The Iowa Electronic Markets (IEM) is a prediction market which has been running since 1988 for research and teaching purposes at the University of Iowa which allows students to invest real money in a variety of future events.
What are prediction markets?
Humans have been transacting in markets for a very long time, the key feature of any market is that buyers and sellers come together to exchange goods or services against something of value. When a transaction occurs, both the buyer and seller settle upon a mutually agreed value or “price” for the product being transferred. The price of a good though, contains much more information embedded into it than what appears upfront. Prices convey the market sentiment and implicitly carry information regarding background of products because all the stakeholders in a product’s value chain, use their proprietary knowledge and factor in all the variables related to the product before arriving at the final price. For example, the prices of flood insurance in coastal regions can help predict the consequences of Global Climate Change better than most environmentalists can.
The question of how can we efficiently extract and use this embedded information is answered by Prediction Markets. These are speculative markets specially designed so that prices of shares in a prediction market can be interpreted as probabilities of future outcomes of events. Prediction market is not a new concept, there have been many prediction markets in place since the advent of the Internet like the Iowa Electronic Markets which have been able to accurately predict multiple political outcomes in the US more accurately than political polls.
A simple prediction market starts with a simple question regarding the outcome of an event which has a “Yes or No” answer. The market participants can buy shares either in favour of Yes or No. The payout for each share is $1 and the price of the shares reflects the probability of that outcome. For example, if the value of a Yes share for “ Will the GDP of Indian cross $5 trillion by 2021? ” is $0.7 then it means that the market believes that there is a 70% chance of having an outcome in favour of the question and if I buy that share today and the prediction comes true, I will get paid $1.
The whole idea behind predictive markets is to leverage the collective wisdom of the crowd in order to converge on an outcome for an event. It is based on the idea that when people have money on the line, they have an incentive to make decisions more rationally, based on private as well as public information after doing due research to the best of their abilities. The predictions of the crowd tend to outperform those of experts because, every individual has some expertise and may also have some information which might not be available to everyone. When these small packets of information are collected and their aggregate is used to predict an event, it contains a lot more information and opinions than those possessed by a single individual or entity.
One might argue that a prediction market is just a fancy name for betting but the major difference between betting and prediction markets is that betting is purely based on chance and it has no benefits for anyone other than the person who is winning the bet while prediction markets are used to extract the knowledge and wisdom from individuals which can collectively be used to better predict event outcomes and have more accurate forecasts for designing better policies. It benefits people other than those involved in the markets.
Even private companies use prediction markets internally to make better decisions. Companies like Consensus Point, specialize in running internal commercial prediction markets to help companies make business decisions. Consensus Point’s solutions prove that prediction markets are highly accurate with an accuracy rate of 90%.
Why have prediction markets not caught up?
Despite all their benefits, traditional prediction markets have one big flaw, which is that almost all of them are controlled by a central authority. Most countries view them as gambling while some consider them as options trading which means that in the majority of regions, these are regulated by the government which restricts the variety of questions which can be asked, the values of bets that can be placed and the number and type of participants allowed.This prevents smooth flow of information and makes the process less transparent.
Having a centralised authority which controls the marketplace prevents a prediction market from reaching its full potential, due to the following reasons:
- Betting caps prevent prices from accurately reflecting opinions of high confidence investors
- Risk of shut down discourages participation
- Market operators can influence outcomes
- Lack of anonymity means people cannot express unpopular opinions
- Market participation might be restricted to individuals from certain geographic or political regions
These markets also have a lot of intermediaries who have access to the market information and can manipulate the results in their favour, they charge high commissions which deters people from participating in these markets.
All these factors combined lead to reduced trust and lack of participation which reduces liquidity in the market and results in less accurate predictions thereby beating the whole purpose of having a prediction market itself.
How can Decentralisation help?
The advent of Blockchain has opened new avenues in various domains and prediction markets can also leverage the power of blockchain to overcome their bottlenecks and grow to their full potential. A decentralised prediction market, operates on a network of computers rather than on a single server making it more robust as there is no single point of failure, it cannot be controlled entirely by any one entity making it deregulated by nature similar to how bitcoin operates.
