What should be Done about Manipulation of Prediction Markets?

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In “Is Manipulation Good for a Prediction Market,” Eric Zitzewitz seeks to counter my view that “Deep Pocketed Manipulators are a Prediction Market’s Friend” by suggesting that even if my argument is correct, manipulators still may be a net bad for prediction markets.

I argued that a manipulator ends up subsidizing the participation of informed traders in the market by putting money on uneconomic positions. Eric responded with three reasons that manipulation nonetheless may tend to undermine prediction markets. In brief (and in my words), he said:

  1. People have a distaste for behaviors which violate the spirit of the activity.
  2. The possibility of manipulation, and therefore a biased indicator, will lead decision makers to rely on less efficient methods for information gathering.
  3. Manipulation makes it harder to understand what is happening in the market – manipulation is harder to decode than noise – because the manipulator actively tries to trick the market.

I suspect Eric is right that many people will instinctively oppose manipulation– even when a manipulator&#8217-s actions comply with the explicit rules of the market, the conduct seems to violate the spirit of the enterprise. The manipulators aren&#8217-t betting that they can out predict you, they don&#8217-t care about out-predicting you, they are just using the market in the attempt to buy a signal for which they have a private value. This violation of the spirit of the enterprise probably strikes most people as just wrong.

I think the best response to instinctive opposition to manipulators is &#8220-get over it&#8221-. Hold your nose if you have to, but take as much of the manipulator’s money as you can. (If it troubles you to take advantage of manipulators this way, consider the public good you are doing by imposing a tax on undesirable behavior.)

Another obvious and useful response is to become more skilled at reading market prices, so as to not be readily fooled. In the face of a dramatic price change, consult other exchanges or the prices in related markets in order to gain context. Deploying such sophistication increases the cost and diminishes the usefulness of price manipulation.

The second and third points Eric makes suggests that the possibility of manipulation will reduce the value of prediction markets and lead decision makers to rely on noisier, but less manipulable tools for information gathering. (E.g., use expert forecasts instead of manipulable prediction markets.) In these cases, manipulation leads to real economic losses.

Useful responses here constitute a research program for the academics and market developers: what effects do various rules have on the potential for manipulation? what effects do the rules have on market efficiency? can manipulation be detected by analysis of trading patterns (perhaps something a prediction market could implement itself), or would more extensive investigations be necessary (likely beyond the capacity of a prediction market)?

Prediction markets, when they work well, create something of value: a price that can serve as a useful probability forecast of future events or conditions. If anyone relies on these prices to make decisions of economic significance, that reliance will create incentives for third parties to influence the prices. On these grounds I think the potential for manipulation is inherent in the enterprise.

So what? To some extent the natural balancing effects of the market will tend to counter manipulation, because manipulation provides a subsidy to participation by informed traders, and informed trading counters manipulation. This process is unlikely to be transparent, however, given that manipulation only works if it is disguised. The best response to the residual prospect of manipulation seems to be to resort to informed-rather-than-naive interpretation of prediction market prices, and research into market rules which may enhance usefulness of prediction markets.

8 thoughts on “What should be Done about Manipulation of Prediction Markets?

  1. Chris. F. Masse said:

    “I argued that a manipulator ends up subsidizing the participation of informed traders in the market by putting money on uneconomic positions.”

    I thought you were kidding, back then. I get your point better, this time. :)

    “get over it”: I got your point, but “two months” is difficult to swallow. It took too long in this case to go back to reality.

    I guess that your take is Robin Hanson compatible. We’ll see what ‘The Master Of The Universes’ says.

  2. Max Keiser said:

    The original iteration of the Virt. Spec. technology had a ‘ramdomizer’ that would move prices in ways that would test the conviction of traders to hold or sell their positions… by buying and selling in huge quantities from the virtual inventory; the admin. of the VS had 20 separate ways to introduce constructive randomness in large volume across different market verticals; small cap, large, cap, comedy, drama, heavily traded, lightly traded, etc… to mimic the same random conditions that can and does effect exchanges like the NYSE and test traders conviction; separating ‘weak hands’ from ’strong hands.’ Without this added layer of risk, and verisimilitude, virtual markets go stale quickly and simply mirror the present instead of being able to discount any meaningful trend to extrapolate from.

  3. Michael Giberson said:

    Interesting idea, supplying in effect virtual noise traders to draw in non-virtual informed traders.

