Wednesday, November 07, 2012

Prediction Market Manipulation: A Case Study

The experience of watching election returns come in has become vastly more social and interactive than it was just a decade ago. Television broadcasts still provide the core pubic information around which expectations are formed, but blogs and twitter feeds are sources of customized private information that can have significant effects on the evolution of beliefs. And prediction markets aggregate this private information and channel it back into the public sphere.

All of this activity has an impact not only on our beliefs and moods, but also on our behavior. In particular, beliefs that one's candidate of choice has lost can affect turnout. It has been argued, for instance, that early projections of victory for Reagan in 1980 depressed Democratic turnout in California, and that Republican turnout in Florida was similarly affected in 2000 when the state was called for Gore while voting in the panhandle was still underway. For this reason, early exit poll data is kept tightly under wraps these days, and states are called for one candidate or another only after polls have closed.

This effect of beliefs on behavior implies that a candidate facing long odds of victory has an incentive to inflate these odds and project confidence in public statements, lest the demoralizing effects of pessimism cause the likelihood of victory to decline even further. Traditionally this would be done by partisans on television sketching out implausible scenarios and interpretations of the incoming data to boost their supporters. But with the increasing visibility of prediction markets, this strategy is much less effective. If a collapse in the price of a contract on Intrade reveals that a candidate is doing much worse than expected, no amount of cheap talk on television can do much to change the narrative.

Given this, the incentives to interfere with what the markets are saying becomes quite powerful. Even though trading volume has risen dramatically in prediction markets over recent years, the amount of money required to have a sustained price impact for a few hours remains quite small, especially in comparison with the vast sums now spent on advertising.

In general, I believe that observers are too quick to allege manipulation when they see unusual price movements in such markets. As I noted in an earlier post, a spike in the price of the Romney contract a few days ago was probably driven by naive traders over-reacting to rumors of a game-changing announcement by Donald Trump, rather than by any systematic attempt at price manipulation. My reasons for thinking so were based on the fact that frenzied purchases of a single contract (while ignoring complementary contracts) are terribly ineffective if the goal is to have a sustained impact on prices. If one really wants to manipulate a market, it has to be done by placing large orders that serve as price ceilings and floors, and to do this across complementary contracts in a consistent way.

As it happens, this is exactly what someone tried to do yesterday. At around 3:30 pm, I noticed that the order book for both Obama and Romney contracts on Intrade had become unusually asymmetric, with a large block of buy orders for Romney in the 28-30 range, and a corresponding block of sell orders for Obama in the 70-72 range. Here's the Romney order book:

And here's the book for Obama:

Since the exchange requires traders to post 100% margin (to cover their worst case loss and eliminate counterparty risk), the funds required to place these orders was about $240,000 in total. A non-trivial amount, but probably less than the cost of a thirty-second commercial during primetime.

Could this not have been just a big bet, placed by someone optimistic about Romney's chances? I don't think so, for two reasons. First, if one wanted to bet on Romney rather than Obama, much better odds were available elsewhere, for instance on Betfair. More importantly, one would not want to leave such large orders standing at a time when new information was emerging rapidly; the risk of having the orders met by someone with superior information would be too great. Yet these orders stood for hours, and effectively placed a floor on the Romney price and a ceiling on the price for Obama.

Meanwhile odds in other markets were shifting rapidly. Nate Silver noticed the widening disparity and was puzzled by it, arguing that differences across markets should "evaporate on Election Day itself, when the voting is over and there is little seeming benefit from affecting the news media coverage." Much as I admire Nate, I think that he was mistaken here. It is precisely on election day that market manipulation makes most sense, since one only needs to affect media coverage for a few hours until all relevant polls have closed. Voting was still ongoing in Colorado, and keeping Romney viable there was the only hope of stitching together a victory. Florida, Virginia and Ohio were all close at the time and none had been called for Obama. A loss in Colorado would have made these three states irrelevant and a Romney victory virtually impossible.

