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A recent article in the prestigious academic journal Science (May 16, 2008, Vol 320, p. 877-8) once again makes the case for regulated prediction markets, more commonly known as “betting exchanges” to online gamblers. The authors make the case that such markets are useful in forecasting future events with less error than traditional measures such as polling. This argument is hard to ignore, with the authors including 21 top economists from such esteemed institutions as Yale, Stanford, Berkeley, and the University of Pennsylvania. Notable among the authors is Justin Wolfers from the Wharton School of business at UPenn, an economist who has gained notoriety in gambling circles due to his work on such topics as NBA referee bias (highlighted in a May 2008 article from MajorWager: http://www.majorwager.com/index.cfm?page=27&show_column=660).

The concept behind using prediction markets as a decision-making tool is simple. “Shares” are made available on an open market, and the participants use their capital (and the promise of profits) to make predictions on future events, which is incorporated into the share price. In general, information tends to be widely dispersed, and a market allows wide-ranging opinions to be gathered and consolidated into a market-wide prediction. In other words, an infinite amount of opinions can be aggregated, and an open market with potential for profit provides an incentive for individuals to make their opinions publicly known.

Prediction markets always get more than their fair share of press near the end of the 4-year U.S. Presidential election cycle. The Iowa Electronics Market, housed at the University of Iowa, is perhaps the most well-known. The authors of the Science paper show that, in the week immediately preceding the Presidential elections from 1988 through 2000, the Iowa Electronic Markets erred by an average of only 1.5 percentage points from the actual vote results, while the traditional Gallup poll was off by 2.1%. Numerous other studies have shown the superiority of markets compared to other forecasting tools.

Of course, there have been some dust-ups regarding prediction markets in the past, most notably the “terrorist strike market”, unveiled a little too close to 9/11 to be palatable to the general public. The official name was the “Policy Analysis Market“, and it was established by the Pentagon to act as a prediction market for Middle East political events. It was quickly scuttled after heated comments from U.S. Senators, calling it “grotesque” and “stupid”, due to the perception of using catastrophic events such as assassinations as profit-making tools. Regardless of its political correctness (and the misinformed opinions of a few politicians), such a prediction market still holds value as a glimpse into the collective mindset of everyone with an understanding of political currents in the region. Utilizing such a prediction market as a component of foreign policy decisions may have ultimately spared the U.S. much grief in Iraq.

In recent years, prediction markets have grown beyond academic and government roles. Dublin-based InTrade is rapidly growing and provides many more options than the Iowa Electronic Markets. Others such as MatchBook have focused more on sporting contests, but provide coverage of other events as demand calls. Of course, those outside the U.S. have access to the largest betting exchange of them all, the massive European markets of BetFair. The success of these exchanges speaks to the public interest and feasibility of prediction markets.

One factor holding back the growth of online prediction markets is their close association with the quasi-legal world of sports betting and internet casinos. InTrade has been fairly proactive in this regard, spinning off from Tradesports to clean up its corporate slate, but it is still knee-deep in the legal sludge surrounding offshore “gambling”. All have to deal with the legal and financial hurdles of operating offshore.

The authors of the Science paper propose that clarification of internet gambling laws is needed to exploit the benefits of prediction markets within the United States. Clearly, the Unlawful Internet Gambling Enforcement Act (UIGEA) of 2006 is one such mechanism restricting the widespread use of prediction markets. Another is the Commodity Futures Trading Commission (CFTC), the regulatory agency which oversees futures markets in the U.S. The CFTC has provided a “no-action letter” to the Iowa Electronic Markets, an assurance that they will not seek any enforcement action against the exchange. However, this protection is not absolute and may not trump state and federal law if challenged. The Science authors propose a number of legal reforms which will allow prediction markets to begin to gain acceptance within the U.S. financial regulatory structure.

By no means does the Science article condone large-scale public markets, at least not initially. They take a (typically academic) conservative approach, recommending new legal framework to allow for the establishment of small markets with limited scope so as to evaluate the promise and use of prediction markets. But baby steps are going to be a necessity in the growth and acceptance of regulated public markets.

Clearly, there are negative aspects to financial markets, and regulation certainly has its place. Bear Sterns, Enron, the S&L scandal of the 80s, and the current housing bubble all caused tremendous loss of wealth resulting from missteps in the financial markets. The current oil crisis is due at least in part to speculation, leading to the introduction of no less than 9 separate bills in the U.S. Congress seeking tougher regulation over the trading of commodities. However, the existence of problems in the financial markets does not necessitate their dissolution. Likewise, prediction markets are sure to encounter bumps in the road, but their utility should far outweigh the risks.

