The Last Look…

I can’t help but feel that prediction markets need to get their act together and make what might seem some tough decisions if they are not to become just another good idea that was usurped by “the man” because they took too long to understand the reality of their position.

As was (and still is) the case with crypto markets, it is hard to find a release from prediction markets providers that is not liberally sprinkled with the word “institutional”. I am sure that the creators of these releases (probably AI) think they are encouraging bigger institutions to get involved, but they’re dreaming. Firstly, the overuse of the word merely serves to highlight their desperation to be taken seriously and not just as another retail-orientated product (which they still are). Secondly, serious institutions are not going to get involved in something with such little regulatory clarity – even in the one centre where they have taken off, the US, no-one really knows where prediction markets stand, and serious institutions hate uncertainty.

An example of this can be found in a release last week from the US Commodity Futures trading Commission, which is currently involved in several lawsuits against US states over who should have jurisdiction of these markets. The CFTC “reminded” platforms and exchanges of the need to price products correctly, noting that its staff has observed “pricing information in the “American” odds format used by casino gambling bookmakers”. This is likely to “mislead market participants about the nature of the transaction”, the commission added.

Some venues are displaying in the odds format because they are the usual way to display sports’ betting – which is still where the wider problem is. The CFTC may have “reminded” everyone because firms that persist in displaying pricing in odds format are undermining its case that these bets are just another form of financial derivative – clearly they are not.

There is no doubt that prediction markets offer an interesting, and potentially efficient, way to trade events, but if they are to escape the retail environment, the sports element surely has to be taken out of the equation? That way, serious institutions can position or hedge themselves against risk to their financial positions – which, after all, is what they invest in. Yes, they can also trade in weather events (we have weather derivatives after all, and that can be a hedge, but I am struggling to understand how a punt on West Ham winning at Burnley next week hedges anything (take the draw at 7/2 BTW, that game has stalemate written all over it).

Instead of trying to replicate the equities regulatory model, where everyone is thrown in together, nuance the offering

At the moment, the legal system is embroiled in the matter in the US, which we all know means it is going to drag on – all of which time, other jurisdictions are going to be more reluctant to embrace the product in its current form, and other potential providers are going to come up with their own ideas.

One of those ideas could be…let me think about it…prediction markets for financial events only? While the current providers are either still trying to include sports in the package (probably because this is where they are making the most money), others could step in and offer what serious institutions really want – another tool to hedge financial risk. In the past, both Deutsche Bank and Goldman Sachs offered single currency FX indices, so you could trade just Sterling for example, without that bothersome euro or dollar stuffing up your great idea by being even worse than the pound, these were, effectively, prediction markets.

Coming up with event contracts is not that difficult therefore, so what is to stop a fully-regulated institution like a bank (more effectively a number of banks) offering a wide range of contracts that proper institutions want to deal in, with a counterparty they need no introduction to? These contracts can be quoted in a multi-dealer environment, so on an exchange or an ECN, both of which are likely to be highly regulated and therefore trusted.

The challenge for providers in the current prediction market environment is that they are either, collectively, unwilling to split their business, or are actually thinking the US legal system will sort out their problem quickly. That seems to be quite a business risk to me, because the longer they are in limbo, the more opportunity there is for someone to steal their thunder by providing what institutions actually want. At the moment, too many providers are effectively saying that, to pick a name out of the air, Vanguard, wants to trade on things like the exact time of the next US attack on Iran, or the outcome of a Dodgers-Yankees game. I can’t speak for that firm, but I suspect they don’t want to trade such things, and I would imagine that investors in their mutual funds would be highly delighted if they were. A firm like that, however, could use innovative prediction markets products to hedge specific risks, which is where I think the industry has to head.

Prediction markets offer something interesting, different and potentially valuable to large firms – at the moment, however, a lack of foresight, or sheer bloodymindedness, is raising the risk of failure…not for the product, but for the current crop of providers

Often a new market has time to develop its regulatory and structural framework, but that is not the case with prediction markets, which are, frankly, in danger of becoming a victim of their own success. Too much is being traded for these markets to be granted any leeway to develop their structure, which means something surely has to happen very soon.

To me, what has to happen is the CFTC and States come to an agreement (highly unlikely); the US legal system decides categorically and finally in one party’s favour (unlikely); or, the providers take a lead from a solid, self-regulated market like FX and create distinct business units (quite possible).

Have the sports betting (sorry prediction) markets, but wall them off from financial products. Equally, ensure that products that are popular with retail (and “small institutional”) are not traded in the same place and with the same protections as large institutional – the latter exists on a “buyer beware” basis, whereas the former often needs protection.

Ultimately, however, this is a potentially simple problem to solve. Instead of trying to replicate the equities regulatory model, where everyone is thrown in together, nuance the offering. Have strict regulation for retail/sports markets, and create separate markets for the serious professionals who want to hedge – and not punt – where the entities’ regulatory regime takes care of matters.

Prediction markets offer something interesting, different and potentially valuable to large firms – at the moment, however, a lack of foresight, or sheer bloodymindedness, is raising the risk of failure. Not for the product, but for the current crop of providers.

colin@thefullfx.com