by Alex Broudy, Technical & Financial Writer
Jun 30, 2022
This series of articles explores the key characteristics of how securities operate in the U.S. The previous article reviewed how assets are valued. This article will focus on price discovery, or the way marketplaces establish a price between buyers and sellers. The next article will cover how technical analysis can be used to understand the likely price direction of assets, including digital asset securities.
Tokenization is enabling investment in assets that were previously difficult or impossible for most investors to access. As private businesses – ranging from start-ups and venture capital to energy exploration and real estate – become newly accessible to more investors, a process of price discovery is beginning.
Price discovery occurs when new assets come to a marketplace where buyers and sellers can collectively agree on a price. While price discovery can happen quite quickly in established markets, it is typically a longer process for newer assets operating in newer marketplaces.
When investing in newer financial instruments such as digital assets or digital asset securities, investors often experience the volatility of price discovery first-hand. Understanding why volatility occurs can help investors explore these assets with a more balanced perspective. Let’s review what price discovery is and why it happens.
Plainly, price discovery occurs when supply meets demand. In economics, this is visualized on a graph where the supply curve meets the demand curve to set a price at which buyers and sellers agree to transact. Because the shape of these curves depends on a variety of fluctuating factors, such as where the transaction takes place, in what currency, and how much the transaction costs to perform, there is no singular formula for price discovery. It’s not an exact science.
For example, tokenized venture capital firm SPiCE VC reported that at the end of Q1 2022, each tokenized share had a Net Asset Value (NAV) of $3.39. At the same time, shares were trading for $3.00 on Securitize Markets, a discount of more than 12%. As investors become aware of this discount, greater demand should drive an increase in price.
Thus, price discovery should be viewed as an evolving and continuous process. This process includes, for example, the current stage of market development, how that market is structured, and what financial information is publicly available to buyers and sellers.
Critically, price discovery is different from valuation. Whereas price discovery is a market-driven process of buyers and sellers agreeing on a price at which to transact, valuation involves more model-driven calculations like the present value of cash flow and price versus earnings estimates that help establish a market value for the asset in question. This difference is important to grasp because it can help investors navigate investments at different stages of their development.
While factors such as liquidity, market and regulatory risk should always be considered before making an investment decision, when it comes time to invest, knowing the difference between price and value can help set realistic expectations. To learn more about market mechanics and how to value and evaluate investments, sign up for updates below.
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