Given this interpretation, I felt that the floor would collapse once the Colorado polls closed at 9pm Eastern Time, and this is precisely what happened:

Once the floor gave way, the price fell to single digits in a matter of minutes and never recovered.

It turned out, of course, that none of this was to matter: Virginia, Ohio, and (probably) Florida have all fallen to Obama. But all were close, and the possibility of a different outcome could not have been ruled out at the time. The odds were low, and a realistic projection of these odds would have made them even lower. Such is the positive feedback loop between beliefs and outcomes in politics. Under the circumstances, the loss of a few hundred thousand dollars to keep alive the prospect of a Romney victory probably seemed like a good investment to someone.

Should one be concerned about such attempts at manipulation? I don't think so. They muddy the waters a bit but are transparent enough to be spotted quickly and reacted to. My initial post was retweeted within minutes by Justin Wolfers to 24,000 followers, and by Chris Hayes to 160,000 shortly thereafter. Attempts at manipulating beliefs are nothing new in presidential politics, it's just the methods that have changed. And as long as one is aware of the possibility of such manipulation, it is relatively easy to spot and counter. The same social media that transmits misinformation also allows for the broadcast of countervailing narratives. In the end the fog clears and reality asserts itself. Or so one hopes. 

Update: The following chart shows the Obama price breaking through the ceiling just before the polls closed in Colorado:

It's the extraordinary stability of the price before 8:45pm, which was sustained over several hours, that is suggestive of manipulation.


  1. "core pubic information" in first paragraph

  2. I noticed the drop around 9pm too, but I have an alternative explanation. 9pm was about when Pennsylvania was called for Obama. After this happened, everyone realized that the state polls were basically correct and that Romney would lose Ohio, WI, etc.

    Romney's only hope entering the election was that the polls were systematically over-counting Democrats (which would've given him a chance in even PA and WI). As soon as the markets ruled this out, the price swung to Obama. The fact that the 28/72 floor dropped at 9pm could be consistent with information release rather than manipulation.

  3. It's possible Brittany, but the floor gave way a few minutes before the PA call at 9pm, and I think it was pretty obvious from the exits released hours earlier that the polls had been basically right.

    I just can't see this big loss of $240K as being due to someone foolish enough to leave such large orders up there for hours as information was rapidly coming in.

    nogre, I thought the expression made sense when I wrote it... think I'll just leave it as is.

    But thanks, both of you, for the comments.

  4. It's interesting how the Law of One Price far from holds in these markets. I'd like to find out more about why. I have a brief post on this at:

  5. There's a post by Robert Wiblin that claims manipulation on Intrade for an extended period is behind violations of the law of one price:

    There was definitely some of this the day before the election, but I've been watching these markets for a long time (started blogging about them ten years ago) and I didn't see any signs of it before that. I just think it's a case of limits to arbitrage, given transactions costs, segmented markets and the difficulty of quickly transferring funds. By the way the piece you linked to is mistaken about the stakes on Intrade, the more visible election markets had tens of millions of dollars change hands over the past few months.

  6. Great work!!
    I followed Intrade closely on election day and noticed the very surprising stability that you talk about. I had assumed that at least by mid-afternoon, there would have been either erratic volatility or (more likely) very strong movement in one direction, according to whisperings about exit polls and turnout. I was ASTONISHED at the stability (and talked about it). Your theory didn't occur to me at all, but, especially with the benefit of seeing the data you gathered, I think you're right.

  7. Thanks Mark. There was also a large sell order (about 10,000 contracts) a shade above 67 the day before the election which was putting a ceiling on the Obama price. This was snapped up in a single order. Cost to the seller (and profit to buyer if held to expiration): $33,000.

  8. Rajiv: I had noticed that stability as well and was also surprised by it -- everything else had seemed to suggest that Obama's "percentage" would have risen a bit. But while this surprised me, the stability on the afternoon and evening of Election Day SHOCKED me.

    This additional info that you just gave is also interesting and does seem to be a likely explanation for the lack of movement on Monday. And again, the relatively tiny cost is almost unbelievable -- truly tiny on the scale of campaign expenditures.