Prediction markets have historically been the
red-headed stepchild of traditional trading. Bridging the gap between finance
and gaming, they’ve consistently encountered regulatory pressures, as well as a
host of legal and ethical considerations.
Also known as information markets, decision markets,
or events-based trading, a consistent feature of this style of market is its
uncanny accuracy in predicting future outcomes. Combining the wisdom of crowds
with financial incentives, these markets have been shown to be more accurate
than opinion polls, or even individual domain experts.
Despite these issues, their popularity is on the rise
and they receive regular publicity during election cycles. This is because of
their reputation for picking winning candidates, often in direct contradiction
to polling results. A prediction market correctly predicted both the 2024
re-election of Donald J. Trump, and New York mayoral primary winner Zohran
Mamdani.
Regulatory Changes
Despite this, regulators such as the Commodity
Futures Trading Commission, have been hostile to them in the past due to their
proximity to gambling. However, in October of last year, Kalshi, the largest US
prediction market, won a legal case against the CFTC, allowing it to run
prediction markets on election results.
With a US administration that’s currently much
friendlier to financial innovation, the lawsuit is being regarded as a landmark
that will open the door to further regulatory progress in events-based trading.
Kalshi’s CEO has openly stated his intentions to create a financial market that
can price in any event in all areas.
A Brief History
Prediction markets actually
predate conventional stock markets by more than a century. Founded in 1602, the
Amsterdam Stock Exchange is widely credited with being the world’s first stock
exchange .
Meanwhile, the oldest documented prediction markets
originate from the Italian city states in the early 1500s where election
markets on papal successors were common. Even back then, these political bets
were regarded as an old practice.
One of the oldest electronic prediction markets still
in use is the University of Iowa’s Iowa Electronic Markets, which launched
during the 1988 US presidential election.
In 2018, Augur, the world’s first decentralized
prediction market, launched on the Ethereum blockchain. It would spur a great
deal of research and experimentation in the space.
Currently, Polymarket, which runs on the Polygon
blockchain , is the world’s largest decentralized prediction market by volume,
with $91.77 million total value locked (TVL) at the time of writing.
How They Work
One of the features that makes these markets
particularly attractive to retail, is how simple and easy to understand they
are. The events in question feature binary outcomes with 50/50 probabilities.
For example, either Bitcoin will hit 200K in August or it won’t.
Participants purchase shares in a contract, with the
price of the shares being closer or further away from $1 the more or less
likely the market considers the outcome to be.
For instance, there’s currently a market on whether
President Trump will release the Epstein files by the end of the year. The cost
of a “No” share is currently priced at 61 cents, whereas the cost of a “Yes”
share is currently valued at 40 cents. The winning side receives $1 per share
for a correct prediction once the results are in.
The prices of these yes and no views inevitably
change closer to the outcome and oscillate as new information is received. For
example, in the above market, the probability of a “Yes” dropped to 13.5%
earlier this month when it was announced that there were no files to be
released.
Traders who purchased “Yes” outcomes at 13.5 cents
can now sell those contracts to buyers at the current market price of 40c, thus
profiting without having to wait for the outcome to be revealed.
Technical Requirements
As interest in these markets continues to grow, firms
seeking to enter the space will be called to review the technical requirements
that are specific to prediction markets. In our estimation, the superficial
similarities to gaming may lead many to underestimate just what it takes to run
a successful events-based market. Behind the scenes, these markets have much
more in common with futures and options exchanges than they do with online
gambling sites.
Owing to the nature of the instrument, continuous
uptime and both 24/7 trading and technical support are necessary. These markets
are perhaps more sensitive to the news cycle than any other, and they can only
price in the constant stream of news affecting contracts if they operate around
the clock.
This means that markets must be able to be listed,
removed, resolved, and settled on-the-fly with no technical restarts,
preferably via API that operations teams can operate without the need for
intervention from technical teams.
They also have to be designed for both scalability
and reliability from the get-go and engineered to be able to handle orders of
magnitude more users than they may be expecting. This is particularly relevant
due to their relative newness to the trading scene, as many crypto exchanges
found out to their detriment during the 2016-2017 bull cycle.
These markets also require flexibility in contract
resolution to be built in. The outcomes may be binary, but events aren’t always
resolved on a set date. For instance, Bitcoin may (or may not) reach 200K on
any day of August, from the 1st to the 31st.
Contracts on sporting events will also require
automated delays in the interest of fairness, so that those closer to the
action are not able to front run contract activity.
Finally, for businesses seeking to run advanced
prediction markets that allow users to trade combinations of outcomes, systems
will have to be equipped with algorithms that can handle the combinatorial
explosion that results when even a small number of binary outcomes are
combined.
Final Thoughts
The loosening of regulatory
controls in the United States promises a surge in new products and a general
encouragement of financial innovation. We’ve seen this previously with 0DTE
options, more recently with perpetual
futures, and now the rise of prediction markets. The next few years are
certainly shaping up to be exciting both for end traders and the providers of
these new financial technologies.
