Auctions and Price Discovery for Web3

How much for that shiny digital gold?
Depends; who’s asking and how much you got?

The foundation of commercial activity is trading (buying and selling).
The foundation of trading is the dynamics between supply vs demand.
And the foundation of supply vs demand is pricing.

Prices of goods on the open markets are defined by producers based on a multitude of factors, including the raw costs of their product, the logistics, labor, and tax laws, and the willingness/capability of consumers.

The long and short of it is that Something costs as much as somebody is willing to pay for it. 

This leads us to ask: how do we figure out what somebody is willing to pay?

The only way is through trial and error. 

Create something, post it for sale, and collect feedback.

The key here is in the feedback part.

The quicker you can collect feedback from as wide of an audience as possible, the sooner you will arrive at an accurate pricing model (sustainable for growth while having the consumer's needs satisfied).

This works for businesses, commodities, and crypto assets alike.

Therefore, prices are not set; they are determined through discovery.

Thus, we stumble upon one of the greatest impacts of crypto on society.

Transactions have become frictionless, 
commerce has become borderless, 
and markets have become timeless.

Open 24/7, 365, and accessible by people of varying social castes and cultures from anywhere in the world at any time; crypto is a tool of social coordination and capital formation, which, in turn, makes it the ideal instrument for the discovery of prices and development of fair markets.

The open and digital nature of crypto, which leverages a slew of novel paradigms rooted in trustlessness, enable rapid experimentation and iteration; two powerful driving elements in building these pricing markets.

However, the speed and novelty of crypto bring with it extremely chaotic creative side effects. Even though it has birthed an entirely new industry now worth multiple trillions of dollars and expanded the horizons of existing markets, it has also brought with it a ton of undesirable outcomes, such as the dearly PumpFun (a mechanism for bootstrapping and launching new assets). 

We are not going to get into the moral conversations about Pumpfun here.

Pumpfun has been securitized by crypto natives as the engine powering the grifty memecoin “Supercycle” on Solana; and on the surface, it may be so, however, noise aside, under the hood, Pumpfun is actually a brilliant mechanism.

As a platform to create custom tokens without the need for any technical skills, the brilliance is in how efficiently it compartmentalized previously complex processes into a simple, intuitive system. 

Before Pumpfun the complexity of launching a token was modest. Some degree of knowledge in programming/computer science and/or economics was a basic requirement. 

Yes, it was able to take advantage of the performance of the Solana blockchain, which kept fees and processing times extremely low, but beyond simply deploying smart contracts, pumpfun took it a step further by integrating a handful of subtle social elements (Leaderboards/King of the Hill and followings of deployer accounts), financial elements of bonding curves for pricing and automating the deployment of liquidity pools.

The most interesting elements of all their synthesis is found in the deployment of liquidity pools.

By having a module to bring a token into circulation on DEX’s, Pumpfun acted as an abstract auction house where buyers and sellers competed against one another to achieve (or fail) a certain price/marketcap for an asset.

It actually highlighted the incredible opportunity and need for novel mechanisms and novel applications of existing mechanisms that transform how markets operate.

The pinnacle of all markets hinges upon a single concept: Auctions.

Existing for thousands of years, auctions are gamified mechanisms for offering/acquiring goods or services.

They are the models through which buyers and sellers negotiate to discover prices and the atomic economic primitives upon which human trade has evolved.

Even though we continue to use them for real estate, fine art, livestock, government contracts, and other unique situations, auctions are predominately left out of the public conscious due to the added complexity of utilizing conditional frameworks.

Typically associated with prolonged, complex, multi-party processes, auctions are the defacto methods of conducting trade activities in markets that have no history, universal reference point, or liquid index.

The purpose of holding an auction is straightforward:
- To get the seller the best possible price
- To get the buyer the best possible price

There are three general participant model types:

1) Forward Auctions
One Seller, multiple buyers.
Effective for the sale of fine art / collectible cars.

Here, multiple buyers are competing with other buyers for the object/service/good the seller is presenting. Typically entertaining due to the thrill factor.

2) Reverse Auctions
One buyer, multiple sellers. 
Effective for private enterprise competition for government contracts.

Here, multiple sellers are competing with each other for the money/to secure the deal that the buyer is willing to wager. 

3) Double Auctions
Multiple Buyers, Multiple sellers.
Effective for markets where prices are somewhat expected, things such as a crypto/stock/commodity exchange’s orderbooks.

Here, both sides place bids/asks simultaneously. Usually, these are higher frequency and less contingent on hype.

There are different auction models individually designed to fulfill their own unique purposes based on the nature of circumstance and industry.

English Auction (ascending-bid auction)
Commonly used for art, these are the most popular form of auction that is seen in movies where prices start low and rise in a step-by-step fashion as people bid in order of who is willing to pay higher than the last bidder. 

