Death of a Prediction Market

A couple of days ago Intrade announced that it was closing its doors to US residents in response to "legal and regulatory pressures." American traders are required to close out their positions by December 23rd, and withdraw all remaining funds by the 31st. Liquidity has dried up and spreads have widened considerably since the announcement. There have even been sharp price movements in some markets with no significant news, reflecting a skewed geographic distribution of beliefs regarding the likelihood of certain events.

The company will survive, maybe even thrive, as it adds new contracts on sporting events to cater to it's customers in Europe and elsewhere. But the contracts that made it famous - the US election markets - will dwindle and perhaps even disappear. Even a cursory glance at the Intrade forum reveals the importance of its US customers to these markets. Individuals from all corners of the country with views spanning the ideological spectrum, and detailed knowledge of their own political subcultures, will no longer be able to participate. There will be a rebirth at some point, perhaps launched by a new entrant with regulatory approval, but for the moment there is a vacuum in a once vibrant corner of the political landscape.

The closure was precipitated by a CFTC suit alleging that the company "solicited and permitted" US persons to buy and sell commodity options without being a registered exchange, in violation of US law. But it appears that hostility to prediction markets among regulators runs deeper than that, since an attempt by Nadex to register and offer binary options contracts on political events was previously denied on the grounds that "the contracts involve gaming and are contrary to the public interest."

The CFTC did not specify why exactly such markets are contrary to the public interest, and it's worth asking what the basis for such a position might be.

I can think of two reasons, neither of which are particularly compelling in this context. First, all traders have to post margin equal to their worst-case loss, even though in the aggregate the payouts from all bets will net to zero. This means that cash is tied up as collateral to support speculative bets, when it could be put to more productive uses such as the financing of investment. This is a capital diversion effect. Second, even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

These arguments are not without merit. But if one really wanted to restrain the diversion of capital to support speculative positions, Intrade is hardly the place to start. Vastly greater amounts of collateral are tied up in support of speculation using interest rate and currency swaps, credit derivatives, options, and futures contracts. It is true that such contracts can also be used to reduce risk exposures, but so can prediction markets. Furthermore, the volume of derivatives trading has far exceeded levels needed to accommodate hedging demands for at least a decade. Sheila Bair recently described synthetic CDOs and naked CDSs as "a game of fantasy football" with unbounded stakes. In comparison with the scale of betting in licensed exchanges and over-the-counter swaps, Intrade's capital diversion effect is truly negligible.

The second argument, concerning the segregation and safety of funds, is more relevant. Even if the exchange maintains a strict separation of company funds from posted margin despite the absence of regulatory oversight, there's always the possibility that its deposits in the Irish banking system are not fully secure. Sophisticated traders are well aware of this risk, which could be substantially mitigated (though clearly not eliminated entirely) by licensing and regulation.

In judging the wisdom of the CFTC action, it's also worth considering the benefits that prediction markets provide. Attempts at manipulation notwithstanding, it's hard to imagine a major election in the US without the prognostications of pundits and pollsters being measured against the markets. They have become part of the fabric of social interaction and conversation around political events.

But from my perspective, the primary benefit of prediction markets has been pedagogical. I've used them frequently in my financial economics course to illustrate basic concepts such as expected return, risk, skewness, margin, short sales, trading algorithms, and arbitrage. Intrade has been generous with its data, allowing public access to order books, charts and spreadsheets, and this information has found its way over the years into slides, problem sets, and exams. All of this could have been done using other sources and methods, but the canonical prediction market contract - a binary option on a visible and familiar public event - is particularly well suited for these purposes.

The first time I wrote about prediction markets on this blog was back in August 2003. Intrade didn't exist at the time but its precursor, Tradesports, was up and running, and the Iowa Electronic Markets had already been active for over a decade. Over the nine years since that early post, I've used data from prediction markets to discuss arbitrage, overreaction, manipulation, self-fulfilling prophecies, algorithmic trading, and the interpretation of prices and order books. Many of these posts have been about broader issues that also arise in more economically significant markets, but can be seen with great clarity in the Intrade laboratory.

