How Crypto Exchanges Work: Orders, Spreads and Custody Risk

Centralized and decentralized exchanges

A centralized exchange (CEX) is a company that runs a trading platform. You open an account, usually verify your identity, deposit money or crypto, and trade inside the company's system. The exchange holds the assets for you and records who owns what in its own database.

A decentralized exchange (DEX) is a set of smart contracts, which are programs that run on a blockchain. You connect your own wallet and trade directly from it, without handing your coins to a company. Many DEXs use liquidity pools instead of a traditional order book: users deposit pairs of tokens into a pool, and a formula sets the price based on how much of each token the pool holds.

Each model has trade-offs. Centralized exchanges are easier for beginners and connect to bank accounts and cards, but you depend on the company. Decentralized exchanges let you keep control, but you are fully responsible for your wallet, and there is usually no one to call if something goes wrong.

How an order book matches buyers and sellers

Most centralized exchanges use an order book: a live list of offers to buy, called bids, and offers to sell, called asks, at different prices. When a buyer and a seller agree on a price, the exchange's matching engine pairs their orders and the trade happens.

The gap between the highest bid and the lowest ask is the spread. On busy trading pairs the spread is usually small. On less popular coins it can be wide, which means you start slightly behind the moment you buy, because selling straight away would get you a lower price.

Market orders, limit orders and slippage

• Market order: buy or sell right away at the best price currently available. It is fast, but you do not control the exact price.
• Limit order: buy or sell only at a price you choose, or better. If the market never reaches your price, the order waits or expires.
• Slippage: the difference between the price you expected and the price you actually got. It happens when a market order is bigger than the offers at the best price, so part of it fills at worse prices further along the order book.

A hypothetical example: you place a market order to buy $1,000 of a small coin, but only $400 worth is offered at the lowest ask. The rest fills at higher prices, so your average price ends up above what the screen showed. On a decentralized exchange the same thing happens when a large trade shifts the pool's price, which is why DEX apps let you set a maximum slippage tolerance. Limit orders and smaller trade sizes help keep slippage under control.

Custody risk: who really holds your coins

When your crypto sits on a centralized exchange, the company holds the private keys, the secret codes that control the coins. Your balance is a claim on the exchange, not coins in a wallet you control. If the exchange is hacked, freezes withdrawals or goes bankrupt, you may wait years to get funds back, or lose them. Several large exchanges have failed this way in crypto's short history.

This is why many people buy on an exchange and then move long-term holdings to a wallet they control. Self-custody has its own risks, mainly losing your recovery phrase, so it only makes sense once you understand how to back up a wallet safely.

How to judge whether an exchange is reputable

• Licensing and registration. Check whether the exchange is licensed or registered with the financial regulator where you live. Many regulators publish searchable registers on their official websites. Rules differ by country.
• Proof of reserves. Some exchanges publish cryptographic evidence that they hold customer assets. It is a useful signal, but it is a snapshot in time and does not always show what the exchange owes.
• Security features. Look for two-factor authentication, withdrawal address allowlists, and clear information about how customer funds are stored and kept separate from company money.
• Track record and transparency. Consider how long it has operated, who runs it, how it handled past incidents, and whether fees and terms are clearly published.
• Withdrawals that work. Test with a small withdrawal early on. A platform that makes it hard to take your money out is a serious warning.

Red flags to walk away from

Be cautious of platforms that promise fixed high returns, push you to deposit quickly, or can only be reached through messaging apps. Other warning signs include no clear company name or address, a warning about the platform on a regulator's website, extra fees or so-called taxes demanded before you can withdraw, and support agents who contact you first. A real exchange will never ask for your password, your two-factor codes or your recovery phrase.