What are prediction markets?

A prediction market is a market where people can trade contracts that pay based on the outcomes of unknown future events (e.g. who will win a general election). The market prices generated from these contracts can be understood as a kind of collective prediction among market participants. These prices are based on the individual expectations and willingness of investors to put their money on the line for those expectations.

A decentralized prediction market is a prediction market that can operate without the control or management of any one central operator. Typically, these markets operate through blockchain-based smart contracts that can self-execute in order to distribute payoffs.

Decentralized prediction markets are among the oldest and most powerful application of blockchains beyond decentralized money, dating back to early projects inspired by Bitcoin [2], forming a motivation for the creation of Ethereum [3] and the basis of the first dApp ICO (initial coin offering) in 2015 with Augur’s REP token.

Prediction markets have been found to be better election predictors than polls [4]. Loud/polarizing voices must “put money where their mouth is” to be heard, and thus opinion manipulation is costly. This idea has seen recurring interest in the past, and we expect it to grow in importance in times of increasing misinformation campaigns and loss of trust facilitated by technical innovation such as AI (enabling increasingly realistic deepfakes) and the partial transition of our lives into the metaverse. At the same time, the need to transparently govern the emerging local structures of the metaverse, such as DAOs, as well as the democratic structures in real life, cries for novel tools: Futarchy based on prediction markets [5] is one of the most promising applications.

Wide-scale adoption of decentralized prediction markets has been unsuccessful to date due to design flaws in the employed protocols. The US Department of Defense, Google, Microsoft, Hewlett-Packard, IBM, Intel, Yahoo and many others have investigated the topic and / or run internal prediction markets for better decision making [6], but consensus so far has been that it is necessary to pay for this powerful tool or charge high fees [7].

References

[1] Hanson, Robin. "Combinatorial information market design." Information Systems Frontiers 5.1 (2003): 107-119.

[2] Clark, Jeremy, et al. "On decentralizing prediction markets and order books." Workshop on the Economics of Information Security, State College, Pennsylvania. Vol. 188. 2014.

[3] Buterin, Vitalik. "A next-generation smart contract and decentralized application platform." white paper 3.37 (2014): 2-1.

[4] https://iemweb.biz.uiowa.edu/research/longrunaccuracy/

[5] Hanson, Robin. "Shall we vote on values, but bet on beliefs?." Journal of Political Philosophy 21.2 (2013): 151-178.

[6] Arrow, Kenneth J., et al. "The promise of prediction markets." Science 320.5878 (2008): 877-878.

[7] Othman, Abraham, et al. "A practical liquidity-sensitive automated market maker." ACM Transactions on Economics and Computation (TEAC) 1.3 (2013): 1-25.