It seems to me that the energies of regulators would be better directed elsewhere, at real and significant threats to financial stability, instead of being targeted at a small scale exchange which has become culturally significant and serves an educational purpose. The CFTC action just reinforces the perception that financial sector enforcement in the United States is a random, arbitrary process and that regulators keep on missing the wood for the trees.

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Update: NPR's Yuki Noguchi follows up with Justin Wolfers, Thomas Bell, Laurence Lau, and Jason Ruspini here; definitely worth a listen. Brad Plumer's overview of the key issues is also worth a look.

Curtailing Intellectual Monopoly

I never thought I'd see an RSC policy brief referring to mash-ups and mix-tapes, but I was clearly mistaken.

The document deals in an unusually frank manner with the dismal state of US copyright law. Perhaps too frankly: it was quickly disavowed and taken down on the grounds that publication had occurred "without adequate review." Copies continue to circulate, of course (the link above is to one I posted on Scribd). Although lightly peppered with ideological boilerplate, the brief makes a number of timely and sensible points and is worth reading in full.

Aside from extolling the virtues of "a robust culture of DJ’s and remixing" free from the stranglehold of copyright protection, the authors of the report make the following claims. First, the purpose of copyright law, according to the constitution, is to "promote the progress of science and useful arts" and not to "compensate the creator of the content." Copyright law should therefore be evaluated by the degree to which it facilitates innovation and creative expression. Second, unlike conventional tort law, statutory damages for infringement are "vastly disproportionate from the actual damage to the copyright producer." For instance, Limewire was sued for $75 trillion, "more money than the entire music recording industry has made since Edison’s invention of the phonograph in 1877." Third, the duration of coverage has been expanding, seemingly without limit. In 1790 a 14 year term could be renewed once if the the author remained alive; current coverage is for the life of the author plus 70 years. This stifles rather than promotes creative activity.

The economists Michele Boldrin and David Levine have been making these points for years. In their book Against Intellectual Monopoly (reviewed here), they point out that the pace of innovation in industries without patent and copyright protection has historically been extremely rapid. Software could not be patented before 1981, nor financial securities prior to 1998, yet both industries witnessed innovation at a blistering pace. The fashion industry remains largely untouched by intellectual property law, yet new designs keep appearing and enriching their creators. Innovative techniques in professional sports continue to be developed, despite the fact that successful ones are quickly copied and disseminated.

In 19th century publishing, British authors had limited protection in the United States but managed to secure lucrative deals with publishers, allowing the latter to saturate the market at low prices before new entrants could gain a foothold. More recently, commercial publishers have turned a profit selling millions of copies of unprotected government documents. For instance, the 9/11 Commission Report was published by both Norton and Macmillan in 2004, and a third version by Cosimo is now available.

Copyright restrictions for scientific papers are especially illogical, since faculty authors benefit from the widest possible dissemination and citation of their work. Furthermore, in the case of journals owned by commercial publishers, copyright is typically transferred by the author to the publisher. Neither the content creators nor the uncompensated peer-reviewers who evaluate manuscripts for publication benefit from protection in such cases. Fortunately, thanks to the emergence of new high-quality open-source journals sponsored by academic societies, things are starting to change.

It's not clear why the policy brief was taken down, or what motivated it in the first place. Henry Farrell, while agreeing with the positions taken in the report, argues that damage to an industry that has historically supported Democrats may be a factor. In contrast, Jordan Bloom and Alex Tabarrok both believe that pressure on Republicans from the entertainment industry led to the brief being withdrawn. They can't all be right as far as I can see. But less interesting than the motivation for the report is its content, and the long overdue debate on patents and copyrights that could finally be stirred in its wake. 

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. 

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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.

The Rationality of Voting

Every election year, like clockwork, some people feel the need to remind the rest of us that (contrary to the exhortations of politicians and peers) our votes do not, in fact, count. Not only do they not count in New York, California or Texas, they don't count in Colorado, Ohio, or Florida either. While the likelihood that a single vote will be decisive may be incrementally higher in the latter set of states, it is negligible everywhere. Steve Levitt goes so far as to say that "it’s only the not so smart people who vote because they’re actually going to influence the election." Phil Arena is a bit more charitable, arguing that "people who believe that their vote counts are simply mistaken." Kindred Winecoff concurs.

