An exchange, like the Luno Exchange, is simply a platform that connects potential buyers with potential sellers. It allows them to exchange things like products, stocks, currencies and in our case: Bitcoin.
Please note Luno doesn't buy or sell Bitcoin, neither do we set the rate of exchange, we're simply the platform to connect buyers and sellers.
Sellers & ask orders
On the one side of the exchange, you have a seller. The seller has Bitcoin and is interested in selling it for local currency.
The seller goes to the Luno Exchange and makes a Bitcoin deposit.
They have 1 BTC they are interested in selling.
They then create an order to sell Bitcoin (called an ask): “I want to get 7000 ZAR for my 1 BTC”.
This is called market making, since they are making an order and adding liquidity to the exchange (in the form of the Bitcoin which hasn't been traded).
Buyers & bid orders
On the other side of the exchange, you have a potential buyer.
The buyer goes to the exchange, makes a local currency deposit, the money to be used to buy Bitcoin.
The buyer can do one of two things: they can close an existing order (pay the 7000 ZAR for 1 BTC), or they can create a new order (called a bid) by saying, for instance: “I only want to pay 5000 ZAR to buy 1 BTC”
For this example, let's say our buyer goes for the second option: creating a bid order.
This is also seen as market making, since they are adding liquidity to the exchange in the form of the local currency, not yet traded.
So now, we have two orders on the exchange. On the one side someone is saying that they will only sell their 1 BTC for 7000 ZAR and on the other side someone is saying that they will only buy 1 BTC for 5000 ZAR.
In this simple scenario the market hasn’t met, since the buyer and seller don’t agree on the price. The buyer wants to pay too little (in the seller’s view) and the seller is asking too much for his bitcoin (according to the buyer).
More supply & demand
As long as there are supply and demand for the items being bought and sold (bitcoin and local currency) more buyers and sellers will go to market and create their own orders, at prices higher or lower than the previous orders.
Eventually, the point will come where the market meets, where there is a buyer and a seller that agrees on a price.
So, let’s say we have another seller with 1 BTC and they say: “I have 1 BTC I want to get 6000 ZAR for it”.
And along comes a buyer that says: “I want 1 BTC and I will pay 6000 ZAR for it!”
In this scenario, the buyer will get what he wants (1 BTC), the seller will get what she wants (6000 ZAR) and that specific order is closed. The market has met.
The previous orders will still be open until a buyer, willing to spend 7000 ZAR and a seller, willing to accept 5000 ZAR for those trades, comes along.
One thing to note is that in order to provide these exchange services, platform integration, customer support, security and make sure that the people trading on the exchange are credible, the platform (in this case Luno) will charge a small fee.