The Case for Decrimininalization of Prediction Markets

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

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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&amp-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&amp-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&amp-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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Based on the analysis of some 600,000 official Iraqi documents seized by US forces after the invasion and thousands of hours of interrogations of former officials in Saddams government now in US custody, there is no evidence Saddam Hussein had ties to Al Qaeda.

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Read the previous blog posts by Chris F. Masse:

  • Business Risks & Prediction Markets
  • Brand-new BetFair bet-matching logic proves to be very controversial with some event derivative traders.
  • Jimmy Wales accused of editing Wikipedia for donations.
  • What the prediction market experts said on Predictify
  • Are you a MSR addict like Mike Giberson? Have nothing to do this week-end? Wanna trade on a play-money prediction exchange instead of watching cable TV? Wanna win an i-Phone?
  • The secret Google document that Bo Cowgill doesn’t want you to see
  • BetFair’s brand-new matching-bet logic is endorsed by the Chairman of the Midas Oracle Advisory Board.

Austan Goolsbee on Iraq and the Collective Wisdom of Bond Markets

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Austan Goolsbee, writing in the New York Times, discusses Michael Greenstone’-s paper (discussed here at Midas Oracle in September) that examines the market for Iraq’-s bonds for an assessment of the long-term future of the Iraq government. Goolsbee’-s quick conclusion: “-But global financial markets have been monitoring the war for months, and with remarkable consistency, they have concluded that the long-term prospects for a stable Iraq are very bleak.”-

It wasn’t until Professor Greenstone began examining the financial markets’ pricing of Iraqi government debt that he had his eureka moment. It was immediately clear that the bond market — which, historically, has often been an early indicator of the demise of a political system — was pessimistic about the Iraqi government’s chances for survival.

First, some background …- the Iraqi government issued about $3 billion of new bonds in January 2006. These dollar-denominated bonds pay 2.9 percent twice a year and mature in 2028, paying the face value of $100.

To say the least, the market for these bonds is not robust: as of last week, a bond with a face value of $100 was trading at around $60. Professor Greenstone calculated that, from the markets’ standpoint, the implied default risk over the life of the bond was about 80 percent.

The important point is that anyone who owns one of these Iraqi bonds has to decide each day whether the Iraqi government is likely to be functional enough to make its debt payments, or will default along the way. All else being equal, if the surge policy is effective, it ought to be raising the market price of these bonds.

Bondholders “aren’t politically motivated,” Professor Greenstone said. “They don’t have to rationalize their previous statements or justify their votes from years past. All they care about is whether there will be a functioning Iraq in the future such that they will receive their payments.” At a certain price, most securities will find a buyer, and there are still buyers for Iraqi bonds. But the price they are willing to pay is very low.

Goolsbee tosses in a few examples which show, in his words, ”- the collective wisdom of financial markets has proved remarkably adept at evaluating events and predicting the future, even the turning points of war“-:

During the American Civil War, for example, when Confederate forces lost at Gettysburg, Confederate cotton bonds traded in England dropped by about 14 percent. During World War II, German government bonds fell 7 percent when the Russians started their counterattack at Stalingrad in 1942, and French government bonds rose 16 percent after the Allied invasion at Normandy in 1944. Many such examples of the prescience of financial markets have been documented by economic historians.

Of course a few cherry picked examples, while suggestive, should not be considered conclusive.

Chris Masse, in a post about negative comments on the war by a just-retired high ranking military officer, said:

We can’t rely on retirees to tell us the truth. We need an anonymous information aggregation mechanism that gives an incentive to people who come forward with advanced information: the prediction markets.

While bond markets might be useful as a stand in for prediction markets, presumably well-designed prediction markets could provide a somewhat more articulated position than can be extracted from a twenty-year bond market.

NOTE: Greenstone’-s paper, “-Is the ‘-Surge Working? Some New Facts,”- is available from the SSRN.