An Introduction to Prediction Markets
Prediction Markets, as defined by Wikipedia, are exchange-traded markets created for the purpose of trading the outcome of events. If you have ever placed a bet on the Super Bowl or any other sporting event, you have participated in perhaps the most common prediction market today: sports betting.
I started getting interested in the idea of prediction markets for something other than sports betting last year, when I realized that prediction markets and prediction models for the 2020 US presidential election had serious deviations. While analyzing the potential positive expected value opportunity, I started wondering: Is there utility in this system that could be positive for society? I believe that in the near future prediction markets will have use cases that expand beyond the current use which is entertainment / speculation.
Prediction Markets Today
There are many types of prediction markets out there. Here are the ones that I am aware of / participate in.
Sports Betting
Sports betting has been around for decades; today it has a market size of $203 Billion and it employs almost 200,000 people. It’s utility is to bring additional entertainment to sports fans.
PredictIt.org / Iowa Electronic Markets
PredictIt and IEM are markets that focus on predicting political and financial outcomes. Due to regulation, they are limited in nature. For example in PredictIt, The max you’re allowed to wager on an outcome is $850 USD, and the maximum number of participants in an outcome is 5,000. These limitations restrict to an extent the true price discovery of an outcome, making these markets somewhat inefficient. While IEM is a non profit with no fees, PredictIt charges both trading fees and withdrawal fees, adding to the inefficiency of the market.
Metaculus
Metaculus is a technology platform that aggregates predictions on future outcomes of all types. The big downside of Metaculus is that it does not allow you to wager real money: it has a points system and leader boards in an attempt to encourage participants to make accurate predictions. However I believe that without skin in the game, the market will always be limited.
Augur
Augur is a peer-to-peer, decentralized, no limit, open source platform running on the Ethereum network that allows users to create their own prediction markets. I have yet to use Augur because executing smart contracts on Ethereum is still expensive when wagering small amounts.
Polymarket
Polymarket is a prediction market built on the Polygon / Matic platform as well as the Ethereum platform. It allows you to wager USDC (a cryptocurrency pegged to the US dollar) on all types of future events. At the moment, most markets on Polymarket are focused on sports, politics, economics, and cryptocurrency events. This is the market I currently use due to its cost, no limits, and types of markets.
How does Polymarket work?
To begin, you need to deposit USDC into Polymarket. Right now there are four ways to do it, including using your debit / credit card (If your financial institution allows it).
I personally use the peer-to-peer option, as it allows me to quickly and cheaply transfer USDC in and out from my Polygon / Matic wallet.
Once you have USDC in your Polymarket account, it’s time to find a market to wager on. As an example, I will be using the market Will the 2021 Tokyo Olympics take place?
Let’s say you are extremely confident that the Tokyo Olympics will take place this summer. You could place a wager on the Yes outcome by buying Yes shares at $0.91 per share (Total cost, ~$0.93 per share, as there is a 2% Liquidity Provider fee for market makers). This means that if the market resolves Yes (Meaning, the Olympics do happen), you will get back $1 per share. After costs, that would mean your earned a 7.54% return on your investment.
What does it mean when the market is pricing Yes at $0.91 and No at $0.09? It means that the market is predicting a 91% chance of the Olympics taking place.
How does Polymarket resolve a market? There are a set of rules in place prior to launching a market. Here are the rules for Will the 2021 Tokyo Olympics take place?
What is the utility of prediction markets? So far it seems like a place to bet on events for fun.
Right now, prediction markets are being used for speculation and entertainment purposes. It’s been a lot of fun wagering a few bucks here and there in different markets, understanding how Polymarket as a platform works. However I do believe that there is utility for platforms like this.
Information Discovery
Prediction markets help information discovery by allowing the wisdom of the crowds to participate in reducing the outcome of an event to a probability. It is likely that at the moment, only individuals are participating in the market example above, using public information to arrive at the 91% number above. If prediction markets were mainstream, it would be logical for market participants such as Japanese government officials, IOC members, policy experts, etc, to use their expertise and knowledge to wage on this market for their benefit. If these experts used their knowledge to participate, the probability of outcome would be more accurate.
While arriving at an accurate probability that a sporting event will take place is perhaps not as useful to society, when it comes to markets in health, economics, and politics, there is utility to forecasting an accurate probability of an outcome. Stakeholders could observe how these markets develop and make decisions based on the information the prediction market is providing.
Institutional Hedging
Prediction markets can be used similarly to derivatives markets. The main difference is that derivatives are built on top of physical and financial assets, whereas prediction markets are built on top of outcomes. A great example of an event where a prediction market could be used as a hedge was when the Ever Given got stuck in Suez Canal. A prediction markets participant named Aaron wrote a great post on how a prediction market regarding the ship on Polymarket operated up until the ship was freed.
The Ever Given event affected many institutions, from ship owners to manufacturers to suppliers to insurance companies, as well as many others. If prediction markets were mainstream, many of these stakeholders could have hedge their risks by wagering that the Ever Given was not going to be freed my March 30th. In the future, prediction markets could create markets on events similar to this and institutional investors could use them to hedge exposures.
Conclusion
While sports betting has been around for decades, technology brought us prediction markets on many other types of events. There are still enormous regulatory and adoption hurdles to overcome in order for prediction markets to become mainstream, but I predict that over the next few decades, prediction markets will become more common in our lives.
Further Reading:
The Ultimate Guide to Decentralized Prediction Markets - Augur staff wrote a great post explaining how these markets would operate in the future if they were adopted by the masses.
Forecasting Newsletter - Nuño Sempere writes a periodic newsletter on the state and evolution of these markets.
How to Get Good at Predicting Politics - A prediction markets trader walks its readers through steps to become a better political forecaster.
Tales from Prediction Markets - Avraham Eisenberg gives us a few crazy examples on how anonymous traders have made large wagers on different markets.
For informational purposes only. This is not investment advice.