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Decentralised finance (DeFi) became a hundred-billion-dollar industry that shook the pillars of traditional finance. A reason behind the rapid growth and user adoption related to the idea of a decentralised financial market based on smart contracts instead of being under the control of a centralised authority.
Centralised finance (CeFi) is the only thing we knew for centuries. Established financial institutions assumed the role of an intermediary as a point of centralised control and offered financial services. Unlike CeFi services, DeFi examples include decentralised, transparent, and permissionless financial products and services.
Both DeFi and CeFi are financial concepts that are relatively new to the crypto industry. They still aren't mutually exclusive. While DeFi aims to democratise finance and put the power back into the hands of ordinary users, CeFi is trying to improve in areas where DeFi falls short.
Before moving on to the central part of this article, we recommend refreshing your memory by reading about the key differences between CeFi and DeFi: ‘How to use crypto: CeFi vs DeFi: A Centralised and Decentralised Finance Comparison’.
Both CeFi and DeFi are full of niche terms and jargon that may sound confusing to most readers. DeFi borrowed a lot of terms associated with traditional finance and incorporated them into the space based on blockchain technology.
For a beginner, it may be hard to understand DeFi terms without having a substantial degree of financial literacy.
Therefore, we have prepared a saga of beginner guides that teaches you all those expert and technical terms you cannot avoid when dealing with finance, either centralised or decentralised. Let’s begin with basic financial terms.
Starting off with the cornerstone of the economy – the key concept in economics that explains how prices are determined on the market.
In simple terms, a market is a place where sellers and buyers meet to exchange goods and services. For example, you want to eat a piece of cake. Strolling down the street you look at different pastry shops or scroll down a delivery app. When you find something that you like, you freely choose to pay $5 for a piece of cake. The pastry shop has the product you are looking for and serves it to you in exchange for money.
Therefore, the law of supply and demand corresponds to an exchange of value between a buyer and a seller. It has to satisfy both parties. Imagine now a different situation – you do not want to pay more than $3 for a piece of cake, but the pastry shop has set its price at $6. It is not realistic that there will be a trade-off but for the sake of understanding, imagine that you both decided to adjust your choices for mutual benefits and met somewhere in the middle.
This trade-off refers to something known as equilibrium price or the intersection of the supply and demand curves in a graph. When supply and demand curves meet, the equilibrium price is determined automatically. Buyers and sellers do not have to haggle each time because the market as whole sets out the agreement between supply and demand.
The concept of supply, as opposed to demand, presents a proportional relationship between the offered quantity and the price of a particular good. Sellers are more willing to sell their products as the price increases. Logically, increased prices are a motivation to producers to increase their supply to maximise profits and the other way around. To wrap it up, the seller’s main interest is financial gain.
The supply curve increases in relation to price. Just like the demand curve, it is determined by elasticity. Elasticity can be roughly divided into five categories: perfectly elastic, elastic, inelastic, perfectly inelastic, and unitary. More elasticity means high responsiveness to changes in price.
A similar example can be found in the DeFi space. For instance, there are price-elastic tokens. A price-elastic token is a type of token where the project’s total supply is not fixed, yet automatically adjusted. Such adjustments are also known as rebases that are performed per a specific target price.
However, there are other factors that affect the law of supply such as the process of producing goods, technological innovation, and regulatory policies. The first element may not be quite relevant all the time within the virtual world since it concerns activities such as the purchase and sourcing of raw materials, the maintenance of machines, transport and distribution. For example, the Covid-19 pandemic has caused a shortage of microchips and therefore, the general availability of electronic devices has decreased.
The other two elements that affect supply may be useful when it comes to DeFi. Technological advancements enhance the supply chain as performance and profits improve. Government policies and regulations may affect supply in both a positive and negative manner.
While applying strict regulations makes it harder to run a business either in the physical or virtual world, a lack of regulation creates uncertainty in a market.
