Price Discovery

Understand DeFi Supply & Demand

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.

What to Know

Before an AMM can work its price discovery magic, it is necessary to aggregate liquidity of a trading pair. Platforms like Uniswap were early pioneers of the liquidity pool concept. In a traditional market, buyers and sellers list prices at which they are willing to transact. Typically a 3rd party exchange would match buyers and sellers. When trusted exchanges and market administrators are removed, liquidity pools serve an essential function of providing a trading venue in which traders can understand and react to coin price information. 

AMM’s within a liquidity pool are a set of instructions that aim to provide an accurate value of the token pair in a particular liquidity pool. The AMM acts as a disseminator of information regarding the price at which transactions should clear within the liquidity pool. If token prices overreact to high demand, arbitrage opportunities present themselves and traders can buy cheap coins on one exchange and sell them higher on another. 

Why it Matters

Due to the trusted nature of traditional capital markets, price discovery is a fairly mundane concept. The trustless nature of DeFi introduced an entirely new set of challenges, as basic market making functions became problems that needed to be solved. The ingenuity of aggregating liquidity – transaction fee revenue sharing, governance token yield farming – allows for DeFi trading venues to support orderly and relatively liquid markets for token pairs and other crypto assets. Like any market, the ease of trading in and out of coins (liquidity) is an essential precursor to establishing a desirable trading venue. As the old adage goes: Liquidity begets liquidity. New mechanisms for price discovery will continue to crop up as smart contract capabilities grow alongside inventive DeFi protocol developers. 

Video by: Bankless

keyTango Analytics

Soon you’ll be able to evaluate prices across different AMM’s like Curve and invest right on keyTango

Go To Curve

Michael Egorov, Founder of Curve
Image by:

What is Curve?

“An exchange expressly designed for stablecoins and bitcoin tokens on Ethereum. The key aspect of Curve is its market-making algorithm, which can provide 100-1000 times higher market depth…”