There’s actually a noteworthy passage on how prediction markets could fail in one of Dominic’s other recent blog posts I’ve been wanting to get a second opinion on for a while:
NB. Something to ponder: a) hedge funds were betting heavily on the basis of private polling [for Brexit] and b) I know at least two ‘quant’ funds had accurate data (they had said throughout the last fortnight their data showed it between 50-50 and 52-48 for Leave and their last polls were just a point off), and therefore c) they, and others in a similar position, had a strong incentive to game betting markets to increase their chances of large gains from inside knowledge. If you know the probability of X happening is much higher than markets are pricing, partly because financial markets are looking at betting markets, then there is a strong incentive to use betting markets to send false signals and give competitors an inaccurate picture. I have no idea if this happened, and nobody even hinted to me that it had, but it is worth asking: given the huge rewards to be made and the relatively trivial amounts of money needed to distort betting markets, why would intelligent well-resourced agents not do this, and therefore how much confidence should we have in betting markets as accurate signals about political events with big effects on financial markets?
Hanson’s answer is that if you know someone is doing this, there’s free money to pick up, and so the incentives push against this. (You don’t have to specifically know that X is out to spike the market, you just have to look at the market and say “whoa, that price is off, I should trade.”) There’s still the problem of linking markets of different sizes—if the prediction market is less liquid and much smaller than the stock market, but the stock market is taking signals from the prediction market, then it makes sense to lose a million on the prediction market to gain a billion on the stock market.
(The solution there is to make the prediction market more liquid and bigger, which currently doesn’t happen for regulatory reasons.)
There’s actually a noteworthy passage on how prediction markets could fail in one of Dominic’s other recent blog posts I’ve been wanting to get a second opinion on for a while:
Hanson’s answer is that if you know someone is doing this, there’s free money to pick up, and so the incentives push against this. (You don’t have to specifically know that X is out to spike the market, you just have to look at the market and say “whoa, that price is off, I should trade.”) There’s still the problem of linking markets of different sizes—if the prediction market is less liquid and much smaller than the stock market, but the stock market is taking signals from the prediction market, then it makes sense to lose a million on the prediction market to gain a billion on the stock market.
(The solution there is to make the prediction market more liquid and bigger, which currently doesn’t happen for regulatory reasons.)