How Exchanges Make Money

To understand an exchange, you have to know how they make their money. Is it fees, lending you money, reinvesting your deposit, or selling your private information? This guides their behavior.

Remember that most exchanges are reasonably safe, or they couldn't stay in business. Understanding their income streams helps you to compare them.

When an exchange makes money on fees, they are motivated to add new ones and raise prices. No one likes fees, but they are usually honest and relatively safe. Watch for hidden charges.

If their income is dependent on reinvesting customer deposits, they may not have your deposit when you want it. This is the same risky "fractional reserve" system that banks use, but without the government insurance or bailouts. Just like with banks, it is very rare for exchanges to have trouble with withdrawals.

Some exchanges don't back their trades with actual bitcoin, dollars, etc. They just offer a bet on the price, where the price is controlled by them. By itself, this isn't much risk to your capital, but it is a big risk to your profits.

Making money by lending you money greatly increases your financial risk. You are usually subject to margin calls. This means you can lose more than your investment. They can come after any assets you pledge as collateral. You can end up losing everthing you have, and deep in debt. Dishonest and desperate exchanges have been known to force customers into margin calls. Lending money is profitable for the lender, but risky for you. This is why brokerages and exchanges use so many euphemisms for loans, like "margin", "leverage", and "gearing".

In a surveillance society we are all accustomed to "free" services, paid for with our private information. This is a bad trade. It is almost never in your favor. When money is involved, privacy is priceless.

Be careful if an exchange opposes arbitrage. Honest exchanges do not lose money from arb. You are buying and selling at their posted price. You should ask yourself why they object. Do they want captive investors? Of course, they may not know you are doing arb if you don't tell them.

All of these business models are common in finance. Banks, brokers, and stock exchanges use the same strategies to make money as cryptocurrency exchanges. With cross-exchange arbitrage, you get faster profits with less price risk.

Learn more about risks.