Price discovery explained
Price discovery is a key concept for transacting any asset. Said plainly, price discovery in a free market occurs when a buyer and seller come together to agree upon a transaction price of an asset. Given a nascent market like DeFi – coins, lending rates, governance tokens, NFT’s – price discovery is an essential function to help create an orderly and liquid market.
Since DeFi is “trust minimized”, much price discovery happens algorithmically. With AMM mechanisms in place within liquidity pools, price discovery is determined by the specific DEXs algorithmic instructions to execute transactions at a certain level within the pool. The mechanism drives pricing with the goal of keeping the pool’s trading pair in balance. For example, in a ETH/BTC pool, when traders are buying ETH, the pricing algorithm takes into account how much ETH is being purchased and raises the price of ETH, while lowering the price of BTC. This automated response keeps the trading pair ratio in balance.