The Regulation and Value of Prediction Markets

Prediction markets are important information-aggregation tools for researchers, businesses, individuals, and governments. This paper provides an overview of why prediction markets matter, how they are regulated, and how the regulation can be improved. The value of prediction markets is illustrated with discussions of their forecasting ability and the characteristics these markets possess which give them advantages over other means of forecasting and information aggregation. The past, current, and future regulatory environment is surveyed.

Prediction markets are exchanges where individuals trade what are sometimes called “event contracts.” Broadly speaking, these contracts specify some future event with different possible outcomes, define a payment structure based on those outcomes, and state a date when the contract expires. An example would be a contract that specifies “Barack Obama wins the US presidential election in 2012” and that pays out $10 after the election if that outcome occurs or $0 if it does not occur. The direct purpose of such markets is to allow individuals to bet on uncertain future events; however, these markets also produce prices that can provide valuable information. In fact, these markets are sometimes specifically created to gather the information that their prices reveal, rather than for the utility of trading to market participants.

Prediction market prices have informational value because they aggregate the beliefs of market participants and reveal what the market overall forecasts are the odds of the event at hand occurring. For example, if the aforementioned contract is selling at a price of $5.50, it means that the market thinks the odds of Obama getting reelected are 55 percent. In the run-up to the election, the media and anyone interested in a market-based measure of the odds of Obama’s reelection could watch the prevailing prices in this market.

Prediction markets have generated forecasts for a wide variety of purposes beyond elections: who will win the Academy Awards, sales of a particular product, and how bad the flu season will be. This information is useful not only to traders wishing to profit from their forecasting and information-gathering abilities, but to researchers, businesses, governments, and others. Yet, despite the variety of ways that these markets have proven valuable, the regulatory environment for prediction markets in the United States has been more skeptical than supportive. In particular, the recent blocking of movie box-office and political prediction markets indicates a worsening regulatory environment.

This paper provides an overview of how we learn from prediction markets, the benefits they generate, their advantages compared to other forecasts, and the regulatory environment. It then makes suggestions for regulatory reform.

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