The Case for Decrimininalization of Prediction Markets

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

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 &#8220-betting exchanges&#8221- 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:

The concept behind using prediction markets as a decision-making tool is simple. &#8220-Shares&#8221- 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 &#8220-terrorist strike market&#8221-, unveiled a little too close to 9/11 to be palatable to the general public. The official name was the &#8220-Policy Analysis Market&#8220-, 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 &#8220-grotesque&#8221- and &#8220-stupid&#8221-, 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 &#8220-gambling&#8221-. 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 &#8220-no-action letter&#8221- 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 &#8220-illegal&#8221- 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.

Jay Graziani
[email protected]

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

Leading political indicators

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American politics does not suffer from a shortage of polls. Zogby. Gallup. Rasmussen. SurveyUSA. Mason-Dixon. Polimetrix&#8230- In an information-glutted world, what matters is not the supply of sources, but the ability to glean trustworthy information from the larger swath of poor data.

Different polling organizations have different strengths and weaknesses. Some use &#8220-tight screens&#8221- to scope out likely voters- others simply sample registered voters, without making any attempt to tighten the survey base to &#8220-likely voters.&#8221- Tight screening is especially crucial to gauge the true state of a primary, when committed base opinion can diverge significantly from less engaged moderate voters, and more importantly, influence those moderates over time to converge to the more partisan perspective. Some use human interviewers, although recently that has given way to IVR (Interactive Voice Recording) polls (the kind where a computer talks to you and asks you to &#8220-press 1 if you will definitely support X, 2 if probably&#8230-&#8221-)

I have found tight-screen, IVR polling to be the most reliable. IVR not only has no marginal cost, but it eliminates all the biases resulting from trying to give the most pleasant-sounding answer possible (the &#8220-sexy grad student effect&#8221- that exaggerated Kerry&#8217-s margin by 15 points in Pennsylvania 2004 exit polling, for example). IVR possible responses can also be randomly rotated from respondent to respondent to eliminate recency biases (first and last responses in a list exaggerated because those are at the forefront of a person&#8217-s memory of the list, not because s/he will vote that way).

The poster-child of IVR tight-screen polling success is Scott Rasmussen&#8217-s Rasmussen Reports. I have only tracked them over the last two election cycles (2004 and 2006), but considering that 2004 was a GOP wave and 2006 a Democratic wave election, I think the data is sufficient to form a valid judgment. Rasmussen&#8217-s track record is simply stupendous. It predicted 49 out of 50 states in 2004 correctly, usually within two percentage points of the actual outcome. In 2006, Rasmussen achieved similarly impressive results &#8212- all the more impressive when you consider that most polling models tend to err in favor of one party or the other. (&#8220-Likely voter&#8221- models tend to favor Republicans, and registered voter-based models tend to exaggerate Democratic strength.)

My other favorite sources include Gallup and Mason-Dixon. Gallup comes closer to the &#8220-registered voter&#8221- model than the tighter Rasmussen model, so Gallup usually lags tighter-screen polls. By election eve, however, the two models usually converge. Gallup&#8217-s election-eve congressional generic vote is hands-down the best in the business. However, their numbers for party primaries have poor predictive value, because they don&#8217-t make much effort to hunt down likely voters.

Differing survey methods can yield very different results. Rasmussen has long shown a much closer Democratic nomination race than most established, &#8220-registered voter&#8221- pollsters &#8212- most recently, it showed a 32-32 tie between Clinton and Obama, with Edwards wallowing 15 points behind. Gallup&#8217-s last numbers tightened drastically to a 31-26 race between Clinton and Obama (Gallup&#8217-s numbers are also hard to compare with Rasmussen&#8217-s because Gallup includes Gore).

Many smart Democrats, notably MyDD&#8217-s Chris Bowers, believe that Gallup and others are mistakenly including lots of &#8220-low information voters&#8221- who simply lag the opinions and thought processes of more-attuned Democratic partisans.

Now that more establishmentarian polling firms are coming in line with Rasmussen&#8217-s results, one can infer that the likely voter/ Chris Bowers theory has gotten the better of the argument.

A survey of pollsters wouldn&#8217-t be complete without knowing which ones to stay away from. Stay away from Zogby and CNN polling. James Carville&#8217-s and Stan Greenberg&#8217-s DemocracyCorps polling outfit is not trustworthy, either &#8212- for example, when they doubled the percentage of blacks in an October 2006 survey sample to bump the Democrats&#8217- generic advantage by 5 points, to reinforce the Democratic narrative of a building wave.

Lastly, partisan pollsters in a competitive election season should always be taken with a grain of salt &#8212- they will use heuristic subtleties to create the best impression possible for their party&#8217-s candidates. Strategic Vision, a Republican outfit, deserves a three- or four-point handicap. Franklin Pierce generated a dubious Romney result for New Hampshire right after its lead pollster, Rich Killion, went to work for the Romney campaign. Such polls should be trusted only as a last resort.

For those of us who wish to divine movements in politics futures, discerning trustworthy data from bad data is paramount. Poll-rigging is the high art of Washington, DC, and as any interest group &#8212- or candidate &#8212- knows, it&#8217-s easier than easy to produce a poll that diverges wildly from reality, if the heuristics are threatening enough.

(cross-posted from my blog, The Tradesports Political Maven)