What Is Price Discovery?

In the world of finance, the term price discovery is defined as being the process of determining the actual price of a security or asset. It is conducted throughout the marketplaces of nearly everything with value, including equities, currencies and futures products. From the open outcry auction system to the digital trading environment, price discovery is the mechanism by which asset premiums are assigned.

Pricing Equilibrium

According to traditional economic theory, price reaches a point of equilibrium where supply and demand curves intersect, thus readily facilitating an exchange.[1] Pricing equilibrium represents balance in the marketplace, the point at which buyers are content to purchase an asset and sellers are willing to exchange it for a premium. Taken one step further, in observation of the efficient market hypothesis (EMH), price is a reflection of all pertinent information and sentiment in an open market.

In the contemporary electronic marketplace, price discovery is conducted at near-light speeds and equilibrium points rapidly evolve. This phenomenon is due to various forces including supply/demand, breaking news items, public perception of value and enhanced order flow. Given adequate liquidity and participation, the process of price discovery may be carried out in an efficient, albeit swift, manner.

A Brief History Of Price Discovery

Anytime a producer takes a good or service to market, supply and demand forces dictate the premium which the producer receives and the consumer pays. It is this dialogue between buyers and sellers that effectively negotiates the exchange of an asset. From Istanbul's Grand Bazaar (founded in 1520) to Khan Al-Khalili in Egypt (founded in 1382), marketplaces around the globe have facilitated the process of price discovery on everything from perfume to livestock for hundreds of years.[2]

A prime example of price discovery taking place in the derivative and financial markets is the open outcry system of trade. Under open outcry, market participants swap verbal queues and hand signals to negotiate the transaction price of a security. Derivative products, stocks and commodities were traded in this manner for hundreds of years, dating back to the first organised futures market, the Dojima Rice Exchange.[3] In the centuries that followed, open outcry venues sprung up around the globe in financial hubs such as Chicago, New York, France and London.

Upon the widespread adoption of electronic trading in the late 20th century, price discovery in the financial markets leapt forward. As trade transitioned from an open outcry to computerised format, the number of participants increased exponentially. This phenomenon spiked both traded volumes and liquidity. The result was a much faster, and arguably more efficient, mode of determining an asset's premium.

Has The Digital Marketplace Compromised The Tenets Of Price Discovery?

Throughout the financial community it's debatable whether or not the evolution of the marketplace has enhanced or compromised efficient price discovery. At the core of the discussion is the impact that huge levels of participation have had upon the process of price discovery itself.

Upon the transition to the digital trading format, robust growth was observed in the derivatives, equities and bond markets. For the initial stages of the electronic marketplace from 1995 to 2007, annual growth rates were astounding:[4]

Market Average Annual Growth Rate
Derivatives 24%
Equities 11%
Bonds 9%

More recent measures of forex and global derivatives market size illustrate that participation remains strong. As of spring 2016, the Bank of International Settlements estimated the forex conducted US$5.06 trillion in average daily over-the-counter turnover.[5] In addition, estimates from 2017 projected the aggregate global derivatives markets to be worth a staggering US$500 trillion.[6] This value was the basis for the worldwide trade of 25.2 billion futures and options contracts for the year 2017.[7]

Answering the question of whether or not the modern digital marketplace compromises the integrity of price discovery is a challenge. The markets evolve on a momentary basis, bringing an abundance of nuance to the equation. However, the argument boils down to one being either for or against it:

  • For: Advocates for the electronic marketplace cite the vastly increased levels of participation as being a positive influence on the mechanism of price discovery. High levels of traded volume contribute to a robust depth-of-market and consistent liquidity. As a result, traders benefit from tighter bid/ask spreads, reduced slippage, and a greater selection of tradable products and potential opportunities. In addition, proponents argue that the digital market enables traders to be geographically independent and more competitive as a result of increased price transparency due to real-time quoting data access.[8]
  • Against: Arguments against the modern market facilitating efficient price discovery focus on systemic challenges undermining the entire process. Practices such as high frequency trading (HFT) are viewed as having tilted the playing field, offering HFT traders an unfair advantage. Unethical practices such as stop running and quote stuffing are also viewed as being products of electronic trading that compromise the tenets of price discovery. In addition, the ability for enormous quantities of orders to hit the market instantaneously via automated or black-box functionality is thought to have increased volatility and created a somewhat-artificial asset pricing model.[8]

Regardless if one believes that the electronic marketplace is good or bad for the process of price discovery, it is likely here to stay. Industry giants such as the Chicago Mercantile Exchange, New York Stock Exchange, NASDAQ and Eurex invest large sums annually to ensure their technological infrastructure remains on the cutting-edge.

Regardless if one believes that the electronic marketplace is good or bad for the process of price discovery, it is likely here to stay. Industry giants such as the Chicago Mercantile Exchange, New York Stock Exchange, NASDAQ and Eurex invest large sums annually to ensure their technological infrastructure remains on the cutting-edge.

Summary

From purchasing livestock or jewelry at a farmer's market, to trading forex currency pairs electronically, price discovery is the mechanism driving exchange. It is a means of determining an asset's premium, the result of an ongoing dialogue between buyers and sellers.

In the contemporary financial marketplace, price discovery is conducted by participants around the globe, in huge volumes and at near-light speeds. While it is debatable whether the digital age has increased the efficiency or compromised the integrity of price discovery, the process will continue to evolve as long as demand and technology move forward.