If you're investing in crypto, one of the most important things you need to understand is how crypto exchanges actually work and how they make their money. The basics apply across the board: Binance, Coinbase, Bybit, OKX, and most of the other most popular exchanges run very similar business models. There are differences among them, of course, but they all have one thing in common. They make an enormous amount of money off of people trading cryptocurrencies.
So how do they do it? When I want to sell my crypto, I generally take my crypto and send it to an exchange. Coinbase is the one I use. Binance is the biggest in the world right now, according to CoinMarketCap. What crypto investors do is take their crypto and send it to these exchanges. In every case I'm aware of, these exchanges are completely centralized. That means when you send them your crypto, they are now holding your crypto. They control their website, and they control the crypto address you sent to. Then, when I want to buy something like Internet Computer Protocol, I connect my bank account to the exchange, send them US dollars out of my bank, and they provide an interface, a website, that lets me trade my crypto and my money back and forth.
How exchanges make money
They make money on fees. That part is transparent and obvious. But many of these exchanges have no transparency at all about what is actually happening with the crypto they're holding, how much of it they're selling versus how much of it they actually have. Binance, for example, has been fined billions of dollars for breaking the law, and CZ, the founder of the exchange, has spent time in prison. These exchanges have a powerful interest in getting people to trade as much crypto as they possibly can.
Consider this: CoinMarketCap, that website everyone uses to check prices, is owned by Binance. You need to understand how powerful and influential these exchanges really are. They pay all kinds of people across the crypto space, and the bottom line is always the same. They want you to sign up for their exchange and trade crypto on it. Because they're not only making money when you swap cryptos, they also have your crypto. When you deposit crypto, and then when you buy crypto, you don't actually know whether you hold any real crypto at all until you withdraw it. That's exactly why I believe it's absolutely essential to get your crypto off of exchanges.
The paper Bitcoin problem
What we've seen exchanges like FTX do in the past shows the danger. Let's say people collectively deposit 100 Bitcoin onto an exchange. If everybody were being honest, and everyone who deposited that Bitcoin put in a sell order, there would be 100 Bitcoin worth of sell orders. But because these exchanges control the website, and because when you interact with an exchange website you are not, in most cases, interacting with the actual blockchain, you are going completely into a third party. And these third parties generally have no transparency about how much crypto they're actually holding versus how much crypto is actually for sale.
So an exchange like FTX could have people deposit, let's say, 100 Bitcoin, and then there would be hundreds of Bitcoin for sale on FTX. In some cases, maybe even thousands of Bitcoin sell orders, with Bitcoin being sold and investors who bought it believing they hold Bitcoin in their FTX account. Do you see the enormous problem with this? To me, these crypto exchanges are the single biggest problem we have in crypto. If you're bullish on any crypto, these exchanges, when they don't have absolute transparency, and almost none of them do, can essentially create what you'd call paper Bitcoin. This has been done in gold and silver forever. It's Bitcoin that exists on their exchange interface but that does not exist on the real blockchain.
Here's how it works in practice. Let's say I put one Bitcoin on and I sell my one Bitcoin. You buy my one Bitcoin and you let it sit on the exchange. What many of these exchanges know they can get away with is putting in a second sell order for one Bitcoin using the same Bitcoin I deposited. Then another buyer comes in and buys that one Bitcoin. Now there are two people on the exchange who each think they own one Bitcoin. I put one Bitcoin on, I'm out, I get my money in the bank, and from my point of view everything is fine. But now there are two people sitting on that exchange looking at their accounts, and both accounts say they hold Bitcoin at whatever the market price is.
Then one of them withdraws the Bitcoin. They get the real Bitcoin in their wallet, and everything's fine for them. Now there's one sucker stuck with paper Bitcoin sitting in their account. They think they have a Bitcoin. The only way they ever realize they don't is when they go to withdraw it. And in this case, that person can even sell the paper Bitcoin, get real money, and put that back in their bank account. The problem just gets passed along.
Where this really goes wrong is when exchanges do this way too much. In my opinion, I would guess that most crypto exchanges, most of them, not all, but most, either are engaging in this behavior right now or have engaged in it in the past, because it's such an insane amount of money that they can effectively print.
What happens when they get caught short
So what do they do when they get caught short? Go back to my example. I put my Bitcoin on, I sell it, and I get my cash in the bank. Two of you buy my Bitcoin, both thinking you each own one. Person one withdraws and gets their Bitcoin. Person two goes to withdraw, and the exchange says your withdrawals are temporarily suspended. In some cases, they genuinely do need to move funds from cold storage to hot storage. But in other cases, the exchange literally does not have any Bitcoin. Now they have to wait until somebody else deposits Bitcoin. Let's say my wife comes along and deposits a Bitcoin. They resume withdrawals and let you withdraw her Bitcoin. Then she goes to sell, and now some other sucker gets stuck buying paper Bitcoin. The cycle continues.
I have no proof of this. But given that an exchange like Binance has been fined billions of dollars and CZ has been in prison, it would probably be a safe guess to assume Binance has been doing a lot of that kind of thing behind the scenes. I have no proof of which exchanges are doing exactly what. But we do have proof that crypto exchanges have consistently engaged in this behavior.
Then, when everybody goes to withdraw at once and the prices crash, or the prices pump, the whole thing comes apart. This strategy of selling paper Bitcoin, or any other crypto, works really well if you can crash the price. And this appears to be happening a lot with the ICP price. If you want to suppress something, consider that Binance, for example, has Binance Smart Chain. They stand to lose a great deal by having ICP get adopted and have its own decentralized exchanges, because then you don't need Binance anymore. It seems like Binance is always suspending ICP withdrawals. What I'd really like to know is how much ICP people think they have on Binance versus how much ICP Binance actually has on the blockchain. I wouldn't be surprised if people believe they hold three to five times as much ICP on Binance as Binance actually has on the blockchain.
Why you can't fully verify any of this
Until we get absolute accountability from these exchanges about exactly how much they hold, this risk remains. And this is the core problem with Web 2: you can't even have a generally trustworthy way to verify any of this. Even if an auditor comes in, the company can cheat the auditor and show them fraudulent information. It's very easy to fake all of this. That's why, in my experience, it's absolutely essential to never, under any circumstances, let your crypto sit on an exchange. If you deposit US dollars, you should immediately buy crypto and get off the exchange onto the actual blockchain. And if you want to sell and you've got it on the blockchain, sell immediately, get the money into your bank account, and generally start with smaller transactions to make sure everything works.
These exchanges then pay influencers to promote them. They pay to push certain coins. It looks like many of these exchanges even push fake volume. Coins pay them huge listing fees to get listed. And then it looks like these exchanges generate fake volume by placing buy and sell orders against each other, because that way an exchange can push essentially unlimited volume for free. They can just pretend a whole bunch of people have sold. If you want to go deeper on how I think about all of this, I share more in my Money playlist. This is what I believe you should know about how crypto exchanges work and make their money.