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Prediction markets are one of the most curious derivatives that have great potential to unlock collective knowledge for predicting future outcomes. Crypto evangelists believed the decentralization of these would improve them even further. What are prediction markets and how do their blockchain versions work? Learn everything you need to know on the topic in this guide by the ChangeHero team.
Key Takeaways
- Prediction markets are platforms where participants can buy and sell shares related to the outcome of future events, such as elections or sports games. The prices of these shares fluctuate based on the perceived likelihood of the event occurring, providing a real-time prediction of the outcome.
- Centralized prediction markets are operated and governed by a single entity, which controls all aspects of the platform. In contrast, decentralized prediction markets use blockchain technology to eliminate the need for a central authority, allowing for greater transparency, security, and censorship resistance.
- Decentralized prediction markets provide greater security and transparency due to the use of blockchain technology, ensuring that outcomes are determined fairly and cannot be manipulated. Additionally, decentralization allows for global participation without the need for intermediaries, enabling a more inclusive and accessible platform for users worldwide.
What are Prediction Markets?
A prediction market is where people trade contracts that pay based on the outcomes of unknown future events. Market prices generated from these contracts can be understood as a kind of collective prediction among market participants. Other names include ideas futures and event derivatives.
Scholars describe early prediction markets as organized gambling markets which later evolved into their contemporary form. They stand in the middle ground of both betting and financial markets. Unlike the latter, they are concerned with concrete events and do not account for advanced implications of the activity such as risk management or asset pooling. Prediction markets are different from betting in that they can produce valuable information which then can be used to inform policy and business decisions.
This information has been dubbed the “wisdom of crowds”: the theory that a collective of people with sufficiently different beliefs, opinions, and backgrounds are smarter than an individual. The crowd is not in the literal sense, as it is susceptible to peer pressure and biases. Rather, it is a belief that prediction markets provide a framework to bring out the collective knowledge of participants to predict the outcome of a particular event.
Types of Prediction Markets
As far as our guide is concerned, prediction markets can be centralized, decentralized, and blockchain-based.
- Centralized markets are organized and managed by a single entity, which sets up the markets, regulates the rules, and sees that the resolutions are carried out. Most prediction markets that have been established over a decade ago are centralized.
- Decentralized prediction markets operate without the control or management of any one central operator. This type of prediction market is possible thanks to blockchain technology and smart contracts. They have their own challenges, for example, how to reliably resolve markets when an event occurs, but solutions are available.
- Blockchain-based prediction markets use smart contracts to eliminate the need for a central party or single operator. Even though blockchain technology enables decentralized prediction markets, centralized prediction markets on a permissioned chain can use technology such as smart contracts.
How Prediction Markets Work
Prediction market participants trade contracts representing an event’s outcome; election outcomes are the most popular event found in these markets. The most common type is the binary option, granting a fixed payout to winners or nothing at all otherwise. More advanced options include index or spread bids, which make the payouts and conditions more flexible.
A simple example would look like this: a contract will pay $1 to holders upon resolution. When the trading for this prediction market is open, those who agree with the stated outcome buy it, and those who don’t — sell. This makes the contract price fluctuate and more or less reflect the communal opinion on the probability of this event.
If, for instance, the option’s price is $0.3, the event is believed to have roughly a 30% chance of happening, and the price is low because more people sell the contract. Even though the buyers are in the minority, should the stated outcome come to pass, they would receive a higher profit off the bet.
How are prediction markets different from futures markets? When trading futures contracts, you bet on future asset prices. However, in prediction markets, the events are not limited to this scenario. Just like futures contracts can be used to assess the market sentiment, prediction markets can tell you what the majority expects to happen.
Prediction Market Mechanisms
Prediction markets trade with the help of a continuous double auction. They match buyers to sellers, much like the stock market. In a decentralized prediction market, the matching is done by smart contracts and automated market makers (AMM).
AMMs provide liquidity for markets where there may not be enough buyers or sellers. They algorithmically determine the prediction market prices by assessing the balance between a pair of assets deposited to the pool.
Due to prediction markets sharing plenty of qualities with gambling, their legality varies by jurisdiction. To access the crowd wisdom without stepping into illegal territory, many organizations offer their users play money, or virtual currency for use on the prediction market platform. Hollywood Stock Exchange and Foresight Exchange are some of the most well-known ones. Blockchain-based decentralized prediction markets also offer users the choice between play money and real money (crypto assets) through testnet and mainnet versions.
Uses of Prediction Markets
The utility of prediction markets is twofold and depends on the point of view: to the participants, it is an opportunity to bet and earn on the difference between the contract price and payout. For outsider analysts, prediction markets are a valuable tool to forecast economic, business, and even political events.
Some of the applications of the wisdom of the crowd were estimating the value of Google’s IPO before the launch; internal markets help Microsoft and Best Buy predict the outcomes of business decisions. The Hollywood Stock Exchange has accurately predicted box office figures; authorities and researchers have tried applying this method to estimate disease spread rates.
