Episode 13: You’ve Been Liquidated
The good, the bad, and the ugly of prediction markets
This week we are talking about prediction markets. From gambling to synthetic derivatives to assassination markets, we will be covering the good, the bad, and the ugly.
A prediction market is a market used to trade on the outcome of events.
The market prices the likelihood of the outcome of the event. It can take the form of a binary market (“Will the price of ETH be above $100 on December 31 2019?”) or open-ended (“What will the price of ETH be?”).
If this basically just sounds like gambling to you… well, you’d be right. That’s what it is. But prediction markets have a lot more to their history and areas of application than just betting on who is going to win the Premier League.
Let’s go beyond gambling. It turns out economists have been thinking about this stuff for some time. Ludwig von Mises, wrote about prediction markets (or information markets) in the 1920’s. He argued planned economies became distorted in part because information about supply and demand and pricing was not open. The economist Friedrich Hayek also wrote along these lines in the 1940’s in the context of free market efficiency. More recently, economist Robin Hanson proposed an idea for governing using prediction markets. People could bet on their belief of whether or not a proposal or policy would better their society. He called this futarchy.
There are lots of applications of prediction markets. Perhaps none bigger than Wall Street’s application: synthetic products.
Synthetic means fake. In the context of finance, a synthetic product is one that is engineered to simulate (or fake) a certain asset or financial position while altering certain key characteristics.
For example, if I’m an investor and I want exposure to the price of European tech stocks but don’t want to take on Euro currency risk, I could probably pay a banker to structure a synthetic derivative for me that achieves that goal. This is BIG business for investment banks.
Usually what actually happens behind the scenes here is the banker basically just enters a bet with you on behalf of the bank (“I bet the price of European tech stocks will go up over the next year if you control for the value of the Euro”) and the banker will then do his best to hedge out that risk (by going short European tech stocks and long Euro). The banker will charge you not only for the hedge he’s put on but also a big fat spread as a cushion for the risk he can’t account for and also a fee in addition to that for his troubles.
With this combination of money, greed, and rent-seeking it’s pretty easy to imagine where the overlap with cryptocurrency might live here. The trouble with creating a decentralized prediction market, however, lies in all parties coming to an agreement on the source of truth. This is called the oracle problem.
Augur, crypto’s original prediction marketplace, takes a cool approach to solving this problem by leveraging its own token. Token holders are incentivized to stake their tokens on the correct, real, or true outcome.
Augur is not alone in creating a protocol for prediction markets. Numerai, a hedge fund with a very cyberpunk aesthetic, has also taken on this area with Erasure. Erasure enables individuals or entities to prove that they have made accurate predictions in the past and to stake their own money on the accuracy of their present and future predictions. This would allow, for instance, a dorm room data scientist to offer her stock market predictions up to a big fund manager. Moreover, she could prove through her timestamped track record that she had been making good predictions for months or years prior.
Prediction markets are one of the few real blockchain applications that are fully implemented and getting used today. These markets are global in nature and benefit from censorship resistance — meaning they are a good fit for crypto.
That said, prediction markets are far from widely used yet and still have yet to be stress tested. We have yet to see what will happen when parties with non-monetary incentives start to get involved in these hyper-rational markets!