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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HISTORY: Prediction Markets Timeline

For an updated version of this document, see the “-paged”- Prediction Markets Timeline.

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CHRONOLOGY &amp- HISTORY: Prediction Markets Timeline

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Feel free to post a comment or contact me, and I’-ll correct or add a factoid. Thanks.

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#1. Historical Prediction Markets

According to Paul Rhode and Koleman Strumpf, prediction markets almost never got it wrong forecasting the 19 presidential elections that took place from 1868 to 1940. (PDF)

#2. The three Iowa Electronic Markets founders (Robert Forsythe, Forrest Nelson and George Neumann)

“-We ran our first market in 1988. We didn’t have regulatory approval at that point so we were restricted solely to the University of Iowa community. We had under 200 traders and under $5,000.”- –- [Robert Forsythe - PDF file]

- [CFTC's no-action letter to the IEM - 1992 - PDF file]

- [CFTC's no-action letter to the IEM - 1993 - PDF file]

#3. Robin Hanson

a) Robin Hanson set up and ran 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. See the Murder Mystery Evening described by Barney Pell —-circa June 8, 1989.

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 concepts of decision markets (PDF) and decision-aid markets.

g) Robin Hanson invented a new market design (for the 2000-2003′-s Policy Analysis Market), the Market Scoring Rules, a mix between CDA and Scoring Rules —-now in use for most enterprise prediction markets and public, play-money prediction exchanges. Note that MSR is mainly used in a one-dimension version, but many researchers are interested in its combinatorial version.

#4. Other Pioneering Public Prediction Exchanges (Betting Exchanges, Event Derivative Exchanges) and Inventors/Innovators/Entrepreneurs

a) The Foresight Exchange was founded on September 22, 1994 by Ken Kittlitz, Sean Morgan, Mark James, Greg James, David McFadzean and Duane Hewitt. The Foresight Exchange is a play-money prediction exchange (betting exchange) managed by an open group of volunteers. It pioneered user-created and user-managed, play-money prediction markets. Any person can join the Foresight Exchange and interact with the rest of the Web-based organization. An independent judge (independent from the owner of the claim) should be appointed among the volunteers. [Thus, it's not "DYI prediction markets".]

b) The Hollywood Stock Exchange was founded on April 12, 1996, by Max Keiser and Michael Burns. See the patent for the Virtual Specialist. For more info, see: Is HSX the “longest continuously operating prediction market”??? –- REDUX

c) BetFair was founded in 1999 by Andrew Black and Edward Wray, and was launched in England in June 2000. As of today, BetFair is the world’-s biggest prediction exchange (betting exchange, event derivative exchange).

d) NewsFutures was founded in March 2000 and launched in September 2000 in France and in April 2001 in the US by Emile Servan-Shreiber and Maurice Balick. See: NewsFutures Timeline. NewsFutures was the first exchange to let people buy or sell contracts for each side of a binary-outcome event. The advantage of this design is that it avoids the need for “-shorting”-, a notion that tends to confuse novice traders. NewsFutures later extend that approach to deal with n-ary outcome events while implementing automatic arbitrage.

e) TradeSports was launched in Ireland in 2002 by John Delaney. InTrade was later purchased and became a non-sports prediction exchange (betting exchange). As of today, InTrade is the biggest betting exchange on the North-American market —-where betting exchanges are still illegal. As for TradeSports, it closed at the end of 2008, alas.

#5. The Policy Analysis Market Brouhaha

a) Robin Hanson was the main economist behind the 2000–2003 US DoD’-s DARPA’-s IAO’-s FutureMAP–Policy Analysis Market project. (For this project, Robin Hanson invented a new market design, the Market Scoring Rules.) On July 28, 2003, two Democratic US Senators called for the termination of PAM, the the big media gave airtime to their arguments, and the US DOD quickly ended the IAO’-s FutureMAP program.

b) The second branch of the 2000–2003 US DoD’-s DARPA’-s IAO’-s FutureMAP program was handled by the Iowa Electronic Markets and was intended to predict the SARS pandemic. (This project later gave birth to IEM’-s Influenza Prediction Market.)

#6. James Surowiecki’-s The Wisdom Of Crowds

a) James Surowiecki’-s book, The Wisdom Of Crowds, was published in 2004.

b) Impact of The Wisdom Of Crowds.

#7. Recent Public Prediction Exchanges (Betting Exchanges, Event Derivative Exchanges) and Inventors/Innovators/Entrepreneurs

a) US-based and US-regulated HedgeStreet was launched in 2004 by John Nafeh, Russell Andersson, and Ursula Burger. A designated contract market (DCM) and a registered derivatives clearing organization (DCO), HedgeStreet is subject to regulatory oversight by the Commodity Futures Trading Commission (CFTC). In November 2006, IG Group bought HedgeStreet for $6 million.

b) Inkling Markets was launched in March 2006 and co-pioneered (with CrowdIQ, which later bellied up) the concept of DIY, play-money prediction markets.

c) In September 2006, TradeSports-InTrade was the first prediction exchange (betting exchange, event futures exchange) to apply Chris Masse’-s concept of X Groups. See: TradeSports-InTrade prediction markets on Bush approval ratings.

d) HubDub was launched in early 2008 and is the second most popular play-money prediction exchange, behind HSX.

#8. Enterprise Prediction Markets

a) 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.

b) In the 1996–-1999 period, HP ran a series of internal prediction markets to forecast the sales of its printers.

c) Eli Lilly sponsored 10 public, industry-level prediction markets in April 2003 (on the NewsFutures prediction exchange).

d) Eli Lilly began using internal prediction markets in February 2004 (powered by NewsFutures).

e) Google‘-s Bo Cowgill published about their use of internal prediction markets in October 2005.

f) Since then, many companies selling software services for enterprise prediction markets have been created.

#9. Disputes Between Traders And Exchanges

a) The scandal of the North Korean Missile prediction market that erupted in July 2006 is, as of today, the biggest scandal that rocked the field of prediction markets.

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