Prediction Markets — Smart Contracts, Brilliant Bets

I think we can safely say 2020 didn’t quite turn out the way most of us had expected when the calendar turned from December 31st into January 1st about a year ago. Few envisioned a pandemic that would shut down world travel, grind business to a halt, and see governments around the world pumping money into economies that fell off a cliff. However, in a year of enormous unpredictability, one thing that remained entirely predictable was the U.S. election and Biden’s victory at the polls, at least according to many sportsbook and prediction markets, who consistently had Biden beating Trump by about what was his final margin of victory, even on the state level.

According to online betting website US-Bookies.com, the odds-on betting favorite won 98% percent — 49 out of the 50 states contested in the presidential election. Georgia was the only state the bettors got wrong. Biden surprised many pundits by beating Donald Trump in Georgia. The margin was small, only 11,779 votes, but Biden became the first Democrat since Clinton in 1992 to carry Georgia. In the electoral college vote, the only one that matters in the world’s oldest standing democracy, as some call it, Biden was forecast to win the election with 310 electoral college votes by US-Bookies.com. Biden won the White House with 306 electoral votes, an Idaho short of matching the betting markets (although he had no chance in Idaho). All-in-all, the prediction markets were far superior to the pollsters.

The contract is a security, not a bet, which allows for greater liquidity. Although many online betting companies have ‘cash out’ options for bets, they only exist between two parties, the bettor and the sportsbook. The prediction market contract can be sold into a pool of buyers, which can be measured in the thousands or even considerably more for highly coveted bets like a contract on the U.S. presidency. This, of course, means the pricing will be a more accurate assessment of the market’s supply and demand. “This liquidity, in turn, ought, in theory, to aid price discovery, since participants with relevant insight or information can take advantage of what they deem to be temporary mispricing rather than having to lock in their bets,” says Allen Farrington in his article On Prediction Markets And Blockchains. “Where this gets interesting,” Farrington contends, “is in interpreting what the prices mean, and therefore what a mispricing is, and what ‘the expectations of participants’ are.” The trick to making money in the prediction market or with a sportsbook is to find an inefficient market, a market that is mispricing a bet, a market that is missing some critical information.

Do Your Homework

Sometimes all it takes is a lot of ingenuity and a little legwork. As Kevin Modesti explains in his article In ‘prediction markets,’ the right political opinion can pay off big, “Before the 2008 Republican National Convention, presumptive GOP presidential nominee John McCain announced that he would introduce his choice for a running mate on Aug. 29 in Dayton, Ohio. The prediction market Intrade posted a long list of contenders for investors to consider.” One particular gambler we’ll call ‘Ken’ saw a profit opportunity.”He went to work trying to answer a practical question: Which prominent Republican politicians could be in Dayton on Aug. 29? Phoning their offices one by one, asking for their public schedules, he eliminated Tim Pawlenty, Bobby Jindal, Joe Lieberman, Mitt Romney, and others — some obvious picks. The day before the scheduled unveiling, Ken tried another trick, checking a website listing flights to and from the nearest airport. It showed a private jet coming from Alaska,” explains Modesti. This plane was carrying the governor of Alaska, Ken surmised, and he bought some low-priced shares in Sarah Palin. He soon celebrated a $25,000 win when McCain unveiled her as his vice-president a few days later.

Of course, this took a lot of intelligence and a fair amount of legwork. A private jet coming out of Alaska sets off alarm bells because it’s a pretty rare occurrence, unlike one coming out of Baton Rouge, Saint Paul, Stamford, or Salt Lake City, but opportunities like this abound in election season. Hindsight is twenty-twenty, but indeed Biden was a punt at around 15 cents heading into South Carolina, a state dominated by African American democratic voters. He had the endorsement of the beloved South Carolina congressman Jim Clyburn. Just as importantly, he was the man many voters in the Palmetto State believed was instrumental in helping Obama become the first black president of the United States. Coattails are long when you tear down racial barriers. Biden won South Carolina in a rout and never looked back. Once again, hindsight is twenty-twenty, but inefficiencies abound in markets with little data, as presidential elections markets do. Biden will be only the 46th man to become president, and these only happen once every four years.

