Explainer: What Is True Price Discovery?
By AAX on Altcoin Academy
What is the price of Bitcoin? As you know, the answer to this question is always changing.
It’s even different across exchanges and the reason for this is that exchanges are not connected to one another, meaning that price discovery is only determined by the buy and sell activity that occurs on the exchange itself.
What is Price Discovery?
Price discovery is the ongoing process of coming to the spot price of an asset or currency. In essence, the price is the point where supply and demand meet. It is about matching buyers and sellers.
Tip: If you want to have a sense of where the price of Bitcoin, or another currency, might be going. It’s good to take support and resistance levels into account.
What Determines Price Discovery?
Price discovery is primarily about supply and demand: if demand exceeds supply, the price will increase; if there is plenty of supply, but little demand, the price will go down.
Other factors that influence price discovery are:
- Attitudes to Risk: If a buyer is willing to take on the risk of a fall in price, for the potential reward of a large rise in price, the buyer may be willing to buy the asset at a higher price to maximize exposure to the market.
- Volatility: How much the price of an asset tends to fluctuate will also influence price discovery. For example, if a price has been falling for twenty minutes, but has been on an uptrend over the course of the week, a buyer may still buy the asset, even though the price may continue to fall for a little while.
- Macroeconomic Environment: Especially with Bitcoin, we can see that when the mainstream economy is under threat, it acts as a safe haven. With more people looking to buy into Bitcoin, the price goes up.
But it’s also about market quality.
True Price Discovery
It’s not just important to understand how price discovery takes place, but also what ‘true price discovery’ is. In other words, what makes the quality of the process of price discovery good and fair?
- Deep Liquidity: This is about how easy it is to buy and sell an asset. If there are lots of orders in the order book, and the environment is competitive, this helps the process of price discovery.
- Order Volume: how much of an asset is actually in the market is also important; a healthy market should be able to accommodate traders of all sizes.
- Market Depth: This is the market’s ability to handle large market orders without the price of an asset being impacted too much.
- Trade Size: In a healthy market, you would expect that small orders are traded more frequently than very large orders. If there are a lot of anomalies, it may mean that the market is being manipulated.
Furthermore, for price discovery to be optimal, an exchange needs to be able to match orders very fast.
This is one of the reasons why AAX is powered by the Millennium Exchange matching engine. In fact, it is the only crypto exchange in the world to be powered by the same matching engine that powers the London Stock Exchange and other first-tier exchanges.
But What is the ‘Real Price’ of Bitcoin?
You understand now what influences price discovery and what makes for that process to happen in the best and most precise way. However, when you look around and explore different crypto exchanges, you will see that there are significant differences in price between various markets.
Some traders may want to take advantage of these differences through arbitrage trading — meaning they may buy Bitcoin in one market (for a low price), and sell it on another market (for a higher price).
While it’s difficult to say what the ‘real’ price is of a given asset or currency, what we can say is that it’s important to trade on a healthy market, with sufficient liquidity, market depth, and volume, a regular trade size distribution, and a powerful matching engine.
Originally published at https://academy.aax.com on August 9, 2019.