Where Do Prices Come From?

Very few of us have the opportunity to experience the heart of what makes our civilization work. Crypto-asset markets are one of the few places where you can participate in a real asset exchange without spending a decade getting training and certifications. If you want to try your hand at playing Wall Street trader for a day, this is the place to be.

If factories are the engines running the world’s economies, then the financial markets are its brain. Unless something goes wrong, we are blissfully unaware that our modern, comfortable and decadent lives are made possible by the great flows of the capital markets on Wall Street.

Without them, companies like Apple and Toyota would not be able to raise funds to produce iPhones or Priuses. Without the price stabilizing service of the futures markets, farmers would be gambling their farms on the price of corn or pork when they go to the market. In countries without a public stock market, employees have no way to invest in their future and their country’s economic growth other than unreliable government programs, savings accounts that lose value due to inflation, or fly-by-night ponzi schemes.

Prices are Not Given

Yet despite the crucial service offered by markets, very few of us have any direct experience of how they work. Every now and then, we are asked to semi-randomly pick a mutual fund from a list offered by our 401K or financial advisor. Some of us throw a few bucks at a hot stock tip (only to panic and sell and the first sign of trouble) or get a .01% CD at our banker’s suggestion.

We are not only ignorant of financial markets – we have very little experience as active participants in any markets. Most Americans live their lives as passive consumers – accepting the prices they see in grocery stores, gas stations, or online marketplaces. We are so inexperienced with haggling that we either pay exorbitant amounts for a Realtor to do it for us, or make an attempt of it every decade or so at a car dealership, and come away hating the experience.

I shared this state of blissful ignorance until I moved to China and suddenly faced the need to haggle for most of my transactions. Goods such as clothing, fruit, meat, electronics, apartments for rent, and Western imports are either much cheaper or only available from small vendors who either don’t post any price, or only use it as a starting point for negotiation.

Haggling

I quickly learned that all prices are subjective estimates of what the seller expects the market will bear. Many people think that haggling is a game of psychological manipulation, and it certainly is that, but more importantly, it reflects the disinformation between buyer and seller. The seller knows his cost, and more importantly, the going market rate, but the buyer usually does not. Haggling is, therefore, a way of indirectly surveying the price the seller thinks the market will bear. Sometimes the price depends on the cost of a good to the seller, but it just as likely may not. A fashion retailer will sell out of fashion clothing far below cost, and a hot, imported gadget may sell for several times what it cost the seller to acquire.

My experience in real-world markets was a big help when I was asked to design and code a Bitcoin exchange in 2013. I created an exchange meant for professional traders by looking over traders shoulders to learn how the billion-dollar foreign currency markets work. I thought I had developed pretty good understanding of how markets worked, but I have never traded on a real-live exchange myself.

Like millions of other people, I only dabbled in Bitcoin myself, investing little real money in it. However, last week, a friend told me about an interesting opportunity: I could get free alt-coins (competing alternative crypto assets to Bitcoin) by using my existing Bitcoins to claim them.

Currency Competition

To make a long story short, after I claimed the alt-coins (with awesome names like Stellar Lumens, Byteball, and Bitcoin Cash), I decided to sell them right away for more Bitcoin. Selling Bitcoin is relatively easy: you just log on to Coinbase.com or Uphold.com and link your bank account. Selling Byteballs requires an account on a much smaller market which lists dozens of smaller currencies and is mostly frequented by serious traders.

So there I was, looking at a trading screen like this:

What’s happening here is pretty simple: people who want to sell Lumens are posting offers to sell a fixed quantity for a set price (Asks). People who want to buy Lumens are posting offers to buy them for another price (Bids). When the bid price is greater than or equal to the asking price, the exchange automatically executes the trade.

Films such as Trading Places, Wall Street, Rogue Trader, or The Pit depict what floor trading on a securities exchange looks like. Traders huddle around a podium and shout or signal offers to buy and sell. Few securities are still traded on a physical trading floor, but all exchanges work the same way.

So do crypto-asset exchanges! While some exchanges allow you to buy and sell for the “market price” (whatever price the market will bear), the smaller, less popular “alt-coins” have very little liquidity (active orders), which means that your order may execute for a very different price than you expected. For currencies like Lumens and Byteballs, it is, therefore, necessary to place orders using a “limit price” — a fixed maximum or minimum.

It works like this: if you want to buy or sell a crypto-asset, you first need to read the market liquidity: look at the order book to gauge or depth of the market in order to know what price you can get away with. If you have a big order, you might break it into several smaller ones to disguise your sale, or you might start selling when you want to buy in order to push the price down before making your break.

All prices (wages and interest too) are ultimately determined through a similar process. Yet very few of us have the opportunity to experience the heart of what makes our civilization work. Crypto-asset markets are one of the few places where you can participate in a real market without spending a decade getting training and certifications. If you want to try your hand at playing stock trader for a day, get an account with a crypto exchange while the field is still open to amateurs.