502,616,243 120,304 Bithumb 26 sec 8 KRW $468,080,176 112,037 OKCoin 20 sec 5 CNY $227,363,950 54,421 Bittrex 7 min, 27 sec 261 Multi $221,398,912 52,993 Poloniex 42 sec 97 Multi $188,967,587 45,23 Coinbase GDAX 12 sec 9 USD $159,246,299 38,116 Kraken 9 min, 11 sec 56 EUR, USD $152,479,145 36,497 HitBTC 1 min, 12 sec 158 BTC, USD $143,855,416 34,432

There are a few interesting trends to note here. First, the top 5 exchanges by volume have only a few trading pairs and they’re all NC-CC. Furthermore, a quick glance at the heatmap on the provided links shows BTCTrade is completely dominated by the YBC/CNY pairing, while OKCoin is almost entirely BTC/CNY and LTC/CNY. So even with 5+ pairings, only one or two are the most active. Another interesting appearance is the KRW pairings, as KRW is not a global reserve currency (its high positioning is possibly due to exchange consolidation).

Of course, these trends can vary considerably, and even the difference between the time of writing and the time of publication of this article may witness a shakeup in the Top 10. Even further is some sources provide wildly different 24-hour volumes (compare CryptoCurrencyCharts and CoinMarketCap), but the top exchanges tend to be the same and their volumes are in the hundreds of millions of USD.

The biggest exchanges tend to have fees, which can be invested by the exchanges to facilitate trading efficiency or security. No-fee exchanges exist (and there are many), but traders should always perform due diligence before transmitting funds to any exchange. Additionally, the largest exchanges have such high volume that liquidity should be no issue.

Exchanges even offer derivatives, which will be explained more later. However, as stated, exchanges are meant for traders, not really for the casual CC customer who simply wants to use CCs to pay friends or a business that wants to cash out their daily CC income.

Brokers

Brokers are individuals or companies that will sell directly to other individuals or companies.

For online peer-to-peer brokers, there are websites that connect brokers to customers, and these sites often track broker performance or history. This helps to ensure the customer is at less risk of being scammed. LocalBitcoins is such an example, though there are plenty of others (and brokers sell more than only bitcoins). However, as many of these brokers operate without a license, scams can still happen. These services may even connect buyers and sellers locally, such that individuals may transact privately and in cash.

Other brokers are companies that use customer-facing websites to exchange NCs and CCs. Coinbase is one such example with major operations in the United States and the UK. These websites offer direct NC to CC exchanging, though cash is not an option (since there’s no person to meet).

Note on licenses: Depending on jurisdiction, those acting as financial exchangers may need to obtain a license for fully legal operation. CC changers, however, are still very new and many governments have not made their stance clear. In order to avoid losing CCs after placing an order, purchasers should avoid storing large amounts of CCs on escrow-based sites operating without licenses – one where monies are kept in central accounts administered by the intermediary – due to the risk of those accounts being deemed illegal.

Finally, individuals may act as brokers without having an online presence. These are the people who work in shops or attend local meetups and offer their services informally. They may charge a fee or simply skim the bid-ask spread as their fee.

ATMs and Storefronts

In regions with high levels of adoption (or expected future adoption), there may be CC ATMs. These can be used to buy and sell CCs in person, with cash, much like an ATM. They tend to be located in high-density areas, so those living in rural areas may need to travel to find a CC ATM. These are a very convenient for those who wish to transact on-the-go without needing to login to a website while away from a wired connection.

Storefronts are basically brokers who operate out of a permanent location. Often the shop sells other items, like a convenience store, but acts as a CC dealer as well. If one can find them, this avenue to obtain CCs also tends to allow individuals to spend CCs on physical products available for immediate purchase.

This map displays locations for ATMs and storefronts. Users can choose ATM only or look for locations that provide “teller” services (i.e., a CC bank teller or storefront location). Clearly some countries have more interest in adopting CC ATMs than others.

Derivatives: Platforms and Instruments

As mentioned above, there are plenty of ways one can buy and sell CCs for personal use. The main exchanges, though, tend to be focused on trading. Finance tends to innovate, so it was inevitable that exchanges would offer derivatives with CCs serving as the underlying asset.