Such markets work on smart contracts which utilise the Blockchain infrastructure. Smart contracts are irreversible and self-executing agreements written in and enforced by code rather than third parties and guaranteed to execute as written.They are tamper-proof, censorship-resistant and auditable. Once a smart contract is signed and verified, it cannot be cancelled by anyone. It will auto-execute when the conditions in the contract are met and the money will be automatically transferred through the underlying cryptocurrency. This addresses a majority of concerns associated with the centralized prediction markets.
Being decentralized, they cannot be regulated or shut down by any government and they do not have any geographical or political limitations attached to them which means that anyone can take part in the markets from anywhere in the world at anytime.This gives access to liquidity pools across the globe.
The lack of any intermediaries also means that transaction costs are minimal and smart contracts reduce the need for people to trust other people in the markets. Users themselves maintain control of their funds, instead of having to trust a centralized third party to hold their money.In addition to this, anyone can create their own markets without the risk of a shutdown.The barrier to entry is reduced significantly and people can also bet on less popular but more likely opinions due to the anonymity afforded by the blockchain network which ensures higher participation leading to better and more accurate results.
Challenges ahead
So far the decentralised prediction markets seem great without any negatives but there are some challenges which must be addressed before they can become widespread. The biggest hindrance is the Oracle Problem which is that once an outcome happens, who will verify it so that the smart contract can be executed? This is an important problem because smart contracts are irreversible so the verification must be correct, having participants verify an outcome can lead to wrong verifications if they have a large stake to gain by reporting the wrong outcome. This can be addressed by assigning reputation points to people reporting correct outcomes and even linking them to financial incentives. Another possible solution is to have reporters bet on the outcome they are reporting and the outcome involving the largest amount of money is considered as the true outcome.
Another problem with decentralised prediction markets is that being an open and uncencensored platform , anyone can create any market they desire which cannot be shut down. This can be exploited by people to give controversial incentives. For example, some participants may create assasination markets betting on the death of a global leader, this might incentivise people with large bets to kill people. Due to these limitations, having a 100% decentralised and open market is not feasible because, if a prediction market is truly decentralized, there is no way to take it down.There needs to be a framework and checks in place to prevent such exploitation of these markets for illegal activities.
Applications and Future outlook
Decentralised prediction markets have huge potential to revolutionise forecasting and markets in general.They can help manage economic risk and improve social welfare. Some potential applications for such markets include, Fact-checking news to tackle the problem of fake news and predicting market performance of newly launched products and movies.
They can also be used to hold politicians accountable for the promises they make by asking them to bet on the outcomes of their own promises which would incentivise them to make realistic promises and work hard to achieve them as they would have a personal stake in it, which would lead to more efficient governance and reduced corruption. Another application is for individuals and proprietors across the globe to hedge risks. For example, a farmer can hedge against the risk of drought by forecasting low rainfall on a prediction market. If there is sufficient rainfall, the crops will flourish but if there is a drought, he/she can get a payout from the prediction market.
A more radical application of prediction markets could be a Futarchy which is a form of government proposed by economist Robin Hanson. In a futarchy, prediction markets are used to determine the government policies will be most beneficial based on measures of national wellbeing which are defined by elected officials.
Conclusion
We have established the benefits of prediction markets and how leveraging Blockchain technology to decentralise and deregulate these markets can help address the limitations of traditional prediction markets. A few companies like Augur, Gnosis and Bodhi have already started rolling out such prediction markets based on different blockchains. Although, in order for decentralised prediction markets to become truly mainstream, there are still challenges which need to be addressed most important of which is creating a hybrid market which can leverage the benefits of deregulation and decentralisation while preventing misuse for malicious intentions.In addition to this, for these markets to become really successful, a large number of participants is required which can only be achieved if a large part of the economy moves to cryptocurrencies and people are comfortable transacting in cryptocurrencies.
References
[1]Shingai Thornton , “Practical Applications of Cryptocurrency: Decentralized Prediction Markets”, Medium ,
[2]Peterson J, Krug J, Zoltu M, Williams AK, and Alexander S (2018) “Augur: a Decentralized Oracle and Prediction Market Platform”, Forecast Foundation, https://www.augur.net/whitepaper.pdf
[3]Howtotoken, https://www.howtotoken.com/explained/try-decentralized-prediction-markets-right-now/
Guest article written by: Pranav Shukla is an MBA student at IIT Delhi. He writes about Technology and Finance and is very passionate about Blockchain and Cryptocurrencies.