What are prediction markets and do they cross the line between investing and gambling?

Published On: February 28, 2022Categories: Latest News6.2 min read

Prediction markets are a niche, relatively new format for binary, yes-or-no, contracts that allow individuals or companies to take a financial position on the outcome of events. For example, a prediction markets provider might ask “will the price of oil hit $125 by the end of March?”, or “Will Joe Biden’s Infrastructure bill be passed by Congress?”.

The Economist magazine recently wrote on the cult following prediction markets have attracted “amongst finance types who rave about the value of putting a price on any event, anywhere in the world.”

Critics are convinced prediction markets are little more than gambling and will remain niche. Others see them as a potentially significant new asset class that will allow investors to both hedge exposure to the outcome of events and provide valuable insight into the likelihood of events by making financial markets actors put their money where their mouths are.

In this blog, we’ll explore both positions while addressing the question of whether prediction markets are a valuable new tool for investors or purely gamification of ‘investment’ that will tempt retail investors into unsustainable losses.

What exactly are prediction markets and how do they work?

Prediction markets pose a simple, binary question of the outcome of an event like “will Boris Johnston still be the UK’s prime minister in April?”. Participants enter the market by answering either “yes” or “no” to the question posed and backing up their opinion with what some would describe as a bet and others as an investment.

The best-established retail-facing predictions market is run by the U.S. start-up Kalshi, which recently won backing from big name investors including Sequoia Capital, who led a $30 million Series A funding round a year ago. Other investors in the raise included Charles Schwab, chairman of Charles Schwab Corporation, Henry Kravis, co-chairman & co-CEO of KKR, SV Angel and previous investors including Neo and YC Continuity.

The announcement of the successful funding round came shortly after the Commodity Futures Trading Commission (CFTC) approved Kalshi as a Designated Contract Market (DCM) in November 2020, making it one of just 16 DCMs in the U.S. The approval made Kashi the first predictions market platform without regulatory limits on the scale of activity, opening the doors to potential participation from larger and even institutional investors.

Kalshi’s prediction markets offer a ‘buy in’ price based on the popularity of a particular answer. For example, to answer yes to the question “Will quarterly nominal U.S. GDP growth be above 3% in Q1 2022” costs a stake of $0.39 and to answer no costs $0.65. Those who make the correct prediction will receive $1 back when the market closes. That would be a profit of $0.61 for those who answered yes and a profit of $0.35 for those who answered no.

Those who answered wrong lose their stake when the market closes with their losses funding the winnings of market participants with the margin of difference the platform’s profit. Kalshi’s profit is very similar to the spread or margin a non-market making spread betting or CFDs broker earns. Kalshi has no financial interest in the outcome of the prediction markets it offers and earns based on the number of market participants.

The price is based on the respective number of participants answering yes or no, with the balance creating something comparable to a betting co-efficient. If more participants are predicting yes than no, the cost of taking a yes position is respectively higher and resulting profit from a correct prediction smaller. The more contrary a prediction, the more profitable it will be if it turns out to be correct.

What’s the difference between prediction markets and binary options?

If prediction markets sound similar to the binary option platforms that were heavily marketed to retail investors in recent years, before regulatory crackdowns such as limiting the size of positions and liquidity requirements for brokers squeezed the sector’s profitability and raised barriers to entry, it is because they are.

Prediction markets are a kind of binary option. The main difference is that they focus exclusively on the outcome of particular events rather than the price direction of financial securities such as commodity derivatives, currencies and stocks.

Like traditional binary options, prediction markets are zero sum – market participants either win or lose the full value of their original cash position. However, prediction markets fall outside the jurisdiction of financial markets regulators like the SEC (Securities and Exchange Commission) because they don’t, or shouldn’t, influence securities prices in other markets – a key difference from traditional binary options on the price direction securities.

The advantages of prediction markets

The advantages of prediction markets are relatively straightforward.

  • They give participants another way to potentially profit from the outcome of global events other than taking traditional investment positions on the asset classes their outcome is likely to influence.
  • More direct exposure to the outcome of events. A trader’s position on oil futures based on the outcome of one event, such as Russia’s invasion of Ukraine, could be derailed by another unforeseen event such as OPEC members significantly increasing output to compensate for sanctions. The profit earned from a right answer on prediction markets, such as “will Russia invade Ukraine in the first half of 2022” would not be compromised by any other event.
  • Prediction markets offer investors with exposure to one event outcome the opportunity to hedge against being wrong by taking the opposite position. For example, an investor that had built up positions in construction companies because of the benefit that Biden’s infrastructure bill would have on the sector could take a prediction markets position on the bill not passing. If it passed, a loss would be taken on the prediction market, reducing overall gains. However, if it didn’t pass, the prediction market position would result in a profit, softening losses accrued as a result of the primary position.

Weaknesses of prediction markets

Criticisms of prediction markets include:

  • The most popular prediction markets to date, such as the question of whether Biden would nominate a replacement for Powell as head of the Federal Reserve, have still only attracted up to 230,000 before it expired. That puts the market, at best, at a similar level of liquidity to that for midcap and smallcap stocks.
  • The zero sum nature of prediction markets is less attractive than stock markets. Because the companies whose shares are traded on stock markets are generally engaged in profitable ventures, the market’s overall value has risen over years and decades despite periods of decline. That overall gain in value benefits all market participants. Prediction markets, by contrast, have clear winners and losers with the profits of the winners financed by the losses of other market participants. The system moves capital around rather than encouraging its growth.
  • Regulatory threat. While prediction markets remain niche and not considered to influence the price direction of securities in other markets regulators are likely to take a light touch approach. A leap in popularity and more money circulating in prediction markets could change that and raise the concern they might impact other markets, attracting the attention of regulators and leading to the kind of restrictions that hit retail-facing binary options brokers.

Prediction markets are, on many levels, very similar to betting markets such as sports markets. But they also have potential benefits for investors such as offering a new way to hedge other positions, which is a potentially crucial difference.

Investment is often compared to gambling and there is certainly an element of chance to how most investments pan out. However, the zero sum nature of prediction markets do make them closer to straight gambling than more traditional approaches to trading and investing.

Despite that, prediction markets do seem to tap into a growing trend towards society having firm opinions on how events are likely to turn out and a willingness to back positions up with financial exposure. It could be a growing trend over the next few years with more investors seeing the market’s potential and backing start-ups like Kalshi.

Whether that is a good thing or not for prediction market participants, especially retail participants, remains to be seen.

About the Author: Jonathan Adams

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