The Last Look…

Prediction markets are the hot topic in certain parts of the world, indeed, Eva wrote about the staggering valuations in this space just a few weeks ago, but the fact is we have seen plenty of outsized valuations over the years that have not lasted long, and, after all, these markets are for retail punters aren’t they, so why should we care? But are they for retail? And am I, not for the first (or last) time, about to dismiss the “next big thing”?

I have been chatting to people in London over the last few days about this – it is a hot topic – and there are mixed views. At the negative end of the scale, there is a belief that it’s a North American “gimmick” as one player put it, “that will be shut down by the regulators in Europe and possibly Asia before it can get off the ground there”.

Another in this camp is an acquaintance who, while seeing prediction markets as an interesting area, believes it will remain the domain of the retail punter and non-bank market makers “who like any market where mug punters lose money easily” and that no-one approaching institutional level will get involved.

There are, without doubt, likely to be a few qualms over reputational risk if institutions do get more involved, and that will probably be sufficient to stymie any real interest and development on their part. After all, a growing number of people (and apparently an increasing body of evidence) suggests that there is a lot of insider trading going on. To be fair, it’s hard not to see why people would think that – economic data is closely protected and there are frameworks in place to ensure there are no leakages and the data is released fairly – it’s a bit hard to maintain operation security when it’s all happening on some random social media network!

One thing most people agree on is that the financial markets side of these businesses will have to be separated from the more esoterical side. In other words, we don’t need a non-farm payroll-related market existing right alongside, at the sensible end, sporting events, and at the more bizarre end, someone finally proving that I am Satoshi…

Prediction markets are most often described in terms similar to binary options and CFDs – both of which regularly incur the wrath of regulators around the world when it comes to retail punters, so to succeed, hence the reputational risk for institutions. More importantly, perhaps, would these institutions even want to come?

I am not sure that the vast majority of the “investor buy side” is willing, or able, to play in these markets as an equal participant – they will have to remain market users, or, the buy side. Some hedge funds might be tempted, but over the years, this segment of the industry has been reluctant to offer anything like two-way pricing, so why would they start now on something like whether Don II will ever make a decision he sticks to? These firms like showing a side, so perhaps there is something there, but is the market structure strong enough to protect their information? And this is important because liquidity in event markets is notoriously fickle, so any interest will have an impact.

As a market user, however, would, for example, hedge funds, be interested in these markets? At some level I suspect they would, which may then, in turn, attract the interest of more market makers (although if these people are as smart as we think, perhaps you don’t want to be a market maker, especially when there’s no real hedging market for you…)

A friend observed last week that funds would like to have a punt on non-farms, for example, because it’s a “cleaner” punt – the number comes out, you have predicted that number (or the market reaction to it, or whether Don II sacks another messenger), you take the payout and move on. It’s short-term trading but not predicated upon the speed of your technology.

There is some merit in this, but again, it comes with potential challenges. Firstly, the vast majority of hedge fund traders see themselves as more cerebral than taking a five-minute punt on non-farms. Don’t get me wrong, they do take punts on these things, but often it is within the context of a longer view. If they’re wrong, but the number isn’t disastrous and changes the thinking of the market, then they can withstand the short-term shock to their P&L. If they’re in a prediction market, and they’re wrong, they’re out. Yes, the damage is limited, but on a risk/reward basis is it worth using the product?

I am sure there are other events that these firms could have a crack at, I use NFPs as an example because it is such a notoriously volatile and unpredictable figure. On which note, and as a digression, one person said to me last week that prediction markets, if they make the mainstream, will take away the role of strategists. Apparently, we will just look at the odds and that will tell us what the world is thinking.

As someone who often pours scorn on the strategists of this world – and yes, they are not known for putting a price out there to back their view – even I find this a bit harsh! The fact is, the market, when it comes to predicting outcomes, is not omniscient, it merely reflects expectations.

If we are going to make our hedging calls on, as Eva brilliantly termed it a couple of weeks ago, “America’s answer to Paddy Power”, then it’s time for me to shut down my keyboard – it would be madness. For all their prevaricating and unwillingness to recall being wrong, good strategists (and they do exist) offer additional insight and information to help you understand where the markets may be wrong. To maintain the betting analogy, bookmakers set the market on horse racing, for example, but the smart punter still does their own research and uses a form guide. There’s room for both.

Anyway, I digress, so back to the central theme and hedge funds partaking of prediction markets, because there is one other problem that would need to be solved – control. The key is in the language, we take a position in, for example spot or options, but in prediction markets were are having a bet.

If I am running a hedge fund, I want to ensure control over my traders’ activities. By all means provide leeway, but where we are talking about very short-term punts, are the systems going to identify the risky bet in time? What if a trader is having a very bad quarter, is facing a probable exit from the business, and decides to try to save it all with one massive punt on Michigan Confidence, or even worse, whether Montreal will score five times in the first minute of their next play-off game (and here’s hoping they do!)? The “Hail Mary” scenario must be one that keeps oversight teams awake at night, in a prediction market world it’s even worse I would imagine.

What does this mean for the prospects of prediction markets therefore? Well, for now they are this year’s hot ticket, and, as always seems to be the case, valuations are just making them hotter. The path ahead, however, looks a lot rockier than the smooth surface they have traversed thus far. Regulatory clarity would help – and the fact that US regulators are suing states over control suggests it won’t be achieved quickly – and there is the big question of the attitude of European and Asian regulators.

Ultimately, I suspect that prediction markets will remain a retail product for some time – mainly thanks to the reputational hurdles, which will take years to solve. Throw in the high chance that the majority of punters will lose money (there is a reason retail FX has failed to keep pace with overall FX market growth – 75-80% of punters are doing their boots) and it is hard to see the curve do anything other that flatten out from here.

Of course, I have been wrong occasionally (“mine – and I still buy” I hear from the crowd) and prediction markets may come to dominate. If that happens then I will probably not be here to write about it because I’ll have other things on my mind – can you imagine what it’s going to be like when they do “out” me as Sitoshi?

colin@thefullfx.com