Smart Contracts: Brilliant Bets

There is nothing worse than being forced out of what you believe to be a winning bet early because your sportsbook is shutting down due to legalization issues. This happened to all of Betfair’s clients in China and the two special administrative regions of Hong Kong and Macau in September 2020. Bets were paid off mostly at a fair price as early ‘cash out’ bets, but still, no one wants to be forced out of a wager before its time.

This wouldn’t have happened with a blockchain-backed bet. As Farrington explains, “Given that any number of law enforcement agencies around the world could shut down an attempt to scale a prediction market on a whim, it is pointless for any corporation to devote capital to such an enterprise. If built on a public blockchain (and designed robustly to avoid extraneous attack vectors), this concern disappears as it is unrealistic that the network can be compromised, barring a worldwide clampdown on any and all Internet activity, which seems rather out the question.”

“Prediction markets based on blockchains remove the counterparty risk to the bookmaker because there is no bookmaker in the first place: this role is automated,” says Farrington. This means that there are no restrictions on what kinds of futures markets can exist: the relatively undercapitalized can make a market in anything at all. On the one hand, this means that insurance, derivatives, and gambling can be done slightly more efficiently, but this brings us back to the point above about the network effects: this is not enough. It would have to be much better than just a little bit to have any disruptive potential on this account.

Farrington provides some interesting events to dabble in futures contracts: “Maybe an Uber driver realizes they make 3 times as much on days it rains and wants to hedge against it being too sunny for too long. Maybe a surf instructor has exactly the opposite problem and happily sells the future to the Uber driver buyer.” Or perhaps someone working in real estate in New York who also has a mortgage on your house there feels overleveraged and fears a COVID-like event that destroys both their career and the value of their home, offers Farrington.

Prediction markets would also cut out any questions of liability. Although insurance can be a pretty cut-and-dry endeavor, SCGM, Inc. in Texas — the company behind Star Cinema Grill, Hollywood Palms Cinema, and District Theatre — found itself in dire financial straits when COVID hit. Even though the company had taken out a $1 million pandemic insurance from Lloyd’s of London underwriters, the insurer denied the claim, stating COVID-19 was not listed as a disease in the policy, a highly dubious position. The plaintiff argued that while COVID-19 was not specified, the policyholder was covered against pathogens that include mutations of a SARS-associated coronavirus, which COVID-19 most assuredly was. With a blockchain-backed contract, Lloyd’s of London would have had no case, and the contract would have been paid out once COVId-19 was officially named and announced by the World Health Organization.

One of the things lost on many people who look down on gambling and prediction markets is that they give bettors the ability to hedge. “A blockchain prediction market allows for the exchange of futures contracts by providing a relatively enormous platform for participants to find one another rather than having to go through one of a select few central exchanges, which are necessarily very large to begin with due to the subtle network effects of that business,” says Farrington. In a world gone mad, as it was in 2020 in many ways, getting a little longshot prediction right can be a highly profitable endeavor and help ease the pain and stress of such an extraordinarily eventful year.

“Maybe you are an investor in Tanzania and want to cross-hedge your exposure to Indonesian and Peruvian investments. A bank will do this for you, but for an enormous fee that is likely to outweigh any portfolio benefit,” says Farrington. The prediction market ideas are almost endless, and no matter how far out they are out there, finding a market for the bet will be a lot cheaper than going to the likes of Lloyds, JP Morgan, or any other pricey market maker.

Wisdom of the Prediction Market Crowd

Of course, predictions markets are fallible. “A few hours before the votes in the 2016 Brexit referendum were counted, betting markets like Election Betting Odds estimated a 20 percent chance Britain would vote to leave. Before the US election in 2016, the markets gave Trump about a 35 percent chance of being elected,” explains Kelsey Piper in her article for Vox. But so were the polls, and there will always be outliers in every human endeavor.

Farrington speaks of two public blockchain projects creating decentralized prediction markets: Augur and Gnosis. If everything goes right, Lepricon will soon be the third playing in this space. As for the betting options, they never run out. Once all the votes were tallied from election day 2020, it was clear Biden was the winner but for some others, like the two senators from Georgia, the race had only just begun and a run-off election was set for early January. The beauty of prediction markets is the offerings just never end. If blockchain can become a part of it, these offerings could be anything one can think of that creates a market.

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