A betting exchange is a peer-to-peer marketplace where bettors can both back (bet on outcomes to happen) and lay (bet against outcomes, taking the bookmaker's role). Instead of betting against the house, you bet against other users. The exchange matches opposing bets and charges commission on net winnings — typically 2-5%.
The fundamental advantage of exchanges is better odds. Bookmaker odds are reduced by the margin to guarantee their profit. Exchange prices are set by market participants, driven towards fair value by competition. For major markets on Betfair, the commission-adjusted odds often beat bookmaker best odds by a noticeable margin.
Lay betting is the unique capability of exchanges. Laying a selection means acting as the bookmaker — you believe it will NOT win. If the lay is matched by a backer, you pocket their stake if the selection loses, or pay out their winnings if it wins. This opens up trading strategies impossible on traditional bookmakers.
Liquidity is the key variable on exchanges. A market is liquid when there are enough back and lay orders to match bets at the desired odds quickly. Betfair's Premier League football and major horse racing markets are extremely liquid. Niche sports, minor leagues, and futures markets have lower liquidity, meaning large stakes may not be fully matched or may shift the odds.
Example
On Betfair, Chelsea to win is backed at 2.10. A bettor lays Chelsea at 2.10 (offering 2.10 to backers). If a backer places £100 at 2.10, the layer's liability is £110 (£100 × (2.10 - 1) = £110). If Chelsea win, the layer pays £110. If Chelsea draw or lose, the layer collects the £100 back stake minus Betfair's 5% commission = £95.