Margin

Trading on margin in CCs carries the same risk as trading stocks on margin – traders can lose more than their initial deposit. Some exchanges offer upwards of 100x leverage, which is not necessarily out-of-the-ordinary for FX trading. Currencies usually move very little against each, so large amounts of capital are required to make any profit. There is one major difference for CCs and NCs, though: news can more easily influence CC pricing than NC pricing. NCs are controlled by central banks, which attempt to stabilize NCs. CCs are entirely at the will of the market.

Derivatives – futures, options, and swaps

Similarly to other asset classes, CCs have their own derivatives. The most common are futures, options, and swaps. Expiry and non-expiry derivatives are available, and “perpetual swaps” provide the holder a conventional futures contract but with the added benefit of no expiration date. Some unlicensed brokers might offer OTC (over-the-counter) derivatives for individuals, though anyone entering into one of these derivative contracts should remain very wary of the credibility of the counterparty.

Moreover, the Commodity Futures Trading Commission (CFTC), which regulates derivatives trading in the United States, has granted a license to a company to start clearing CC-based derivatives. This has two implications. First, it means CC-based derivatives will become more standardized and transparent, as regulatory agencies tend to require significant transparency. And two, it indicates CCs are mature enough to garner the attention of eras-old institutions. This could signal an explosion of CC-based derivatives appearing on standardized, public exchanges. The announcement was made in July 2017, so look out for more CC derivatives in the near future.

The Other Derivatives and Smart Contracts

There are also many derivative platforms that use CCs as their unit of trade. These are not financial instruments but systems that rely on CCs to make deals between peers. ICO ecosystems are one such platform. A buyer may purchase an ICO coin or token for a specific amount of NC, then the token is useful inside the application. A simple example would be upvotes on a community forum. Perhaps each upvote costs 1 CommForumCoin, and it ICO’d for 1000 coins for $10.

On another note, Ethereum holds massive potential for derivative platforms, because the CC was designed with Smart Contracts in mind. These could be normal, binding legal contracts between two parties that are implemented with the Ethereum developer tools. Smart Contracts are added to the Ethereum blockchain and can be executed automatically (such as a rent contract that triggers a monthly rent payment to the landlord’s wallet). The crypto world tends to use the term Smart Contract in two ways, the coded implementation and an actual legal contract. This might sometimes lead to confusion, but context tends to clarify the issue.

Innovative FinTech solutions

As a FinTech company ourselves (CityFALCON), we are very active in the space and are seeing several interesting start-ups coming out to improve the experience for end users and at a reasonable cost. One of such start-ups is CoinCube. They are an automated crypto asset wealth management platform, allowing users to track and seamlessly invest in a vast array of digital assets at the click of a button. Users can select from pre-built indices or create their own custom portfolio and the web app then allocates and rebalances the users’ portfolio. If you are looking for broad market exposure to the crypto asset class but want to minimize your time commitment and maximize your returns, this may the tool for you.

Risks

Liquidity

One main risk of CC trading is liquidity. Since trade is not centralized or standardized, the large number of exchanges has fractured the market, and while an individual may buy a particular CC on Exchange X easily, it may be difficult to sell it on Exchange Y. Liquidity squeezes are also possible, especially during times of high volatility. In fact, moving coins between Exchange X and Exchange Y may present good arbitrage opportunities. However, some of the largest exchanges see hundreds of millions of pounds of CCs traded daily. If individuals participate in only such active exchanges, liquidity risk falls decidedly.

Further note that liquidity varies greatly by CC. The major CCs, like Bitcoin and Ethereum, will likely boast high volume on the major exchanges, not to mention larger numbers of peer-to-peer possibilities. Smaller CCs and ICO coins may trade very little, and any intermediate-sized injection of an NC would cause market swings. These latter ones are ripe for speculation, but without some form of expected future usage, they are better suited to gambling.

Loss of Keys

As there exists no physical counterpart to CCs as there are with NCs, coins are “trapped” in wallets. The fundamental technology behind CCs is cryptography, which includes encryption. This means that anyone who loses his/her key cannot unlock the associated wallet. Blockchain requires public broadcast of all transactions, and wallet addresses are publicly known. The only way to take coins out of a wallet is by using the key.