Here's Arena's version of the argument:

If you've ever said something like "My vote doesn't count, because I live in New York", you're the type of person who makes my head hurt.  We may not know for sure how things will turn out in New Hampshire this coming Tuesday, but that doesn't mean that an individual's vote will "count" for much of anything in that state.   The fact that everyone who knows anything about politics knows how things will go in New York (or California, or Texas) doesn't make any meaningful difference to the question of whether individual votes in those states are likely to determine the outcome...  Don't confuse uncertainty over the final outcome with a significant probability of a single vote determining the outcome.  Those two things are not even remotely the same.

And yet we have people waiting in line for hours to cast ballots in Ohio, and making multiple trips to polling stations in Florida, bearing significant burdens to engage in what Winecoff asserts is simply "cheap talk." Would these voters make similar sacrifices to vote in New York or California? And if not, are they somehow deluded or dumb?

I believe that it is Arena and Levitt who are mistaken about the rationality of voting, and not the voters themselves. The premise of their argument is correct, but not the conclusions they draw from it. The likelihood of a single vote being decisive is negligible in all states, and voters by and large are fully cognizant of this fact. And yet it is perfectly rational for some voters to incur significant costs to vote in New York, and to incur even greater costs to do so in Ohio.

To see why, one needs only to recognize that the elation one feels when a preferred candidate wins depends both on the margin of victory and on whether or not one has cast a ballot. A single voter cannot materially affect the former, but can certainly determine the latter. Furthermore, the margin of victory can be forecast with a fair amount of accuracy: there is little doubt that the margin in Ohio, no matter who wins tomorrow, will be smaller than that in New York. Provided that the joy of celebrating a victory is greater when one has cast a ballot, and especially so when the margin of victory is small, it makes perfect sense to incur greater costs to vote in Ohio than in New York.

Similar arguments apply to the grief that comes with defeat. In this case it is the failure to cast a ballot when the margin is tight that can give rise to great regret. People in this situation are perfectly well aware that their vote alone would not have materially affected the outcome, but they are not much comforted by this thought. The point is that if a relatively small coalition could have jointly generated a different outcome, then one's failure to join such a coalition can be a cause of distress. There is nothing irrational about such preferences, and they clearly lead to greater turnout when and where elections are predicted to be close. This turnout differential is not based on mistaken beliefs about what one alone can accomplish, and is not driven by cognitive limitations either.

This perspective on voting also explains why people often vote strategically, rather than always voting their conscience. Think of Nader supporters contemplating a vote for Gore in 2000. The size of the coalition of such supporters who could have blocked a Bush victory in Florida turned out to be extremely small, and the possibility that Nader could play such a spoiler role in the election was certainly anticipated. Some of those who chose to vote their conscience may well have regretted this choice once the outcome of the election was finally determined, and some who chose to vote for Gore may well have done so to avoid such regret. The fact that no single voter was decisive is entirely irrelevant. Collective responsibility for coalitional choices comes naturally to us, especially when the groups involved are not large. It is not the motives themselves, but the pretense that they do not exist that constitutes the true departure from rationality.

People vote for all kinds of different reasons. Some consider it a civic duty, others enjoy the process, and still others take satisfaction from the exercise of voice. Voting can be a powerful expression of identity; an affirmation, as Noah Millman puts it, of membership in a political tribe. It can be a result of peer pressure or the desire to avoid social sanction. But incurring greater costs to vote in closer elections is also perfectly consistent with a calm, reasoned, and above all intelligent response to the preferences with which we are endowed.

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Update: Andrew Gelman and Steve Waldman are also worth reading on these issues, although their perspectives differ somewhat from mine. Andrew argues that in swing states the probabilities of being decisive are not effectively negligible, and therefore does not accept the basic premise of Arena's argument. Steve maintains that the argument is "right but wrong-headed" and shows that norms of political participation sustained by sanctions can be stable. Voting is clearly rational in the presence of such norms, as is resistance to the kinds of arguments that Arena makes.

The first action I took as an American citizen was to register to vote; I did this within minutes of receiving my naturalization certificate. I plan to cast a ballot tomorrow in the great and resilient city of New York, even though there isn't a competitive race in sight. Doing so won't affect the outcome, but it will certainly affect the experience of watching the returns come in, no matter who the winner may be.