Example: Tony is selling his vintage car. A group of three people gather at his garage. Alex says he will pay $1,000. Barney then says he will do $1,100. Charles comes in at $1,200. This goes on until Alex says he will pay $5,000. Barney and Charles do not want to pay more than that, and the auction ends. Alex gives Tony $5,000 and takes the car home.

Penny Auction (ascending-bid auction)
Pay-per-Bid. similar to English auctions, where prices start low and rise as more bids come in, the unique element of a penny auction is that each incoming bid requires the bidder to pay to submit a fee. Technically, in a regular English Auction, each incremental bid can be a penny above the previous one; which can result in necessary delays. By imposing the fee, abusive nonsense is deterred, and the fees can potentially be used to subsidize operational costs or donations.

Dutch Auction (descending-bid auction)
First come, first serve. Also known as a descending bid auction, Dutch auctions start at a high arbitrary price and incrementally decrease until somebody accepts the bid.

Example: Larry is selling all of his Pokemon cards. All his neighbors come to the house want to buy it. He says he wants $10,000. Nobody responds. He says $9,800. Nobody responds. Every 15 seconds, he lowers the price by $200; until at $8,000, somebody says they will take it. Larry then collects his cash and hands over the cards.

First-price, Sealed Bid Auction
Exactly what they sound like, participants signal their willingness to pay through a method that does not reveal it to others. Participants register their bids, sellers collect the offers and, after collection, they are all opened simultaneously. The highest bid wins and pays his price. Great for preserving bidder privacy (so counterparties don’t know what other bid), and avoiding redundancy.

Vickrey Auction (Second-price, Sealed Bid Auction)
An adaptation of the regular sealed bid auction, only here, after all bids are collected and opened, the winner (highest bidder) pays the second highest bidder price. (this encourages honest bidding and minimizes the potential for extreme overpaying)

These are just a few of the more popular models. There are numerous nuances and modifications of models that either mix/adapt elements of the above-listed ones or introduce other factors such as timing, bid privacy, settlement prices, and reserve thresholds to augment the outcomes.

But this isn't an educational post on different auctions.

The purpose is simply to illustrate that auctions are flexible mechanisms that can be integrated into nearly any situation where buying and selling occurs.

Which brings us back to Crypto.

From Parachain Slot auction held by Polkadot, to the multitude of projects that conducted ICOs/IDOs/IEOs, to the CEX stake-to-earn programs, the validator competitions in consensus mechanisms, and everything in between, auctions have been the breeding ground of experimentation in crypto.

However, the vast majority of these experiments have been heavily skewed toward users deeply familiar with technology or finance, leaving the vast majority of market participants sidelined.

Besides Pumpfun, retail has only really had a chance to interact with crypto native auctions in the more traditional sense, predominately in the NFT segments for PFPs, art, gaming material, and other strange (arguably worthless) digital objects on platforms such as Opensea.

Perhaps this was for good reason.

As can be seen by the amount of capital destruction that took place in the 2022–2023 NFT bear market, the timeless wisdom of price not always being equal to value and the inevitable reality that prices will always return to their “real” value over the course of time is a bi-product of market forces.

On the fungible side of things, we arrive at the same conclusion after witnessing the memecoin and AIAgent mania of 2024. Hundreds of billions of dollars in market capitalization arrived and disappeared within mere months. 

Maybe there was no genuine innovation behind bidding below the floor price on collections of monkey pictures or live-streaming crude content in an attempt to pump a token’s price.

BUT!

Both things have a common thread between them.

Auctions.

Auctions invited massive speculative capital which propped up markets.
Auctions gave people a chance to become a part of something.
Auctions brought thousands of new users into the space.
Auctions distilled the valueless from the valuable.

As a matter of fact, auctions (double-sided) have been, and continue to be, the drivers of all crypto markets today!

Yet, we still can't seem to figure out a fair price for things…

Volatility continues to consume the industry, and there seems to be no cure.

That is because there is no problem to cure.

Price is relative.
Price is discovered over time. 
Things change over time.
Thus, prices change over time.

If we want/expect crypto to achieve its ultimate promise of a form of value and for blockchain to truly become the rails of truth upon which the world’s value transacts, we must push forward with more experimentation.

Markets are the most efficient they have ever been.

The very definition of commerce is evolving, and the form factor is becoming all the less traditional.

As we continue to accelerate into a more digital and connected world with a geopolitical shift that is redistributing power and transforming how value is ascribed, we will constantly require novel mechanisms upon which to develop markets and establish prices.

We may not know how exactly the future will play out…
But there is one way to predict it most accurately…

By building it ourselves.

So go out there and experiment like never before!