What traders bring to and want from prediction markets

Alan Jewell March 19th, 2007

For those prediction markets that wish to attract traders, the following are one trader’s thoughts on what a mutually beneficial relationship might look like.

A few things traders can bring to prediction markets:

Liquidity, liquidity, liquidity.
Arbitrage - to the extent your event derivatives can be arbitraged against other markets, traders will figure out a way to do it. Weather events, political events, and similar events are all game in my opinion. Arbitrage transfers wisdom from one market to another by correlating them properly when they are askew.
Less gamesmanship. Potential manipulators of the market would have to tread a lot more carefully, lest they feed their capital to the traders without accomplishing anything.
More Efficiency. I’m no believer in the Efficient Market Hypothesis, but I do believe traders can make markets more efficient than they would be otherwise.

A few things traders want from the markets:

Liquidity. Yes, it’s a Catch-22, and time, patience and marketing are perhaps the answer.
Less friction. For CDA markets, for example, bid-ask spreads and fees must be low. Less friction = more trading = more fees for your market. If you can’t lower your spreads, consider letting traders sell contract bundles for you, and find an equitable way to mitigate counterparty risk.
Provide conditions for arbitrage. As an example, look at the Iowa Electronic Markets 2008 Presidential contracts. As of this writing, it’s UDEM08_VS @ 0.521 bid and UREP08_VS @ 0.464 bid. This is a market that could be easily arbitraged. First of all, it’s my opinion that event derivatives like this should include all possibilities. Third party candidates ~~are going to get some vote share~~ would attract some speculation - why not a contract “OTHER08_VS?” Now if IEM would allow it, arbitrageurs could sell both existing contracts for 0.985, which implies the arbitrageur could borrow money from this market over the next year and a half for about 1% interest and reinvest it in something else (T-bills for instance). If OTHER08_VS were included, it would be even more attractive. IEM won’t let arbitrageurs do this as far as I am aware (and for understandable reasons as it would introduce the need to mitigate and manage counterparty risk), but they should at least do it themselves, and mint some easy, albeit limited money for the university until the arbitrage goes away. The byproduct of this unexploited arbitrage is that the price of the sum of contracts would come down (by my estimate to 0.94 or less), making contracts less expensive for speculators, and thus attracting more liquidity.
Downloadable historical data, including price, volume, and even the order book. Traders like to backtest strategies, and simple comma delimited files will do for most.
Programmable interface. Some traders increasingly use automated strategies. Build it (with all of the above)and they will come, eventually.