In traditional economics, the term ‘total supply’ refers to the overall quantity or amount of a particular product or service that is available on the market during a specific period. It refers to the aggregate level of production or availability of a product within a given time frame.
Understanding the term total supply is important for analysing market dynamics, determining price levels, and assessing the overall efficiency of resource allocation. Total supply is often examined along with total demand to analyse the equilibrium price and quantity on a particular market.
In the crypto world, total supply refers to the total number of tokens that are currently in existence, including both the publicly available tokens that are circulating on the market and tokens locked through some means.
In traditional economics, the term ‘circulating supply’ refers to the total quantity or amount of a particular currency or asset that is actively circulating in the market and is available for trading. It is part of the total supply of an asset or currency that is not locked or held in reserve, but rather accessible to market participants.
The term is much more used in the crypto context, where it refers to the number of tokens that are available for trading on exchanges and held by investors, excluding tokens that are locked.
A total number of tokens that are publicly tradable via exchanges, either a centralised exchange or decentralised, at a given time amounts to circulating supply. The circulating supply is used to calculate market capitalization because it directly reflects market demand.
In traditional economics, the term ‘fixed supply’ simply describes a situation where the quantity of a particular asset or currency is predetermined and remains constant as time passes. In other words, the total supply of an asset doesn’t change regardless of the supply and demand curves.
When a particular asset is associated with a fixed supply, its quantity available for trade or use cannot be increased or decreased. Fixed supply stems from a number of factors, such as scarcity, limited availability, or design choices. When it comes to CeFi, a common example is land as the amount of land available for use is fixed and cannot be increased.
When talking about fixed supply in the crypto context, the first thing that may come up is Bitcoin's fixed supply. Bitcoin’s supply schedule is governed by a set of rules known as the Bitcoin protocol. There will only ever be a maximum of 21 million Bitcoin, estimated at around 2140. A fixed number of Bitcoin is created every 10 minutes toward the total number.
Remember the part when we talked about elasticity and five broad categories? Bitcoin’s fixed supply is an example of inelastic supply.
When talking about the financial system of the decentralised blockchain space and crypto trading, you will probably hear the term tokenomics. The fusion of the words token and economics is the science of the token economy that deals with all the aspects of a tokens' creation, value, utility, and asset management.
In the context of tokenomics, the law of supply (and demand) functions similarly to centralised finance. The law states that the price of an asset is determined by the core balance between its supply and demand in the market.
Logically, when the demand for a crypto asset exceeds its supply, the price will rise, and when the supply of crypto assets exceeds its demand, the price will fall.
The law of supply and demand in the crypto environment can lead to changes in market conditions. Similar to the traditional financial system, external factors such as regulatory developments and technological innovations regarding digital assets can influence supply and demand dynamics in the crypto market.
Now that you know a few things about the law of supply within traditional financial services, we suggest reading this article to compare it to crypto supply metrics: 'Crypto Basics: What are Tokenomics?'.
The law of demand states that the demand for a particular good or service goes up as the cost decreases. In other words, demand and price are inversely proportional. If we think of a market as a place that consists of a bunch of individuals, the total demand equals the sum of the demand of all these individuals.
Demand is influenced by other factors that have to be taken into account. These refer to the consumers’ capital power or income, the current value of money, consumer preferences, and the price of complementary goods.
Since demand derives from the law of diminishing marginal utility meaning that consumers use goods to satisfy their urgent needs first, the fundamental principle says that at a higher price, consumers demand a lower quantity of goods.
The shape and magnitude of the demand curve shifts in response to changes in consumer income, subjective expectations, and similar, but not to changes in price.
Even though the main postulate is that when demand increases, the price decreases accordingly, there are some cases when prices are not affected by a demand increase. Here we are talking about Veblen and Giffen goods.
The so-called Veblen goods are assets for which demand increases as the price rises since they are perceived as status symbols. These are usually luxury items such as designer items or expensive cars. The term was suggested back in 1899 by Thorstein Veblen, an unorthodox economist, who identified conspicuous consumption. In other words, people think that more expensive equals better quality.
