Introduction to Price Discovery in DeFi

The Value in Gathering a Crowd

Trading venues first and foremost represent a gathering of people. For example, Amsterdam’s “First Regular Trading Market,” a gathering that started on a street named Warmmoesstraat in the fifteenth century, led to the first stock exchange - The Amsterdam Stock Exchange. In the late eighteenth century, a gathering under a Buttonwood tree in New York led to the most iconic contemporary stock exchange, The New York Stock Exchange. 

The objective of the gatherings was clear: to trade, while the people represented an ensemble of information, perspectives, and requirements that created the driving force for trade—the price. DeFi’s strength is in its ability to naturally generate a price discovery process within a versatile market structure created by its network of communities.

Determining a price, better known as price discovery, is key to a well-functioning and efficient market. Price is a clearing mechanism and an allocator of resources. When performing well, price discovery drives growth and jobs while creating a feedback mechanism that tells us how well we are doing—so given a gathering, a trading venue, what makes for good price discovery?

A Wave of Potential Looking for a Price

Financial theory tells us that the answer is in information and rational actors. The idea is that a complete set of information distilled through rational actors will produce the ideal feedback mechanism in price. However, once you consider the actors don’t always behave rationally, and information is never complete, it is easy to see how discovering price is quite the journey. Yet, the idea is simple enough; the more people that contribute, the more information there is, the better the price discovery process. But, unfortunately, that is not entirely true. Data and information are like a tidal wave. It can be destructive if you don’t have the market structure and trading venues to manage it, and it is here where DeFi outperforms TradFi.  

Imagine hundreds if not thousands of companies starting up every day with the ambition to list their shares within six months. Firstly, that is unheard of, and secondly, the exchanges would never manage, and the market structure simply does not exist for such a colossal undertaking. But that is what is happening with new projects and their tokens in DeFi.

TradFi lists assets based on a history of performance and backing - a way of ensuring a product-market fit, a robust customer base, and that the company has matured into a price discovery phase. DeFi is different because it is accessible and transparent. Each project comes with its own community, its own gathering, its own ensemble of information, its built-in price discovery. 

Further, DeFi is a network of communities contributing to each other’s development - the caveat is that a readily made public price with liquidity in DeFi does not imply maturity, which explains all volatility we see while the industry is growing.

When DeFi Meets TradFi

DeFi has given rise to innovative assets, emergent market structures, new financing mechanisms, governance, and trading venues, creating composability with transactions that settle almost instantly. In essence, it creates massive value along with enormous risk reduction, especially for assets that would previously be illiquid or simply not considered.

DeFi is an extension of TradFi, which means we still all live in a society with rules, so regulation is paramount; if an asset is a security or derivative, the trading venue that hosts it will need to follow the laws. The added value comes from the DeFi tools and blockchain technology applied to these assets and exchanges. 

For example:

  1. An on-chain registered security token issuance from a regulated platform.
  2. That platform would integrate with DeFi, and the distribution would be an initial decentralized offering (IDO).
  3. The IDO would issue securities from a permissioned AMM liquidity pool to set the starting price.
  4. If the liquidity pool is on a permissionless public blockchain, the security owners would have access to the rest of DeFi.
  5. The issuing company could use DeFi tools such as staking to entice shareholder engagement or incentives for customers to use their products or services.
  6. The security holders could access DeFi ranging from lending protocols to other regulated trading venues that may offer different features (yield) or incentives (rewards for trading).

As a result, the offering would be a lot more transparent, directly accessible to all eligible parties, and significantly more versatile in terms of utility for the holder in the DeFi space.

Blockchain is an incredible coordination tool, and DeFi uses it to create communities that drive value in and throughout the space. Just as it was centuries ago in Amsterdam, people are naturally congregating, now virtually in DeFi, to provide a wave of data, information, and value through new on-chain price discovery.

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