There was a bear raid in the Bush 2004 presidency futures contracts, driving the market prices to almost zero. However, prediction markets have the financial incentive to bet against the market manipulator: the contract price dumps but the probability of the event doesn’t. In other words, the chance of winning a contract payout remained the same but the price of the derivative got significantly cheaper before the traders stabilized the price. This case demonstrates how prediction markets provide accurate forecasts.
Benefits of Decentralized Prediction Markets
Security, Transparency, and Inclusivity
Decentralized prediction markets offer numerous advantages over centralized prediction markets, including lower fees, enhanced privacy, and a global reach. People use digital assets to participate, meaning they don’t have to connect their bank account or debit card to the marketplace.
Decentralized prediction markets also have the potential to unlock the predictive power of this forecast method. If more participants from various backgrounds and even cultures and nations have access to the pool of crowd knowledge, its accuracy increases. The data being publicly and securely recorded on a blockchain can also be valuable to researchers who would want to verify the results or check if a market has been tampered with.
There is no data on whether real-money prediction markets are more accurate than ones that use virtual tokens. In the same vein, the accuracy of a decentralized prediction market in comparison to traditional ones still needs to be studied.
Accuracy and Legality
However, it is a fact that prediction markets tend to perform better than polling for election outcomes. It does not mean that it is always precise: the Brexit and 2016 Trump presidency political markets proved to be wrong. One of the reasons a market can fail to provide accurate predictions is a limited pool of participants which creates an echo chamber. As we already mentioned, accessibility can help remedy that.
Most prediction markets that target US users operate with “play money” rather than “real money” due to federal and state laws outlawing online gambling. The same applies to other jurisdictions where gambling is illegal. Most prediction markets that operate with real money receive a free hand from regulators due to the academic nature of the platform. Decentralized prediction markets these days are not illegal but not regulated in most jurisdictions either.
Decentralized Prediction Markets
Augur
One of the most well-known examples of decentralized prediction markets is Augur, since it was the first one to receive recognition. Augur operates on the Ethereum blockchain and is powered by a native token REP (Reputation). Augur uses a native oracle which gets the information from reporters who stake REP. Regular users can buy the prediction shares with other cryptocurrencies, such as DAI and ETH.
Betfolio
This betting market is a newer one and it shows: Betfolio is built on Polygon and utilizes non-fungible tokens (NFT). They propose a type of prediction market which gives flexible payouts that depend on the amount of bets. In their own words, this type of decentralized prediction market is “risk-free”, because even the losing side still gets paid.
At the time of writing, the open markets bet on the future price of AVAX and ETH and the market cap of an unreleased token. Each of them gets over a hundred bets on average, even the daily pools.
Polkamarket
To complete the compilation of crypto prediction markets, we should mention Polkamarket. It is also deployed to Polygon, as well as Polkadot L2 Moonbeam, and Kusama L2 Moonriver. The utility token POLK is necessary to create, curate, and resolve markets; bets can be placed in MOVR or USDT.
Polkamarket has a long list of represented categories and types of opinion polls. For example, one that is currently open is the prediction market for the UEFA Euro 2024 winner.
The Future of Crypto Prediction Markets
Potential for Growth and Adoption
Prediction markets have proven capable of eliciting simple features of the market’s assessment of uncertain events. The borderless nature of blockchain-based prediction markets can unleash even more of the potential by making them as accessible as possible.
Unfortunately, decentralized prediction markets have attracted controversy both for ethical reasons and the possibility of manipulation. Even with the capabilities of smart contracts and decentralized oracles, liquidity and the number of market participants do not quite meet the level of their centralized counterparts.
Addressing Challenges
Some kinds of prediction markets may create controversial incentives, such as a market predicting the death of a world leader. Censorship resistance inherent to decentralized platforms makes it hard to filter illegal and unethical markets unless the community is actively involved.
The Commodity Futures Trading Commission (CFTC) has issued no-action letters to some prediction markets, allowing them to operate legally, usually for their ability to contribute valuable aggregate information. There is little reason to believe the CFTC or their counterparts can’t do the same for crypto prediction markets and enable scholars to see what these decentralized idea markets can tell us.
Future Outlook and Opportunities
The potential for growth and adoption of decentralized prediction markets is significant, with opportunities for innovation and development in the field. At the moment, these projects are very niche but are worthy of use and appreciation.
Conclusion
Prediction markets are open markets that enable the prediction of specific outcomes using financial incentives. They are exchange-traded markets established for trading bets in the outcome of various events.
We hope you enjoyed learning about this exciting use case for crypto and blockchain. Read more from us on Telegram, X, Reddit, and Facebook, and subscribe! Find insights in our blog for more guides and analyses of the crypto world.
Disclaimer
This article is not a piece of financial or investment advice. No price prediction is guaranteed to provide exact information on the future price.
When dealing with cryptocurrencies, remember that they are extremely volatile and thus, a high-risk investment. Always make sure to stay informed and be aware of those risks. Consider investing in cryptocurrencies only after careful consideration and analysis of your own research and at your own risk.
