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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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Dartmouth College professor Eric W. Zitzewitz

Ah. Our good doctor has leaned to smile (as opposed to posing as a prison guard, on his old Stanford website). Good.

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Eric Zitzewitz (at LinkedIn):

Current
- Associate Professor of Economics at Dartmouth College

Past
- Assistant Professor of Economics at Stanford Graduate School of Business
- Business Analyst at McKinsey & Co.

Education
- MIT
- Harvard College

He got tenure ahead of schedule. Congrats.

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Eric W. Zitzewitz at Darmouth

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Much better pic than the one displayed on his old Stanford page (where he looks like a prison guard).

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Eric Zitzewitz at Midas Oracle:

Volumes on InTrade are way up from 2004.
Is Manipulation Good for a Prediction Market? Accuracy Isn’t Everything.
An Employee Stock Option Prediction Market
Manipulation can affect prices.
XM-Sirius merger
Thoughts on Weather Bill
Prediction Markets for the CFO
Forget the polls and computers, let markets pick the top 2.

[...] Point-shaving is a crime of opportunity, and the opportunity comes from the structure of sports betting markets. The commissioners of the major sports need to address these systemic issues. A transparent and well-regulated gambling sector could easily out-compete the unregulated offshore bookmakers and the illegal onshore ones. More important, it would reduce the number of betting scandals we’re likely to see in the future.

See the previous Midas Oracle blog post on the UK Gambling Commission’s effort to suppress the quirky bets.

Pssttt… Justin Wolfers cites the name of a Stanford student (sir Jonathan Gibbs) in his Op-Ed. –> His Royal Highness Jonathan Gibbs is already registered on Midas Oracle, and I hope he will is going to tell us more about his “intriguing” paper (PDF) soon.

Jay Hopman: Using Forecasting Markets to Manage Demand Risk

Jay Hopman
Lab/Group Name: Intel IT
Job Function: Researcher, Enterprise Process Optimization

Bio
[...] He joined ISTG Research in 2001 after working in IT Product Engineering, Business Operations, and Strategy & Technology. Jay serves as ISTG Research liaison to the Intel Research High Volume Manufacturing Committee (HVMC) and participates in the virtual ISNG Research Staff. His research focus is developing better models and methods to support demand and supply planning and forecasting. He manages the Demand Generation / Product Transitions Research team, working with researchers at Stanford, MIT, and U. of Miami to complete case studies of Intel product transitions and develop new approaches and solutions.

Previous: INTEL BUSINESS CASE: INTERNAL PREDICTION MARKETS DO WORK.

Much better pic than the one displayed on his [old] Stanford page (where he looks like a prison guard).

Eric Zitzewitz at LinkedIn

UPDATE: Eric Zitzewitz = Associate Professor of Economics at Dartmouth College – Greater Boston Area, MA, USA

Eric W. Zitzewitz at Darmouth

- Inkling Markets’ Nate Kontny: n8.tumblr.com – Sorry to learn that he broke some rib(s). Wish him the best.

- George Tziralis: tziralis.tumblr.com

If you want a free blog, I still recommend WordPress.com. You should own your domain name (yourname.com).

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Psstt… Mister Nate Kontny, if you want to dissipate your pain for a few minutes, here are two links:

- The JibJab funny-like-hell videos –

- Steve Jobs‘ commencement speech at Stanford U.