Should prediction markets be legalized in the U.S.? Almost certainly. They would have benefit across numerous industries, from business decisions to political policies to financial forecasting. Unfortunately, this would require building an unlikely bridge over the Puritanical moral moat placed around gambling in the U.S. But there is no inherent difference in betting on who will win in an election than what the price of oil will be in 6 months, or what the S&P 500 will close at on a particular date. Distancing prediction markets from “illegal” gambling, and instead likening them to regulated financial markets, will be a necessary first step towards broader acceptance.

The academic groundwork on prediction markets has already been laid, and offshore exchanges have begun to turn these concepts into functioning businesses. As these markets grow and begin incorporating more diverse opinions, we can expect their success rate at predicting the future to only grow. To restrict such a promising tool simply due to its perception that it is a gambling outlet is silly indeed.

6-25-08
Jay Graziani
MajorWager.com
graziani@majorwager.com

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[This article is cross-posted from Major Wager.]

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BAD NEWS: There is a bunch of chaps at BetFair who are monkeying around with the concept of prediction markets.

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THEIR INTENT IS NOBLE.

Mark Davies, Betfair’s Managing Director Corporate Affairs, said:

Whilst these climate markets are experimental, they demonstrate a commitment to use our assets to innovate and make a difference.

If sincere (as I take it), then their statement may have been inspired by the mission statement of the original starship Enterprise.

Space, the final frontier. These are the voyages of the starship Enterprise. Its five-year mission: To explore strange new worlds. To seek out new life and new civilizations. To boldly go where no man has gone before.

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IMPACT OF THEIR PRESS RELEASE

So far, 8 days after their P.R. output, only 2 web publications took the bait. [UPDATE: 7.] Does not strike me as an intergalactic success.

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ANALYSIS OF THEIR GLOBAL WARMING PREDICTION MARKETS

#1. Their choice of the term “decision markets” is not appropriate, here.

• Decision markets are conditional prediction markets intended (by some idealists) to be used as a decision-making tool replacing human decision makers.
• Decision-aid markets are conditional prediction markets intended to be used as a decision-aid tool advising human decision makers.
• Prediction markets are markets for contracts that yield payments based on the outcome of a partially uncertain future event. That’s what those BetFair climate markets are, actually.

#2. Their intended clientèle is imaginary. Their press release said:

This is the ideal place for experts, academics, businesses and interested parties to put money behind their views on long-range forecasts.

The thinking that socially valuable prediction markets (long-term, or not) are for the deep thinkers and the decision-makers is the most common mistake I see among the wannabes in our field. The prospects for any event derivatives are always of the same two species: the casual bettors and the sophisticated traders. (Beware of the economists who propose those markets; they don’t trade, wrote Steve Levitt of Freakonomics.)

#3. Out of their 3 event derivatives on global warming (HSBC Investable Climate Change Index, ECX CFI Futures Contract, and Highest and Lowest UK Temperature), the first two, at least, are flawed products.

• Absence of advanced indicators that the market makers can follow to inform their trades;
• Absence of polarizing subjectivity prompting the casual bettors and lite traders to perform uninformed transactions.

No wonder that the HSBC and ECX prediction markets have seen no trade, so far. (As for the temperature prediction markets, only 33 US bucks have been put in there.)

#4. My prediction is that the first two BetFair Global Warming prediction markets (HSBC Investable Climate Change Index and ECX CFI Futures Contract) will fail miserably.

#5. MY CONCLUSIONS:

• From the above, it seems that BetFair are aware, internally, that they should aim at the elites who value the prediction markets.
• They did not hire the best, or did not assign the best to this problematic.
• There is a wall between BetFair’s betting exchange approach and our prediction market approach (adopted by InTrade). This wall should be torn down —for the good of both parties.
• BetFair shall complement their traditional marketing with our prediction market branding. The only way is to focus on the prediction market science and the people who produce it —our good friends the US-based economists (like Eric Zitzewitz et al.).

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APPENDIX

HSBC Investable Climate Change Index – PDF file

European Climate Exchange

BetFair’s Global Warming prediction markets: HSBC Investable Climate Change Index, ECX CFI Futures Contract, and Highest and Lowest UK Temperature.

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NEXT: PIECE OF EVIDENCE #2 THAT BETFAIR-TRADEFAIR ARE MINDING THE PREDICTION MARKETS.

NEXT: InTrade’s global warming prediction markets are more socially interesting than BetFair’s ones.

So I figured out I should write up a little something, especially since I saw this morning that my previous blog post (Is GMU professor Robin Hanson an inventor, an innovator, or… a complete loser??) was yesterday’s most downloaded stories.

