Why prediction markets aren’t popular

[Nick Whitaker]

Link post

I argue with J. Zachary Mazlish that, among other things, regulation is not the primary obstacle to prediction markets, so philanthropic dollars should not be used to lobby for their deregulation.

[lukasb]

Thanks for sharing!

Here’s the part I found most interesting [emphasis mine]:

Rather than regulation, our explanation for the absence of widespread prediction markets is a straightforward demand-side story: there is little natural demand for prediction market contracts, as we observe in practice. We think that you can classify people who trade on markets into three groups,⁶ but each is largely uninterested in prediction markets.

• Savers: who enter markets to build wealth. Prediction markets are not a natural savings device. They don’t attract money from pensions, 401(k)s, bank deposits, or brokerage accounts.

• Gamblers: who enter markets for thrills. Prediction markets are not a natural gambling device, due to various factors including their long time horizons and often esoteric topics. They rarely attract sports bettors, day traders, or r/​WallStreetBets users.

• Sharps: who enter markets to profit from superior analysis. Without savers or gamblers, sharps who might enter the market to profit off superior analysis are not interested in participating. They also largely don’t need prediction markets to hedge their other positions.⁷

In our view, much of the volume that exists on financial markets comes from money that is not attempting to beat the market by correcting pricing errors (like an asset that is underpriced compared to its likely returns), but money that wants to be in a market for other reasons, like investing in companies that will deliver a long-run return (as savers do), or making a sports event more exciting (as gamblers do). In both instances, market participants’ demands are relatively inelastic.

There are two separate but important features of this inelastic demand for market participation. The first feature is just that the market is by default large, which means there are significant profits to be made if a sharp can find a way to make prices more efficient.

The second feature is that inelastic participants are often willing to pay a small premium for market access. But in doing so, investors or bettors of these kinds create a pool of surplus that smart participants try to obtain, which in turn drives prices toward efficiency. Think about depositing your paycheck in a retirement account – the goal is to build a diversified portfolio for long-term gains, not to eke out every cent of possible return. Sharps compete to buy and sell stock to these savers at just above and below the best price. They get to arbitrage the market, while savers happily get easy access to liquidity.

It’s not just savers that pay for market access: gamblers are willing to make negative expected-value bets for the fun of betting. Even sharps are sometimes willing to pay to hedge their positions and reduce risk.

Markets become efficient when making them efficient is profitable. Large markets and markets where people will ‘pay’ expected return for access create those conditions. In our view, in prediction markets, no type of market participant – savers, gamblers, or sharps – is clamoring to be in the market, so there is no strong incentive pushing the market toward efficiency.

[Ozzie Gooen]

Happy to see this discussion moving forward.

Some quick points:
1. I largely agree about being skeptical about conventional prediction markets, compared to their hard-core enthusiasts. I came to similar conclusions a few years back, in part because I noticed that prediction markets were legal in the UK but no one used them.
2. The main value (that we care about) of prediction-markets ultimately is an externality. I’m not very optimistic about subsidies for them.
3. Obviously, prediction tournaments like Metaculus /​ Good Judgement Project, are not prediction markets, as described here.
4. All that said, I think that formal prediction markets do clearly produce some value and can fill a useful niche. For example, they could allow for hedging in areas that provide useful information to the public. In some of these cases, to the public, this is could be a literal epistemic free lunch. Sure, it’s not all the epistemic information you might ever want, but it is something. This is equivalent to the fact that the stock market provides a lot of great information to the public, for free, but that the information is limited+specific.