We are academic researchers who study prediction markets. We are writing in favor of allowing NADEX, or a similar entity, to offer a broad range of political and policy event futures, including the three they are currently proposing.

There are four broad reasons for our support:

1. Existing political event futures have proven useful. Political event futures have been offered in small quantities by the onshore Iowa Electronic Markets (IEM), and by offshore exchanges such as Intrade. Prices from these markets have made possible a broad range of academic research.

2. Political event futures facilitate price discovery in other asset markets. One of the findings of this research is that firms and industries are exposed to political and policy risk. Political event futures provide investors with a market-based assessment of outcome probabilities, which reduces investors’ uncertainty when trading other assets. In addition, if allowed to operate onshore, political event futures markets might eventually grow to the point where they might provide useful hedging opportunities for firms. The currently proposed position limits are likely sufficient for most individuals to hedge their personal exposure to election outcomes.

3. The full potential of political event futures cannot be realized in academic-scale markets or offshore. Despite the utility of the IEM and Intrade, both markets are hampered by the current regulatory environment. An onshore exchange that allowed positions of the size NADEX is suggesting could ultimately reach a scale where it could attract liquidity to contracts that currently do not succeed on Intrade. There are many exciting potential applications of such markets, in research and policy making. Offering contracts on questions of great popular interest (such as Presidential elections) is crucial to attracting investors to an exchange. Once there, they face lower costs of participating in other markets, such as those currently offered by NADEX.

4. Concerns about gambling and manipulation are misplaced. Trading securities whose payoffs depend on political outcomes is no more “gaming” than trading securities whose payoffs depend on commodity or equity prices. Clearly, one can trade any security out of gambling motives, so the key question is whether the subject of these contracts is a “game,” or an economically important event. It is hard to argue that elections are not economically important events.

One might be concerned with two forms of manipulation: outcome and price manipulation. Many individuals have already large stakes in election outcomes; for example, a top executive in a public company will have will have a significant exposure via their equity holdings, as well as through any impact of the election on policies such as tax rates. Many individuals also have substantial exposure to election outcomes via their careers. Given the position limits proposed by NADEX, the market is likely to make at most a small contribution towards the number of individuals with meaningful stakes in election outcomes. One might be concerned with trading by those involved in supervising elections, and it might be reasonable for policy to prohibit trading by those individuals.

Turning to price manipulation, there have been a couple episodes that appeared to be attempt by traders to influence perceptions of an election by manipulating prediction market prices. The evidence suggests that effects on prices are relative short-lived, and effects on perceptions are often counter-productive for the manipulator (e.g., through media stories mentioning the manipulation). Onshore election markets will likely be significantly more liquid, making price manipulation even less attractive. A further protection comes from the fact that the outcomes of interest (election winners) will be linked to prediction market prices only through perceptions. Concern about price manipulation might be better devoted to cash-settled futures, where contracts settle based on other financial market prices.

To summarize, we view markets in securities contingent on economically-relevant events as an innovation that generate positive externalities (by aggregating information) as well as benefits to participants. Innovations with positive externalities should be encouraged by policy makers, not limited. If the Commission has questions about any of the statements made or research mentioned in this letter, it should feel free to contact any of the undersigned.

- Over the long run and many predictions, markets outperform most individuals;
- The more participants there are in a market, the more accurate it is (although there are diminishing returns);
- The more participants there are in a market, the fewer individuals are able to outperform its accuracy.

Read the rest, and subscribe to his new blog.

For info, here’s the Midas Oracle feed at Twitter. I publish there plenty of prediction market news that don’t appear on this blog.

iGenius: How Steve Jobs Changed The World from georgy thompson on Vimeo.

The intelligence and security community also has mixed views. John F McCreary, the Chief Analysis Officer for KGS Security, who had a senior role at the United States Defense Intelligence Agency, notes that the National Intelligence Council successfully trialed prediction markets, until political pressure ended the experiment. However, he believes that, since they “violate the scientific principles of auditability, replicability and irrefutability”, they lack credibility. Retired Naval Intelligence Commander Jennifer Dyer sceptically points out that, “anyone who has bet on sports would be wary of the effects of a large, very specifically motivated group of bettors”. According to Professor Anthony Glees of the University of Buckingham, “there must be a few analysts in the FCO and at GCHQ looking at these sorts of websites but I doubt if they spend much time on them”.

See also the excellent analysis of Mike Smithson.

Roxana Strohmenger (e-mail me at chrisfmasse at gmail dot com to get a copy of the report):

At the end of the day, a prediction market must have sufficient “information completeness” even if the individuals interacting in the market do not, to accurately predict outcomes with a reasonable degree of certainty.

Paul Hewitt:

Prediction markets must have sufficient information completeness to accurately predict outcomes with a reasonable degree of certainty.

I don’t think there is any question that the usefulness of prediction markets has been exaggerated. We don’t hear much from James Surowiecki anymore. So a few of those polled probably indicated that he doesn’t exaggerate the usefulness (at least not anymore). Justin Wolfers isn’t as well known as Robin Hanson in the prediction market arena. This probably accounts for the large size of the “Don’t Know” vote. This leaves the “Yes” category, which would be made up of Robin Hansonites, who believe the slightest possible improvement in predictive accuracy over other methods justifies a significant investment in prediction markets.

If the question had been asked in a prediction market instead of in a poll, such answers would have led us to believe that the market knows little about the subject, if anything at all. Of course it would have been difficult, if not impossible, to create a prediction market in which the “outcome” is an opinion!

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UPDATE: Here’s an example (among many) of the grave problems with prediction markets, which are unreported by the media.

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PDF document.

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Robin Hanson:

I can confirm that this disinterest is real. For example, when I try to sell firms on internal prediction markets wherein employees forecast things like sales and project completion dates, such firms usually don’t doubt my claims that such forecasts are cheap and more accurate. Nevertheless, they usually aren’t interested.

The other take about forecast accuracy.