There is no central authority such as a bank to help someone unlock an account. For the more privacy-centred wallets, there is not even any linkage to the person or business. But even for wallets that are linked to a real person, there is no institution from which to request identifying information to unlock wallets.

Fraud

While it seems obvious, this is still important to mention. CC transactions are difficult if not impossible to track, and therefore sending money to a less-than-reputable requestor can easily result in losses. CC transactions are public (due to the nature of the blockchain), but that doesn’t mean owners are known. Furthermore, as stated above, there is no central authority to monitor for fraud, so fraudsters can easily jump from victim to victim using the same account.

Moreover, transactions are irreversible by design of the technology. This implies that once a transaction is completed, there are no “chargebacks”. Only merchants and service providers acting in good faith will voluntarily return funds. For any transaction to receive incoming CC, the receiver should wait for confirmation rather than assume the transaction will complete – at least for two strangers transacting.

Regulatory and Seizure Risks

A major concern for those using CCs in markets where CCs may circumvent legal frameworks is exchange risk. Since some exchanges move so much volume, they often employ a ledger to track trades rather than actually executing trades on the blockchain. This means that participants must trust an exchange to accurately and faithfully track trades because blockchain transactions are only recorded when a customer wants to cash out. The exchange’s ledger implies that, if a government were to seize the exchange, there is no way for participants to retrieve their funds. If the transactions are not recorded in the blockchain, they are not in the trader’s personal wallet.

For an analogy, if one’s personal CC wallet is physical cash, exchanges are banks. If the bank’s assets are seized (or stolen – see the hacking risk below), customers cannot get their money back from the bank. In mature financial markets, governments generally protect depositors with insurance, but this is not the case with most CC exchanges. On the other hand, when the transaction is executed on the blockchain, it is akin to withdrawing cash from an ATM. It is now in the owner’s possession and no one can steal or seize it (the blockchain should be distributed around the world, so even if a politically oppressive country shuts down blockchain servers, CC owners still have copies of their wallets in other countries).

One very important recent rumour is one coming out of China. It was whispered that China might crack down on domestic exchanges, and it caused quite a scare. However, any country could seize an exchange and likely have legal grounds to do so, especially if the exchange is operating without a license or determined to be mainly for facilitating crime.

Hacking

Hacking and cybercrime are becoming ever-more prominent. Since escrow exchanges are not built on the same technology as blockchain (they use traditional ledgers to track trades), the distributed, no-trust-required irreversibility of transactions does not apply. If the exchange software suffers from points of weakness, there is no guarantee hackers will not exploit that weakness.

To avoid actual CCs from being transferred to a fraudulent account, many exchanges maintain “cold storage” wallets, where funds are kept. Since such wallets are disconnected from the exchange, even in the event that hackers attack the exchange platform, there is only a fraction of CC funds available (likely for the average daily incoming and outgoing blockchain transactions).

Cold storage might also protect customers against government seizure if the cold storage is located in another jurisdiction and the operators are able to access it after the seizure (though countries looking to outlaw CCs probably are not releasing operators so easily).

Conclusions

There are three ways to obtain CCs: exchanges, brokers, and peers. Brokers and peers often overlap, as they are individuals or organizations that deal in CCs and converting to/from NCs. CC ATMs and storefronts exist in some dedicated markets, though they are not nearly as widespread as traditional banking systems. Exchanges are generally meant for trading, just like FX, and many offer various derivatives and margin.

Liquidity risks are low for the large exchanges and most popular CCs. Seizure risks are also somewhat low, at least in most countries. Fraud and hacking risks, however, are much higher, and anyone interested in obtaining CC from a broker should be wary of the broker’s credibility. Furthermore, anyone interested in participating in a ledger-based exchange should perform due diligence before transferring money.

CCs and blockchain technology will become more influential as time passes, and one day they may even form a major component of global finance. People who adopt it now are helping to advance that end. CCs should not be intimidating, and even those with no interest in FX or technology can participate in the revolution that is Cryptocurrency.

You can track all real-time and personalised news (for you!) of companies and cryptocurrencies mentioned in the article on CityFALCON here.