A decentralized market for predictions!

Blockchain is so trendy right now that it’s become almost more trendy to discuss its limitations. I’m conservative by temperament anyway, so I’ve been reluctant to get on any cryptocurrency bandwagons; but today I’d like to make an exception. Namely, I’m really pretty excited about the possibilities that a few new companies may be opening up for a truly global, decentralized market for predictions. This won’t be new for you old-timers with as much as 2-3 years experience at crypto investment, but for everyone else let me walk through the idea.

Prediction markets have much in common with the apps and websites that already exist for online gambling. There’s also an overlap with financial options trading. All of these embed particular predictive risk distributions in a set of financial exposures, allowing gamblers/investors to exchange risk based on their specific beliefs about the future. But existing institutions today are much more limited than may soon become possible through distributed ledger technology. This is because today’s functionality relies on trusted central operators, such as a bookie or a bank, to keep track of the players, the bets and the stakes, as well as to structure the instruments, pool the funds and handle the payouts. What’s new is the idea to expand and broaden the risk-sharing potential, while disintegrating the scorekeeper and other central functions out into algorithms distributed among a cryptography-secured network like Ethereum.

Decentralization is key to the new concept in several ways.

First, disintermediation will lower costs. At present, gambling and financial options trading both tend to be extremely “fee-rich” activities. Of course participants in our new predictions market will still have to pay a fee for their blockchain transactions (more description below), but it will be trivial compared to the vigorish charged by a bookie or the built-in fees for derivatives in today’s financial industry.

Second, decentralization will increase the choice and granularity of predictions. Today, central authorities create the bets (both gambling and financial) that they believe are in their own interests to offer; and the vast number of potential clients can then only choose from among those available payoff structures. In a future decentralized predictions market, anybody will be free to offer a prediction, and anybody else will be free to buy it or not. In time the new market, as a highly flexible, living, democratic, low-cost system, could expand to address any field of knowledge that (a) has a provable outcome and (b) has at least two players interested in it. Farmers could bet on bad weather, in order to offset their crop losses in case of a cold spell or unseasonable rains. Financial institutions might be happy to take such bets, which would be uncorrelated with securities markets. Similarly, bets could be placed on Californian wildfires or earthquakes, or these could even be traded against tornado or hurricane bets to offset costs and exposures. Distant counterparties might be interested in taking the opposite sides of many such regional predictions – at the right price, of course. A wide but completely unpredictable range of risk exposures might become relevant to at least some small subset of participants.

Decentralization will also have the huge advantage of reducing counterparty risk. At present, if you place an online wager or buy a bank’s call option, you are not only placing your nominal bet; you are also betting that the relevant entity’s liquidity-management processes are such that you will be paid out if you win. The decentralized system will rely instead on a publicly-shared algorithm paying out a previously deposited sum. This takes counterparty exposure out of the equation. Which is actually more important than we tend to believe, for several reasons. First of all, even the most reputable individual institutions can go bankrupt – the only thing preventing bank failure in times of crisis is government, and government has been known to make politically-motivated judgments that may or may not protect your interests. (Think of the Lehman Brothers bankruptcy in 2007 that unleashed the full fury of the Great Recession.) Furthermore, any centralized organization can have system errors, security failures or human operator errors, or can simply be mismanaged; and because of the inherent power imbalance their customers are essentially helpless. (Think of the Wells Fargo account fraud scandal, in which millions of fraudulent accounts were set up, and fees were charged for them, without clients’ consent.) A blockchain-based decentralized ledger system is highly fault-tolerant because of its redundant distribution among many thousands of separate nodes. It will thus be more stable, and because of its lack of any single human locus of management, more free from conflicts of interest than today’s centralized approach.

A blockchain-based predictions market also has the potential for being truly global. Since there is no need for a central headquarters and the payoffs can be in digital currency, the service can easily cross national boundaries. If so, there may be no time-zone, no off-hours, no bureaucratic finger on the scales, no limitation on the number or nature of participants. This means that the market can draw upon the entire population of the world for participation, potentially maximizing the liquidity and variety of available predictions. The system could be richer in choice, more complex and more universal in every way than alternatives offered by a provincial centralized system.

Just a few words on how the system will function.

In simplest form, the idea is as follows: an “issuer” deposits k amount of currency, creating the stakes for a “prediction” that statement x will be confirmable at time y through reference to oracle z. (An “oracle” is an external information source: for example, the feed of the S&P 500 could be used as an oracle for predictions about stock prices.) The issuer then creates two digital tokens, let’s call them black and white, and writes a software contract with two possible outcomes. Outcome 1 pays the full k amount of money to the holder of the black token if, and only if, statement x is confirmed. Outcome 2 pays k amount to the holder of the white token if, and only if, statement x is false.

To give an example, an issuer who is firmly convinced of one of the outcomes, let’s say, Outcome 1, can sell all of his Outcome 2 tokens for whatever the market will bear. This creates cash flow which the issuer considers to be essentially risk-free, merely at the cost of tying up some money in a deposit. Meanwhile, an investor who disagrees with the issuer’s analysis can buy those Outcome 2 tokens at a discount to their nominal value, earning a payoff if the event fails to happen. In the end, both players are given an opportunity to choose their own risk profile.

This is only the most basic possible case. Of course the terms of the prediction contracts could be much more calibrated and sophisticated, and so could the investment strategies of the players. There could be thousands of issuers, complex offsetting trades, scalar tokens rather than just black & white, etc, etc. The vision is that a market like this could develop into a vast global risk-sharing system in which decentralized market forces would gradually equilibrate pricing around the “truest” measures of risk. Insurance policies could be based on it. Financial markets could be stabilized by it. Even governments could hedge some of their exposures.

As mentioned, there are already several companies in this space, attempting to develop into something along the lines I’ve described. Without elaborating on their similarities or differences, the main names I’ve come across are Augur, Gnosis, and Stox. There may well be others, but these three appear to be in various stages of testing and beta rollout.

Spending a little time with Augur was sufficient to reveal what may be the biggest weakness of the concept just at the moment. Namely, a lack of participation and liquidity. So far, it appears to be mostly just a playground of cryptocurrency early adopters, so the majority of predictions seem to be rather narrow (will Ethereum trade above $400 by end-2018, etc); and the vast majority of bets seem to remain empty, failing to find interested parties to take the opposite side. Even when the predictions do find both necessary participants, the amounts at stake tend to be very small – sometimes just a handful of dollars, rarely if ever more than a few thousand. The total capital tied up in Augur predictions at present is apparently only about $1.3 million – not a quantity to give Morgan Stanley sleepless nights.

This may all just be an inevitable feature of any network in its birth phase. Network benefits grow geometrically as the number of participants increases linearly, so with more users we could at some point expect to see these markets accelerating dramatically, offering qualitative improvement in both liquidity and choice. On the other hand, it’s impossible to say when that might happen. Speaking as an investor, it is just as important to be right about the timing of a new project as about its ultimate potential. A lot of people have gone bankrupt before they were vindicated by events.

Other than this question of participant growth, the only real weaknesses I see in the idea have to do with challenges that face most blockchain ventures. For instance, will governments decide not to tolerate this new and unregulated financial sector? Will unscrupulous operators find ways of hacking the new systems, throwing them into disrepute? Will Ethereum (or other blockchain protocols) be able to scale with the new services, or will there be a constant plague of bottlenecks? There are many questions still to be resolved, but most of them pertain to the crypto space in general, not specifically to predictions markets. On balance, I think this is an idea whose time is coming.

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