Any exchange, whether trading crypto, commodities or stocks, is designed to match the demand from traders wanting to buy an asset at a specific price with someone willing to sell at that price, and to automate the process within a user-friendly interface such as a website or App.
The traditional model for doing this is known as a Centralised Exchange, or CEX. It is described as centralised because there is a single point of control for the service – from both a technology and management perspective – with which the user has to establish trust by supplying KYC.
The technology within a CEX establishes the price for tradable asset pairs such as EUR/BTC through what is known as an order book.
The order book is essentially a list of offers from customers to buy or sell a specific amount of Bitcoin at a specific price in Euros. Order books automate price discovery through the wisdom of the crowd.
The exchange doesn’t decide the price, it simply provides the means for the market to arrive at the price based on the relative demand from buyers and sellers.
In order for an automated order book to provide an accurate price, it needs sufficient liquidity – the volume of buy/sell order requests. If liquidity is weak then there will be big gaps in the price that users are prepared to buy and sell at. This is known as price inefficiency or Slippage – where the price that a trade is placed at differs from the executed price because there is insufficient liquidity to cover the whole order.
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