Prediction markets have historically been the
red-headed stepchild of traditional trading. Bridging the gap between finance
and gaming, they’ve consistently encountered regulatory pressures, as well as a
host of legal and ethical considerations.
Also known as information markets, decision markets,
or events-based trading, a consistent feature of this style of market is its
uncanny accuracy in predicting future outcomes. Combining the wisdom of crowds
with financial incentives, these markets have been shown to be more accurate
than opinion polls, or even individual domain experts.
Despite these issues, their popularity is on the rise
and they receive regular publicity during election cycles. This is because of
their reputation for picking winning candidates, often in direct contradiction
to polling results. A prediction market correctly predicted both the 2024
re-election of Donald J. Trump, and New York mayoral primary winner Zohran
Mamdani.
Regulatory Changes
Despite this, regulators such as the Commodity
Futures Trading Commission, have been hostile to them in the past due to their
proximity to gambling. However, in October of last year, Kalshi, the largest US
prediction market, won a legal case against the CFTC, allowing it to run
prediction markets on election results.
With a US administration that’s currently much
friendlier to financial innovation, the lawsuit is being regarded as a landmark
that will open the door to further regulatory progress in events-based trading.
Kalshi’s CEO has openly stated his intentions to create a financial market that
can price in any event in all areas.
A Brief History
Prediction markets actually
predate conventional stock markets by more than a century. Founded in 1602, the
Amsterdam Stock Exchange is widely credited with being the world’s first stock
exchange .
Meanwhile, the oldest documented prediction markets
originate from the Italian city states in the early 1500s where election
markets on papal successors were common. Even back then, these political bets
were regarded as an old practice.
One of the oldest electronic prediction markets still
in use is the University of Iowa’s Iowa Electronic Markets, which launched
during the 1988 US presidential election.
In 2018, Augur, the world’s first decentralized
prediction market, launched on the Ethereum blockchain. It would spur a great
deal of research and experimentation in the space.
Currently, Polymarket, which runs on the Polygon
blockchain , is the world’s largest decentralized prediction market by volume,
with $91.77 million total value locked (TVL) at the time of writing.
How They Work
One of the features that makes these markets
particularly attractive to retail, is how simple and easy to understand they
are. The events in question feature binary outcomes with 50/50 probabilities.
For example, either Bitcoin will hit 200K in August or it won’t.
Participants purchase shares in a contract, with the
price of the shares being closer or further away from $1 the more or less
likely the market considers the outcome to be.
For instance, there’s currently a market on whether
President Trump will release the Epstein files by the end of the year. The cost
of a “No” share is currently priced at 61 cents, whereas the cost of a “Yes”
share is currently valued at 40 cents. The winning side receives $1 per share
for a correct prediction once the results are in.
The prices of these yes and no views inevitably
change closer to the outcome and oscillate as new information is received. For
example, in the above market, the probability of a “Yes” dropped to 13.5%
earlier this month when it was announced that there were no files to be
released.
Traders who purchased “Yes” outcomes at 13.5 cents
can now sell those contracts to buyers at the current market price of 40c, thus
profiting without having to wait for the outcome to be revealed.
Technical Requirements
As interest in these markets continues to grow, firms
seeking to enter the space will be called to review the technical requirements
that are specific to prediction markets. In our estimation, the superficial
similarities to gaming may lead many to underestimate just what it takes to run
a successful events-based market. Behind the scenes, these markets have much
more in common with futures and options exchanges than they do with online
gambling sites.
Owing to the nature of the instrument, continuous
uptime and both 24/7 trading and technical support are necessary. These markets
are perhaps more sensitive to the news cycle than any other, and they can only
price in the constant stream of news affecting contracts if they operate around
the clock.
This means that markets must be able to be listed,
removed, resolved, and settled on-the-fly with no technical restarts,
preferably via API that operations teams can operate without the need for
intervention from technical teams.
They also have to be designed for both scalability
and reliability from the get-go and engineered to be able to handle orders of
magnitude more users than they may be expecting. This is particularly relevant
due to their relative newness to the trading scene, as many crypto exchanges
found out to their detriment during the 2016-2017 bull cycle.
These markets also require flexibility in contract
resolution to be built in. The outcomes may be binary, but events aren’t always
resolved on a set date. For instance, Bitcoin may (or may not) reach 200K on
any day of August, from the 1st to the 31st.
Contracts on sporting events will also require
automated delays in the interest of fairness, so that those closer to the
action are not able to front run contract activity.
Finally, for businesses seeking to run advanced
prediction markets that allow users to trade combinations of outcomes, systems
will have to be equipped with algorithms that can handle the combinatorial
explosion that results when even a small number of binary outcomes are
combined.
Final Thoughts
The loosening of regulatory
controls in the United States promises a surge in new products and a general
encouragement of financial innovation. We’ve seen this previously with 0DTE
options, more recently with perpetual
futures, and now the rise of prediction markets. The next few years are
certainly shaping up to be exciting both for end traders and the providers of
these new financial technologies.
This post is originally published on FINANCEMAGNATES.
