For the Bitvo Exchange | By Tristram Waye | Jan 11, 2021

Crypto gives users some significant advantages.  The asset doesn't come from a government or a human being.  You get a payment rail, anonymous transfer, and a distributed peer to peer network.

And the network is secured by math.  But how do you accurately price an asset where every user is distributed and international? How do you know the price you pay is the right one?

Price discovery is a fundamental part of every secondary market on the planet. It helps to give an accurate value of any asset based on all known market information.

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Every Bitcoin holder and trader relies on price discovery for buying and selling decisions. They depend on it for measuring their performance, determining taxes, and for accurate payments. And through their trading activities, traders are also part of the process.

Price discovery helps shape the entire altcoin and token market where ETH and BTC are used for purchases, funding, lending and staking.

The elements of pricing come from an interplay of crypto financial products. One of these products is crypto derivatives.

Price signals from options and futures

The Bitcoin or Ether price you see on any crypto exchange represents the price for worldwide trading. It also represents an interplay between derivatives like futures, options, and stablecoin arbitrage flows.

Sophisticated traders use futures and options to add exposure to cryptocurrencies and other assets. They also use them to hedge exposure. Activity at different strike prices and contract dates send pricing signals across the market.

The pricing in these products reflects in part the interplay of hedgers and speculators.

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Today you will hear how options volume is bullish or bearish for BTC based on the put/call ratio. The press uses futures activity to extrapolate expectations about BTC's next big move.

These reports influence readers trading the spot or cash markets on exchanges.

Stablecoins arbitrage out BTC price differences

Stablecoins have played an important role in the price discovery in crypto as well. In the ICO boom period through 2017, trading provided large price disparities across international markets. Dan Matuszewski described how traders used Tether to quickly arbitrage from the US to China. In 2017, the market was still young and unsophisticated.

By using stablecoins in this manner, price disparities in BTC were reduced around the globe.

Today, stablecoins are among the fastest-growing crypto products, with USDC doubling its volume in August 2020 alone. Stablecoins provide faster access around the cryptosphere, making arbitrage more efficient. This reduces price differences in the leading cryptocurrencies around the world.

On Ethereum, the platform is increasingly shaped by the various smart contract-based protocols. The explosion of stablecoins has increased traffic and fees on the platform. And the rapid expansion of DeFi and yield farming has also added significant demand shaping pricing.

6,000 projects provide demand for ETH and BTC

The explosion of DeFi is also part of the pricing environment. Over 6,000 token and altcoin projects typically trade pairs using BTC or ETH. This creates a demand-pull for ETH and BTC from centralized exchanges to DeFi.

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In DeFi, ETH and BTC are used to buy altcoins that are staked and lent to earn yields from automated market makers. Now there's several billion roaming around this space. All this staking and lending makes DeFi a growing part of the crypto price discovery mechanism.

DeFi provides a contrast to the more mature price discovery in Bitcoin. Various projects in the DeFi space like the infamous Yam goes to $150 one day and zero the next. Or the notorious SushiSwap saga where the integrity of the anonymous founder shaped pricing.

The influence of BTC fund flows

Funds are another source of price signaling. Fund flows indicate the expectation of some participants in the space. Greyscale's fund family is an example of a fund providing price signaling.

Demand for these funds, or movement out of them, can influence the demand and supply of the coins they trade.

Other funds, like hedge funds, help to add another pricing dimension. There are the originals like Galaxy Digital, Pantera, and Travis Kling's Ikigai. These are joined by many other investment and trading funds contributing to crypto price discovery.

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Crypto miners are the original contributors to the price discovery process. Mining rewards and the minting of new coins provide a constant but dwindling supply.

A change in the mining rewards like the 2020 halvening helps to shape activity around the protocol. But it is the ongoing securing of the network without human intervention that adds confidence in the system.

Confidence is an important factor in price discovery.

The growing dynamism of crypto price discovery

Prices aren't simply supply and demand based. They are dynamic feedback loops involving an array of financial products and signals.

Traditional markets have numerous elements that contribute to price transparency. These include interest rates, government debt, risk-free rates, equities, derivatives, and swaps. Cryptocurrency is quickly developing a similar structure.

Every new crypto product and service becomes part of the growing nervous system for pricing.

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Accurate real-time pricing internationally gives clear signals of the value of crypto assets.

Pricing helps with risk transfer from users to speculators. It helps with insurance pricing and a more accurate determination of yields. This, in turn, helps people make better, more accurate purchasing decisions.

A mature pricing mechanism brings crypto that much closer to becoming mainstream finance.

This article appears as a featured article in NCFA's digital magazine, Fintech Confidential (Issue 3 Dec 2020). Click to read the latest thought leadership, insights and trends about Fintech in Canada:

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