Prediction Market

Predicting the outcome of an event and betting on it as a form of entertainment and monetary gain is traced to the immense interest on papal appointments in Italy in the sixteenth century. To be sure, it helped that betting or gambling is not considered a sin in the Bible! This led to creation of unorganised prediction markets, which have been filtered and now become more organised channel for predicting the outcome of political, sporting and other such events.

What is Prediction Market?

A prediction market is where participants or people can trade contracts that reward them based on the outcomes of unknown future events. In simple terms, prediction markets are exchange-traded markets created for the purpose of trading the outcome of events.

These markets have been used to reasonably forecast the outcome of political contests, sporting events, and even economic trends. The market prices generated from these contracts can be visualised as a kind of collective prediction among market participants.

The most notable feature of prediction markets is the accuracy of the forecasts they produce. Overall, prediction markets are a fascinating tool for forecasting the future and understanding the collective beliefs of market participants.

Understanding a Prediction Market

Prediction markets involve a collection of people speculating on a variety of events—exchange averages, election results, quarterly sales results, or even gross movie receipts. The price in a prediction market is a bet that a particular event will occur. It also represents an estimated value that the person placing the bet assigns to the parameters being considered in the bet. These prices are based on the individual beliefs of traders, and the market prices of the contracts are considered as the aggregated belief.

Prediction markets are also known as betting markets, and they allow people to place bets on binary outcomes of future events, from presidential elections to entertainment award wins, sports matches, and asset prices.

Uses of Prediction Markets

Prediction markets represent a wide variety of thoughts and opinions, making them quite effective as a prognostic tool. They can benefit from the wisdom of crowds by collecting and weighing the predictions of a large number of traders, providing a market-wide forecast that is generally more reliable and balanced than any individual forecast.

Prediction markets can be used to create crowd-sourced forecasts, collecting predictions from dozens or hundreds of traders rather than a handful of experts. They can efficiently aggregate a plethora of information, beliefs, and data, and obtain truthful and relevant information through financial and other forms of incentives. For example, financial institutions pay attention to prediction markets on things like central bank rate hikes.

Example of Prediction Markets

Prediction markets are open markets where specific outcomes can be predicted using financial incentives. Some examples of prediction markets include PredictIt, which predicts events in the financial and political markets, and Polymarket, which is built on the Ethereum network with Polygon technology and enables users to bet on the outcome of events such as presidential elections, entertainment award wins, sports matches, and asset prices, including crypto price predictions. Other examples of prediction markets include Augur, which is a decentralized prediction market platform built on the Ethereum blockchain.

Types of Prediction Markets

There are several types of prediction markets. The most common form of a prediction market is a binary option market, allows traders to make conditional bets based on time on predefined values of assets, such as stock indices, commodities, forex, and events. Binary options are a type of financial instrument that allows traders to make conditional bets based on time on predefined values of assets, such as stock indices, commodities, forex, and events. Binary options carry a premium, a set strike price, and an expiry date similar to standard exchange-traded options. Broadly there are four types of prediction markets: Continuous Double Auction, Automated Market Makers & Market Scoring Rules, Real Money vs. Play Money, and Other Crowdsourced Forecasting Methods. Though there are certain spinoffs, like Play Money Markets and Blockchain-based Prediction Markets.

Continuous Double Auction

In Continuous Double Auction, traders place bids and offers on contracts, and the market price is determined by matching the highest bid with the lowest offer. It is known for its efficiency in price discovery, and it is used in many financial markets, including stock exchanges, commodity markets, and foreign exchange markets.

Automated Market Makers & Market Scoring Rules

These two use algorithms to determine the market price of contracts. The former is used in decentralized finance (DeFi) applications and maintain liquidity by automatically adjusting the price of assets based on supply and demand. The latter is used to overcome the thin market and irrational participation problems in prediction markets.

Play Money Markets

Here traders use virtual or play money to trade contracts instead of real money. Play Money Markets are used for educational purposes, to teach people how to trade and invest in financial markets without risking real money. It is often used in stock market games, where participants can trade stocks, bonds, and mutual funds across beginner, intermediate, and advanced levels.

Blockchain-Based Prediction Markets

This one uses blockchain technology to handle the odds, the pool of funds collected from participants, and the payouts at the end of the event. In a blockchain-based prediction market, smart contracts are used to completely negate human interaction and all the errors that come with it. These bring increased transparency, security, and trust among users and are more accurate at predicting future events. 

Real Money vs. Play Money

Real Money markets involve the use of actual money to trade contracts, while Play Money markets use virtual or play money. But Real Money markets are generally considered to be more reliable and accurate than Play Money markets because they involve real financial incentives and are more likely to attract serious traders.

Other Crowdsourcing Methods

These involve forecasting methods such as surveys, polls, and prediction tournaments. These platforms operate by using the opinion of the crowd or the people at large but outside the mechanism of the stock market.

Benefits of Prediction Markets

Prediction markets have many advantages over traditional forecasting methods. One of the main benefits of prediction markets is their ability to quickly incorporate new information and adjust to changing circumstances. They are largely efficient and impervious to manipulation, as it is difficult for any one participant to influence the market price.

Blockchain-based prediction markets have additional advantages over traditional prediction markets, including increased transparency, security, and trust among users. Smart contracts are used to counterbalance human interaction and all the associated errors. They are more trustworthy than individuals and organizations that could come tagged with their own vested interests and opinions.

FAQs

What Role Do Prediction Markets Play in Economics?

Prediction markets play an important role in economics by providing crowd-sourced forecasts that are generally more reliable and balanced than any individual forecast. Prediction markets can be used to create crowd-sourced forecasts, collecting predictions from dozens or hundreds of traders rather than a handful of experts.

What Is a Decentralized Prediction Market?

A decentralized prediction operates on a decentralized platform, such as a blockchain. It enables people to buy and sell contracts based on future events without the need for a central authority controlling who sends what to whom. Under this, all information regarding the market is publicly available to everyone, and there is no central authority that can withhold information to give them an advantage over the market participants. They are more secure and transparent than centralized prediction markets, and are less susceptible to manipulation.