Prediction markets

Platforms such as NewsFutures, the Hollywood Stock Exchange, and the Foresight Exchange operate using play money, albeit play money that can sometimes be converted into prizes. Thus these platforms evade anti-gambling legislation by operating as games of skill.

The consulting firms running corporate prediction markets have taken the same approach as experimental economists on campuses: they have subsidised participation, allowing everyone to leave a winner, albeit to varying degrees.

Finally, two markets that we are aware of, Economic Derivatives and Hedgestreet, have obtained regulatory approval to offer trading of innovative futures contracts. Hedgestreet started in 2004, and Economic Derivatives, a joint venture by Deutsche Bank and Goldman Sachs that runs markets in economic numbers, has been operating since 2002.

In Australia, the legal environment has prevented prediction markets from establishing themselves in most states. In addition, there is a concern that for major bookmakers such as Centrebet, trading on economic derivatives would bring them into conflict with the Australian Stock Exchange and the Australian Futures Exchange.

Since Australian betting agencies already handle significant sums of money for elections and major sporting events, relaxation of the regulation governing such markets would bring little risk, but a significant public benefit.

Future applications

Prediction markets are extremely useful for estimating the market’s expectation of the probability of a particular event occurring. Markets on election outcomes serve a useful public purpose in providing an up to the minute barometer of the probability that a given party or candidate will be elected. For firms whose business is exposed to a large degree of political risk, our advice is to follow the betting markets, not the opinion polls or the televised talking heads.

Prediction markets doubtless have their limitations, but they may be useful as a supplement to the other relatively primitive mechanisms for predicting the future like opinion surveys, politically-appointed panels of experts, hiring consultants, or holding committee meetings.

With the exception of a short-lived attempt by a United States defence agency to create information markets, governments have shied away from directly operating them. This may be a sensible policy stance - yet politicians should also recognise that if the valuable information generated by trade in these markets is not fully internalised into the profits earned by these private firms, prediction markets will be underprovided. In the area of economic derivatives, it might well be in the interests of government departments to fund the creation of markets that aggregate traders' expectations of future economic releases.

Indeed, the Reserve Bank of Australia already closely tracks the difference in yields on inflation-indexed bonds and non-indexed bonds - effectively a prediction market on future inflation.

More generally, the highly restrictive stance that governments have taken towards regulating prediction markets does not appear to take any account of the informational benefits of such markets. Would there be a public benefit from liberalising gambling regulations to give prediction markets a freer hand? You bet.