On the other side of the spectrum, we have Giffen goods. The demand for Giffen goods rises as the price rises and vice versa. For example, Giffen goods are bread, wheat, and rice. Unlike Veblen goods, these are understood to be common items with not many good substitutes.
One classic example of the Giffen goods is the 19th-century Irish potato famine. During the famine, the price of potatoes increased and the demand increased. Instead of buying other foods such as meat, people bought even more potatoes.
We can use a more recent example of contradicting the law of demand, as well. During the Covid-19 pandemic, almost every part of the world experienced the same shortage of toilet paper since consumers hoarded toilet paper. This is something that is referred to in economics as ‘panic buying’. As the name suggests, it is a situation where consumers broadly increase their demand due to a perceived threat of scarcity or fear.
In the context of cryptocurrency trading, the law of demand can be applied to the relationship between the price of a cryptocurrency and the users' demand.
In case the demand for a particular crypto asset rises, but the current supply is limited, the price increases. However, the demand for coins may rise regardless of their true value. This occurrence is termed as overbought. If a broad quantity is sold without a valid reason, this is described as oversold.
Similar to traditional finance, there are many factors that influence the demand for cryptocurrencies such as trends, endorsements, technological innovation, and media recognition. For example, someone might feel like missing out on profit and decide to invest.
Price is basically the monetary value of a good, service or resource established during a transaction. The market price of any type of asset or service is set out by the law of supply and demand.
In traditional finance, we have the price theory which is a microeconomic principle that says that the forces of supply and demand establish the logical price point for a particular asset or service.
Sellers and buyers meet at the market, either a traditional market or a cryptocurrency market. Typically, sellers want to charge as much as they reasonably can for their products and services, while buyers want to pay as little as possible to obtain them. The theory of price states that the supply and demand forces will make them meet somewhere in the middle.
Most markets are highly regulated to avoid the breach of competition law, the occurrence of cartels, monopolies, and misuse of a dominant position. Taking all this into account, price is not only driven by the law of supply and demand, yet also by price floor and price ceiling.
Market-based pricing occurs when a particular asset's price is set according to current market prices for the same or similar prices. Basically, prices should be in line with competitors’ prices.
If it is done the right way, a market-based pricing strategy enables a business to set prices a bit higher during the introduction of the product to the market and later on align prices with competitors to remain profitable.
A company that prices its offerings in relation to market demand has a better chance to gain market share. Obtaining market shares enables a business to stay competitive even in times of higher demand when it may offer higher prices even if similar products are less priced.
When it comes to financial markets, such as a traditional CeFi stock market, various parties such as brokers, traders, institutional investors, and investment firms meet. For a share to be traded, both parties should reach an agreement at the same point in time.
The stock market price list is a bit more complicated but it lies on the same economical premises; you can see buyers’ quotes as the bid price and the sellers’ quotes as the offer price. If those two are equal, financial transactions go through. If not, a difference known as a spread or margin occurs.
We are not going to deal with financial markets right now, but it is good to know a thing or two about it because the crypto market resembles it.
Even though crypto received some bad reviews in the beginning, like being based on the greater fool theory, this is how many markets work. Prices and value are not always established by practical factors such as utility, yet by the forces of supply and demand.
If consumers think that something is worth $1 million, then it will probably be worth that much. The willingness to pay a certain price drives its value.
From a traditional economics angle, prices in DeFi systems are determined by the interplay of supply and demand. Supply represents the number of tokens available, while demand signifies the will of users to obtain these tokens.
The equilibrium price emerges where supply and demand intersect on crypto trading platforms, reflecting the value market participants place on tokens. Similar to CeFi examples, there are other factors that may influence pricing within DeFi services such as liquidity, market dynamics, token use, speculation, and market sentiment.
Next step: What are the risks of using a decentralised exchange (DEX) vs a centralised exchange (CEX)?Go to next step
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