    In real money markets the virtual trader would be spending the house’s money on average any time it trades away from fundamental value, but in a play money world the “house money” is cheap.

  4. Chris. F. Masse said:

    The original version of HSX was very interesting.

  5. Max Keiser said:

    re: ’supplying in effect virtual noise’ yes, basically this is correct – and very valuable to determine long range estimates for box office – a year or more in advance – cross indexed against demographic and ‘psychographic’ info. stored in the dbase; crossed indexed again with polling info. to determine who in the dbase is trading with consistent behavior patterns (something we used to have on hsx V.1).

    …let me posit the following; the u.s. dollar, being a fiat currency; created by the virtually unlimited credit available to investment banks; who further gear the availability and profitability in dealing in this virtually free credit/money using virtually risk less interest rate arbitrage schemes such as selling Yen and buying Islandic Krona/New Zealand dollars: are in effect dealing with hollywood dollars – as surely as they are dealing in U.S. dollars. The U.S. dollar, in other words, is a virtual currency whose supply is determined not by supply but by demand.

    …and the VS tech. can be used to manage any monetary system in any currency; virtual (or otherwise) – in a global economy devoid of any gold-backed (i.e., limited availability) unit of currency exchange.

    …the VS tech. as it is currently being used to make weekend box office guesses is like using a nuclear reactor to cook an egg.

  6. Michael Giberson said:

    But with a currency like the U.S. dollar (or Yen or Euro), the markets are naturally “noisy,” so that little would be gained by injecting additional random noise.

    At least as my un-researched, unsubstantiated guess, the approach is most useful in maintaining liquidity and trader interest in relatively thinly traded markets.

  7. Max Keiser said:

    I would disagree. U.S. dollar, Yen, and Euro’s prices are, to a large degree fixed, by central banks.

    Additionally, there are significant problems with U.S. markets re: transparency in all markets – contributing to loss of price-integrity for stocks, bonds, and currencies as ‘black box’ trading subverts natural supply and demand curves; resulting in hyper growth (inflation) in money/credit – with a simultaneous net reduction in volatility…

    How does this manifest on the NYSE? And why is the VS tech. better?

    Groups like Blackstone, who benefit by price fixing by the Fed, have an easy time manipulating prices and they are effectively stepping on the throat of capitalism while picking the system’s pockets.

    While on HSX, by using all the bells and whistles of the VS tech. V.1 (1996-1997) we could counter any attempts by traders (or groups of traders) to manipulate the market by adjusting the ‘ghost trader’ mechanism, what you call, ‘virtual noise’ to increase beta in twenty different ways – and basically get the rogue element to heel without losing order flow.

    As long as we simultaneously maintained price integrity against a known set of values (box office trends) we did not lose the interest of the honest traders who were grateful that we had the means to stop the attempts of the manipulators to ‘manufacture profits’ even though it was obvious that a ‘large player’ was buying/selling in ways that appeared anomalous.

    (note: as I’ve said many times, markets are only truly predictive if they are being manipulated)

    There was also at that time – – back in ‘96-’97 – when we had an HSEC (Hollywood Securities and Exchange Commission) to deal with problems more directly.. but by and large, you can never get rid of those trying to manipulate markets; and the way to handle it, in my opinion, is through enhanced system-generated beta tactics as I’ve outlined. But it’s tough if you have a compliant Fed fixing prices as is the case with the NYSE and related markets.

    Yes, we also had the Hollywood Reserve Bank (HRB) to set rates on HSX V.1 run by Dr. Zeros… (all money accounts and starbonds paid interest from Tom Cruise AAA to BillyBob BBB) But he was not in the pocket of the traders and manipulators as the U.S. Fed is today. (he was in fact, a bot – programmed to look at yield curves, etc. )

    Our HSEC was not a ‘captured regulator’ as the SEC appears to be…

    Net, net, there is not enough ‘noise’ in the American system to stop blatant manipulators like Blackstone flooding the system with cheap credit – that is having the effect of destroying what value is left of the U.S. dollar… And there can be, if managed properly, sufficient noise in the HSX system to enhance price integrity and thwart manipulators.

    keep in mind – – Americans purchasing power is evaporating, and you can thank the Fed and groups like Blackstone for that… while, if managed properly, the purchasing power of the Hollywood Dollar should be going up against the dollar…

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