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The Promise of Prediction Markets

Prediction markets are forums for trading contracts that yield payments based on the outcome of uncertain events. There is mounting evidence that such markets can help to produce forecasts of event outcomes with a lower prediction error than conventional forecasting methods.

-”The Promise of Prediction Markets,” K.J. Arrow, et al.,Science, May 16, 2008

The title of this post is taken from an article in the May, 2008 issue of Science magazine, written by nearly two dozen leading economists in support of legalized prediction markets. The authors argue:

The range of [prediction market] applications is virtually limitless—from helping businesses make better investment decisions to helping governments make better fiscal and monetary policy decisions.

They cite the use of internal prediction markets by entities ranging from the Department of Defense to Eli Lilly, Google, and France Telecom. But despite the wide-spanning social net benefit from the implementation of such a powerful tool, regulation on both the federal and state level, more or less prohibit the creation of prediction markets. The authors of the article encourage regulators, namely, the Commodity Futures Trading Commission (CFTC) to create separate rules from the gambling industry for prediction markets, thus providing a “safe-harbor” for market creators.

In the six years since this open letter was published, to many of the authors’ dismay, not only has the CFTC failed to create safe-harbor rules, but the 2010 Dodd-Frank Act empowered the Commission to regulate prediction markets even further “in the public interest.” In April 2012, the CFTC rejected a presidential election prediction market application by Nadex, an already-registered derivatives market. Every other application the Commission has received has experienced the same fate.

So if a registered prediction market cannot be developed, what possibilities exist for the creation of this proven forecasting tool? There are two:

  1. Just as with the lottery, the government could develop its own regulated prediction market. The CIA has even described PMs as “A ‘Standard & Poors 500 Index’ for Intelligence”
  2. A distributed autonomous organization (DAO), much like Bitcoin. Such decentralization has allowed bitcoin to thrive the world over, despite irking bankers and regulators alike.

The problem is that (1) already failed. DARPA’s “Future Markets Applied to Prediction” (FutureMAP) prediction market platform “was cancelled in the summer of 2003,” according to the Central Intelligence Agency’s Puong Fei Yeh, “under a barrage of congressional criticism.”

Option (2), however, is where matters get interesting. And that’s where we’ll begin next week with “Why Augur?”

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