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Prediction markets have historically been the red-headed stepchild of traditional trading. Bridging the gap between finance and gaming, they’ve consistently encountered regulatory pressures, as well as a host of legal and ethical considerations.
Also known as information markets, decision markets, or events-based trading, a consistent feature of this style of market is its uncanny accuracy in predicting future outcomes. Combining the wisdom of crowds with financial incentives, these markets have been shown to be more accurate than opinion polls, or even individual domain experts.
Despite these issues, their popularity is on the rise and they receive regular publicity during election cycles. This is because of their reputation for picking winning candidates, often in direct contradiction to polling results. A prediction market correctly predicted both the 2024 re-election of Donald J. Trump, and New York mayoral primary winner Zohran Mamdani.
Regulatory Changes
Despite this, regulators such as the Commodity Futures Trading Commission, have been hostile to them in the past due to their proximity to gambling. However, in October of last year, Kalshi, the largest US prediction market, won a legal case against the CFTC, allowing it to run prediction markets on election results.
With a US administration that’s currently much friendlier to financial innovation, the lawsuit is being regarded as a landmark that will open the door to further regulatory progress in events-based trading. Kalshi’s CEO has openly stated his intentions to create a financial market that can price in any event in all areas.
A Brief History
Prediction markets actually predate conventional stock markets by more than a century. Founded in 1602, the Amsterdam Stock Exchange is widely credited with being the world’s first stock exchange.
Meanwhile, the oldest documented prediction markets originate from the Italian city states in the early 1500s where election markets on papal successors were common. Even back then, these political bets were regarded as an old practice.
One of the oldest electronic prediction markets still in use is the University of Iowa’s Iowa Electronic Markets, which launched during the 1988 US presidential election.
In 2018, Augur, the world’s first decentralized prediction market, launched on the Ethereum blockchain. It would spur a great deal of research and experimentation in the space.
Currently, Polymarket, which runs on the Polygon blockchain, is the world's largest decentralized prediction market by volume, with $91.77 million total value locked (TVL) at the time of writing.
How They Work
One of the features that makes these markets particularly attractive to retail, is how simple and easy to understand they are. The events in question feature binary outcomes with 50/50 probabilities. For example, either Bitcoin will hit 200K in August or it won’t.
Participants purchase shares in a contract, with the price of the shares being closer or further away from $1 the more or less likely the market considers the outcome to be.
For instance, there’s currently a market on whether President Trump will release the Epstein files by the end of the year. The cost of a “No” share is currently priced at 61 cents, whereas the cost of a “Yes” share is currently valued at 40 cents. The winning side receives $1 per share for a correct prediction once the results are in.
The prices of these yes and no views inevitably change closer to the outcome and oscillate as new information is received. For example, in the above market, the probability of a “Yes” dropped to 13.5% earlier this month when it was announced that there were no files to be released.
Traders who purchased “Yes” outcomes at 13.5 cents can now sell those contracts to buyers at the current market price of 40c, thus profiting without having to wait for the outcome to be revealed.
Technical Requirements
As interest in these markets continues to grow, firms seeking to enter the space will be called to review the technical requirements that are specific to prediction markets. In our estimation, the superficial similarities to gaming may lead many to underestimate just what it takes to run a successful events-based market. Behind the scenes, these markets have much more in common with futures and options exchanges than they do with online gambling sites.
Owing to the nature of the instrument, continuous uptime and both 24/7 trading and technical support are necessary. These markets are perhaps more sensitive to the news cycle than any other, and they can only price in the constant stream of news affecting contracts if they operate around the clock.
This means that markets must be able to be listed, removed, resolved, and settled on-the-fly with no technical restarts, preferably via API that operations teams can operate without the need for intervention from technical teams.
They also have to be designed for both scalability and reliability from the get-go and engineered to be able to handle orders of magnitude more users than they may be expecting. This is particularly relevant due to their relative newness to the trading scene, as many crypto exchanges found out to their detriment during the 2016-2017 bull cycle.
These markets also require flexibility in contract resolution to be built in. The outcomes may be binary, but events aren’t always resolved on a set date. For instance, Bitcoin may (or may not) reach 200K on any day of August, from the 1st to the 31st. Contracts on sporting events will also require automated delays in the interest of fairness, so that those closer to the action are not able to front run contract activity.
Finally, for businesses seeking to run advanced prediction markets that allow users to trade combinations of outcomes, systems will have to be equipped with algorithms that can handle the combinatorial explosion that results when even a small number of binary outcomes are combined.
Final Thoughts
The loosening of regulatory controls in the United States promises a surge in new products and a general encouragement of financial innovation. We’ve seen this previously with 0DTE options, more recently with perpetual futures, and now the rise of prediction markets. The next few years are certainly shaping up to be exciting both for end traders and the providers of these new financial technologies.