#1. Robin Hanson has very high expectations. (More on this in a moment.)

#2. Robin Hanson is a truthful person.

Mix the two elements together and you get a “bombastic statement” ( ), which surprised many people.

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Robin Hanson‘s statement (yesterday):

I’ll take credit for creating some ideas the world has found useful, but I have completely failed both the market test and the academic test. That is, I can’t convince any business to let me join them to deliver my ideas at scale, and I can’t convince any top journal to publish my ideas.

The comment was made on this Mike Linksvayer’s blog post.

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Robin Hanson’s Big Idea on Prediction Markets:

- “Decision Markets” (PDF): A set of decisions (in the form of conditional prediction markets) is traded. The decision that gets selected in the end by this complex market mechanism is the one that the organization (a corporation, a democracy) applies to itself.

- I am not an academic expert, but I think that his “decision markets” and “futarchy” papers have not been accepted by top academic journals.

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Chris Masse’s Take on Decision Markets:

- Intrinsically, it’s all logical and a great idea.

- The problem is that there is no need for the decision markets. The executives and politicians like to make decisions themselves. With all due respect to my readers, I’ll have a graphic metaphor. Trying to sell the concept of decision markets to executives and politicians is like trying to sell very sophisticated, mechanized, high-performance dildos to young men; there is no need for that in the market. For some mysterious reason, the young men insist on performing “that”… using their own instrument.

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Robin Hanson, in the prediction markets timeline:

a) Robin Hanson set up and run a rudimentary prediction exchange (a market board, PPT file) in January 24, 1989. The outcome to predict was the name of the winner of a Poker party.

b) Until evidence of the contrary, it seems that Robin Hanson was the first to set up and run a corporate prediction exchange —at Xanadu, Inc., in April 1989. See: A 1990 Corporate Prediction Market + Anonymity is important for employees trading on internal prediction markets.

Robin Hanson: “I started a market at Xanadu on cold fusion in April 1989. In May 1990, I started a market there on whether their product would be delivered before Deng died.”

c) Until evidence of the contrary, it seems that Robin Hanson was the first to set up and run a bunch of imagination-based prediction markets (what Chris Masse class the “X Universes”) —See the Murder Mystery Evening described by Barney Pell —circa June 8, 1989. Here’s Robin Hanson’s design of a non-electronic, rudimentary prediction exchange: Market Board – PPT file.

d) Until evidence of the contrary, it seems that Robin Hanson was the first to write a paper on prediction markets created and existing primarily because of the information in their prices (as opposed to markets created primarily for speculation and hedging).

Could Gambling Save Science? – (Reply to Comments) – by Robin Hanson – 1990-07-00
Market-Based Foresight: a Proposal – by Robin Hanson – 1990-10-30
Idea Futures: Encouraging an Honest Consensus – (PDF) – by Robin Hanson – 1992-11-00

e) Robin Hanson godfathered the Foresight Exchange (created in 1994) and NewsFutures (created in 2000).

f) Robin Hanson invented the (debatable) concept of decision markets (PDF) —a decision-aid tool and/or decision-making tool (one application: firing CEOs).

g) Robin Hanson invented a new market design, the Market Scoring Rules, a mix between CDA and Scoring Rules —now in use at Inkling Markets, Washington Stock Exchange, and MicroSoft Research.

h) For more information, see Robin Hanson’s classification of markets.

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Overall, Robin Hanson’s problem is that he did bet the farm on “decision markets”, which is a good idea with no market for it.

Among others, I am very bullish on the imagination-based prediction markets (the “X Universes”), which Robin Hanson invented, and which Mike Linksvayer rates as “moronic”.

#2. Decision-Aid Tool – Decision markets are conditional prediction markets intended to be used as a decision-aid tool advising human decision makers.

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Am I nailing well the Robin Hanson ambiguity here?? It seems to me that in his papers (Decision Markets – Futurarchy), he is in case #1. At other times, I spotted him in case #2. (((I need to take another look at his slides and talks to be sure he was in case #1, as I thought at the time.)))

My Take: Case #1 will never happen. Complete B.S. from libertarians intoxicated by science-fiction. For a good reason: human decision makers take pleasure in making decisions —they will never outsource decisions to a market mechanism. Give me a break. Waste of time to listen to that stuff. Case #2 is interesting—although it requires faith in markets. I wonder how many decades or centuries will pass before we see a bunch of bold CEOs testing conditional prediction markets as a decision-aid tool. You’ll notice with me that they aren’t many conditional prediction markets, out there, these days, on the public prediction exchanges (betting exchanges). Is it because the traders are not interested (as I was told) or because the public exchange managers lack interest in research (as one might suspect)?