Risk Markets And Politics

Sunday, January 08, 2006

Prediction Market Predictions

Succumbing to the basic human needs to predict and create lists, which are especially prevalent near calendar changes, here are some forecasts for 2006:

Prediction markets can do more than provide information and entertainment. This will be a major theme this year, especially for exchange businesses like Intrade.

  • Further emphasis will be placed on the risk-sharing possibilities of prediction markets. This focus has a double practicality, as it sets the stage both for robust liquidity and favorable regulation. A central issue in the development of sports- and entertainment-related markets in the United States will be the degree to which they provide a hedging function for pre-existing risks. Intrade or another firm will approach film studios and offer them a way to partially insure box-office receipts through prediction markets. Regardless of the outcome of these kinds of endeavors, the regulatory environment will remain more favorable in Ireland, the U.K. and Australia at year-end. The term "peer-to-peer insurance" will gain traction.

  • Interest will grow in applying prediction markets to matters of public choice. Prediction markets tied to tax- and subsidy-related legislation provide strong incentives for "latent" groups to form and give special interests a way to hedge their legislative fortunes. This thread of development will gain momentum before the more ambitious Futarchy, which needs to address how hedging behavior will skew informational interpretations of price.

  • There will be a paper published which models market size and liquidity based on hedging utility, degree of risk-aversion/seeking among participants and the volatility of contracts.

  • Attempts to seriously use prediction markets as a new form of intellectual property will encounter no-trade conditions. Leaving aside publicity bets, in some cases these problems may be overcome by identifying third parties for whom the market's information is valuable enough that they are willing to subsidize liquidity.

On the informational side, corporate internal prediction markets will thrive, led by NewsFutures. Additionally, firms will begin to explore using external prediction markets to replace traditional public test groups. This movement will eventually lead to surprising results in fields as diverse as modeling, advertising, music, publishing, and consumer products. (Fortunately, the sort of network technology that makes this possible will also relieve excessive commoditization.)

2006 will see intensified competition and consolidation among exchanges. Here are some highlights relating to firms involved with prediction markets and alternative derivatives:

  • Intrade's EBOT will face stiff competition from the CME, whose alternative derivative offerings will expand. A major advantage of online prediction markets is their ease of use and expanded client-base versus traditional futures markets. With the EBOT restrictions, Intrade loses this advantage and has to face an entrenched, much larger competitor. Consider one example. Intrade has indicated that it is interested in hosting a weather-related market, but in 2005, CME's US weather derivatives market grew over 350% to 214,501 contracts in volume. Intrade will of course offer distinct contracts, but the only real factor that will keep CME from competing in any new markets will be the latter deeming them too small or controversial to be worth the effort.

  • Plagued by low volume, Hedgestreet's business model will begin to morph into that of a broker. They will explore ways to provide look-alike contracts to CME and NYMEX futures. Instead of hosting markets, they will sell micro contracts internally hedged by the standard futures. The advantage of the smaller contracts to customers will be accessibility and size, while Hedgestreet will capture relatively large commissions. Eventually, the public will be able to hedge energy and real-estate prices as part of standard online banking interfaces. Possibly, the large exchanges will take a more active role in somehow capturing the business of smaller hedgers; given a widely distributed and inexpensively maintained interface, this could be feasible.

  • Investment banks and the CME will have conversations concerning equity earnings-release auctions which would work much like the current economic derivative auctions. This would give sell-side entities a more efficient way to compensate their equity researchers, and would give CME another toe in the equity waters. Unfortunately, it is too easy for the large companies that would likely be covered by such markets to manage earnings by a penny or two each quarter.

  • If CME doesn't actually tender a NYMEX bid, expect NYMEX's IPO to be delayed.

  • Mark Cuban will take an interest in a prediction market business.

Macro-economic and miscellaneous predictions related to risk:

  • Asian reserve policies, savings- and exchange-rates will be the main drivers of inflation, volatility and interest rates, with the latter three moving together in the same direction.

  • Regarding housing, the first point is a real yawner: interest rates will be the main determinate of prices. The second point is more arcane and relates to the new housing futures. As mentioned in the last post, self-fulfilling prophecies tend to be most robust when there is bad information. "Bad" here can mean a few things: 1) Wrong, as when an unfounded rumor causes a bank run, 2) The correct information is insufficiently disseminated, or 3) The correct information isn't released frequently enough. Since the housing futures will settle based on an apparently quarterly index, and there will be massive pressure to sell the index as a function of hedging, there is some chance, however small, that the new futures market will weigh on housing in a self-fulfilling manner.

  • Energies and metals will continue to do well, both on the back of Asian demand and as systemic and inflationary hedges.

  • Byron Wien will check the online prediction markets before making his 2007 surprise list. He cites at least a 50% chance that Mitt Romney will emerge as the likely 2008 candidate at some point during 2006. Tradesports gives Romney a 10% chance of winning the nomination. Experts will continue to overestimate small probabilities as a function of reputational "call-buying" which is made "profitable" by selection bias in public memory.

  • Chatter about the threat of a systemic derivatives "blow-up" in the financial industry is overstated. There will be none in 2006 barring a massive natural disaster, terrorist attack, or - positively - a major technological breakthrough such as a cure for cancer or fusion.

Don't forget the Prediction Markets Summit - East, which will be held in New York on February 3rd. Intrade will take this occasion to let us in on more details regarding their EBOT venture. Oh, and Chris Masse will somewhat surprisingly not renounce his French citizenship.


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