Introduction
When you stumble across the terms blockchain and markets in the same sentence, you no doubt consider the booming ecosystem of exchanges facilitating cryptocurrency trades. Blockchain technology is incredibly versatile, however, and allows for markets of all sorts to be built on top of it.
Financial assets can be either physical objects (tangible) or digital goods (intangible). But regardless of the type, where there are assets that hold value, there is a potential market.
In this article, we’ll take a look at a particular kind of market that could benefit significantly from blockchain technology – prediction markets.
What are prediction markets?
A prediction market is a speculative market where participants trade not on options or cryptocurrencies, but instead on information. Specifically, investors in prediction markets bet on the outcomes of future events.
This can be any event conceivable (provided, of course, that a broker is willing to list it). Let’s take the example of a question with a yes/no outcome: Will a train from the US to Europe run by 2025?
There are two possibilities here. Either it will, or it won’t. If you’re confident that such a train will not be operational in the next five years, you could purchase a number of no contracts. These might be priced somewhere between $0 and $1.
If the train is not running by the deadline, no contracts will be redeemable for $1, and yes contracts will have no value. Conversely, if it does operate, then no contracts will be worth nothing while yes contracts will be worth $1.
In the meantime, the value will fluctuate as market sentiment changes, and new information becomes available. In our above example, for instance, prices of no contracts might increase if there is no development in underwater tunnel technology as the deadline nears. An announcement that a major company plans to roll this train service out for 2024 might, however, cause the price of yes contracts to increase.
It seems like a standard speculative market. Participants will purchase contracts in the hopes that they’ll increase in value over time. But prediction markets are far from your average speculative platform. When used correctly, they can be powerful forecasting instruments.
Why are prediction markets useful?
Chances are that, in placing a bet, a market participant has some knowledge that influences their decision. Unlike in regular gambling, there are external factors that will impact the likelihood of particular outcomes.
Smart investors will do their research, and experts will weigh in. Those with insider knowledge or familiarity with the subject matter will invest in the contracts they feel are most likely to be worth more. In a nutshell, prediction markets serve as aggregators of information.
In our cross-continental train example, if no contracts are trading at $0.90 and yes contracts at $0.10, it tells us that relatively few people have faith in the concept’s success. The market’s collective insights have been reflected in the data, as those with information are economically incentivized to ‘report’ their knowledge.
Prediction markets excel at amassing and representing information. They work on the principle that the wisdom of the crowds will always be superior to the data known to only a few experts. By examining these markets, stakeholders across all industries – from IT to renewable energies – can benefit from understanding what the ecosystem believes is likely to occur. More than that, the markets crowdsources information to get an accurate picture of future outcomes.
Proponents even believe that prediction markets could serve as a core technology in a new form of democracy known as futarchy.
We need not have yes and no contracts, either. We can use any mutually-exclusive outcomes – one popular example is that of a presidential election. Suppose that two candidates, Candidate A and Candidate B, are competing. Betters could buy Candidate A contracts if they believe Candidate A will win, and Candidate B ones otherwise.
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Prediction markets and blockchain technology
Prediction markets may very well be formidable tools, but their value proposition could be greatly strengthened if they were to be decentralized. Centralized platforms today are limited in what they offer – whether due to local regulations or to owners’ reluctance to list certain contracts. Ultimately, users must trust the operator of such a platform, and pay additional fees for the ability to make use of their services.
The conventional centralized model can be replaced by decentralized alternatives with a blockchain-based approach. This can provide many benefits, such as censorship-resistance, a reduced number of intermediaries, and increased accessibility.
Censorship-resistance
Incumbent prediction markets are typically run by a single party. This means that entities such as government authorities or malicious actors can easily shut them down. Decentralized platforms cannot be taken down so easily.
When governed by smart contracts, this single point of failure no longer exists. Every node on the network runs the code. Should the contracts be built in a certain way, no user will be able to edit or delete the programs that underpin the market.
No middlemen
Blockchains don’t require administrators. As the work traditionally done by third parties is outsourced to automated code, there is no longer a need for intermediaries. Users interact directly with smart contracts, meaning that they don’t pay fees to a third party (as would be expected with a centralized platform). This also removes some counterparty risk since the user isn’t trusting anyone.
Permissionless
With decentralized prediction markets, individuals around the world are free to place bets or to create contracts available to users globally. Geographic and regulatory restrictions that plagued previous platforms could cease to be a problem.
The power of blockchain oracles
If there’s no broker and no form of central authority, how do we determine which outcome has occurred at the time of expiry?
We would need some kind of “truth” mechanism here – and this is where blockchain oracles come into play. We want to be able to draw on a source of data that tells us with certainty whether an outcome did or did not happen. To do this, there are a handful of possible approaches.
The simplest would be to tap into a third-party website or feed, but that fundamentally undermines the use of a blockchain. After all, the third-party would be in control of the outcomes – they could choose to lie for their own gain, or become a target by those seeking to cheat.
Another option is to financially incentivize users to truthfully report on events. Staking mechanisms can be implemented, which require that users put forward tokens to report. Should they report correctly, they will receive some form of remuneration. Attempt to cheat, however, and they will lose their stake. This model is used by Augur, the first blockchain prediction markets platform, for dispute resolution. Others, such as Gnosis, allow users to pick from a range of centralized and decentralized solutions.
The use of blockchain oracles in prediction markets is a relatively new concept. As a nascent technology, we have yet to see which form of oracle is best suited to the different types of prediction markets. Last year, Binance Research published a report on the matter. Notably, they identified a Design Flaw Attack and other flaws in one of the most popular implementations of prediction markets.
Closing thoughts
Prediction markets are exciting tools for betting on future outcomes, but they’re also sophisticated instruments for gleaning reliable information on virtually anything. By financially incentivizing individuals to share their own knowledge on a market, we can generate insights into social, industrial, and political trends.
As it stands, the shortcomings of centralized platforms prevent prediction markets from living up to their true potential. But that’s poised to change with decentralized alternatives. As more capable oracles are developed, blockchain technology could host provably fair code that can’t be tampered with.