The fundamental concept behind the prediction markets — that is, speculating on the outcome of future events — is very old indeed, but it’s only been in the last two decades or so that the idea gained prominence with mainstream, retail investors.
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The prediction markets first captured the general public’s imagination during the 2004 presidential election, when it was discovered that an obscure futures market called Iowa Electronic Markets (IEM) proved more accurate in predicting the election’s outcome than national polls conducted by professional polling organizations. The IEM, along with another market called Intrade, were pioneers in the prediction markets, and since that time they’ve only become more popular. Today, all investors can benefit by being aware of these influential markets, whether or not they plan to trade in them.
— What are the prediction markets?
— How do the prediction markets work?
— Why are prediction markets so accurate?
— Are the prediction markets safe?
— What are the most popular prediction markets?
— Prediction markets: The takeaway.
What Are the Prediction Markets?
Prediction markets are also called event futures markets and information markets. They are a unique type of futures exchange that facilitates speculation on the outcome of all sorts of common events. They differ from traditional securities markets in several important ways.
Rather than representing an equity ownership or debt obligation in a company the way a stock or bond does, every contract or investment, if you will, on a prediction market is linked to a specific future event or a specific piece of information that will be revealed in the future.
As mentioned above, one example of an event covered by prediction markets is the presidential election. An example of a data point or piece of information that might be speculated on is consumer price index numbers. Conceptually, any future event or piece of information that can be documented and verified could be the subject of a prediction market contract.
How Do the Prediction Markets Work?
Investors buy and sell contracts that pay a predetermined amount of money — a specific payout — if a future event comes to pass.
For instance, a contract could pay $1 if U.S. jobless claims exceed 235,000 in August. If an investor buys that contract for, say, 75 cents, they stand to make a 25% return if the number comes in at over 235,000 and they collect a dollar. The counterparty — the investor who sold the contract — would lose 25 cents, or the same 25%, if they held onto the contract and were forced to pay out the full dollar in the event the jobless numbers came in low. Either investor, however, could lock in gains or limit losses by selling, or buying back the contract on the prediction markets before it expired, providing, that is, they could find a willing party.
Prediction contracts are dynamically priced in real time whenever the markets are open. Prediction exchanges use active supply and demand data and sophisticated algorithms to determine market prices. If confidence in an event increases, that is reflected in the demand for that contract, and prices rise. If confidence falls, the price of the corresponding contract will fall in conjunction.
The key to the success of prediction markets is the aggregation of information. A huge amount of knowledge, news, opinions and information is represented in the collective mind of the market. Incredibly, this aggregate intelligence often ends up making very accurate predictions.
Why Are Prediction Markets So Accurate?
The prediction markets derive their uncanny accuracy through a concept sociologists and statisticians call “the wisdom of crowds.” By tapping into the knowledge base and informed opinions of a large, diverse and independent population that is highly incentivized to make a correct prediction, such markets are usually much more accurate than any relatively small number of experts.
The keys to the wisdom of crowds are independence, decentralization and reward.
When a significant enough reward or compensation is offered and there is no central authority dictating or influencing the decision-making process, participants will do their honest best to come up with a correct answer, as long as they are acting independently with freedom from social pressure.
The result is that the overall collective judgment of the crowd tends to be remarkably accurate.
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Are the Prediction Markets Safe?
The prediction markets are not regulated by the Securities and Exchange Commission (SEC) because prediction markets don’t strictly meet the criteria for being considered a security. Instead, these innovative marketplaces are overseen by the Commodity Futures Trading Commission, better known in the industry as the CFTC.
Investors should not, however, assume that prediction markets are regulated as robustly or to the same extent as the stock and bond markets are. Rather than active regulatory supervision, most prediction markets operate under a regulatory scheme called a CFTC no-action letter. This allows them a high degree of self-regulation as long as they run a fair market, avoid deceptive practices and abide by the same basic rules as other futures markets do.
The no-action letter says that the CFTC won’t take any action — that is, enforcement action — if the markets keep their noses clean. If they step out of line, however, you can bet they will be prosecuted to the full extent of the law.
Like any market and any investment, there are risks. The prediction markets are relatively immature and may be more susceptible to market manipulation and fraud. Also, there are no guarantees of liquidity like those investors are used to on the major stock and bond markets. It is possible to buy a contract but have trouble selling it if there are few — or no — takers. In other words, be very careful if you decide to trade predictions.
What Are the Most Popular Prediction Markets?
The previously mentioned IEM is the forerunner of today’s prediction markets. While its contemporary counterpart Intrade was forced to close its doors for financial and regulatory reasons, the IEM is still going strong. That market is used mostly for academic research and to test the predictive power of the masses, but there are several other platforms that are quite popular among prediction speculators.
PredictIt
PredictIt may be the most popular and important of the mainstream prediction markets. It’s a real money event futures market where speculators can buy and sell shares or contracts that have an interest in a variety of future events.
PredictIt focuses on political events, such as who will be the eventual candidates for specific elective offices and who will ultimately win them. This market is known for having an intuitive and user-friendly interface and for covering a wide range of political markets.
Polymarket
Polymarket is probably the most technologically advanced prediction exchange. It uses state-of-the-art algorithms, Ethereum blockchain technology and artificial intelligence (AI) to give market participants a secure and transparent trading experience.
Polymarket covers a broad spectrum of events that include politics, health, finance and even pop culture.
Kalshi
Kalshi is the predictions market for the speculator who wants the highest degree possible of security, regulation and transparency. This market was the first and may be the only fully regulated platform approved by the CFTC. Being fully regulated means that Kalshi operates under the same stringent regulations that traditional derivative markets do.
Traders also appreciate the broad spectrum of markets this exchange covers. It includes geopolitical events, world economic indicators and even the weather.
Prediction Markets: The Takeaway
The prediction markets are a fascinating part of our overall trading and investing environment. They offer insight into the opinions and psychology of the investing public that anyone can benefit from even if they never place a trade.
Understanding the concepts and the mechanisms behind the prediction markets can enhance an investor’s experience in the financial markets and beyond. In short, the prediction markets can help almost anyone make better, more informed decisions about money, politics and our world.
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What Are Prediction Markets? Predictit, Polymarket and Kalshi originally appeared on usnews.com
