What are prediction markets?

Prediction markets are marketplaces where people trade on the outcomes of future events. Market prices can indicate what the marketplace believes the probability of the event is. For example, “who will win in a sporting event?” For this sporting event there will be two tokens, one for each team. If the price of token A is higher than token B, it means that the market believes team A has a higher chance of winning.

Indice de Contenidos

  1. How prediction markets work
  2. What are the uses of prediction markets?
  3. Centralized or decentralized prediction markets

How prediction markets work

Most prediction markets are a binary option market (e.g., “yes” or “no), where the two options will expire at the price of 0% or 100%. Before expiry, the two assets trade between 0% and 100%, which indicates what the marketplace thinks the odds are. Let’s return to our sporting event example. If the market price of token A is US$0.30 and the price of token B is US$0.70, then the market believes the likelihood of team B winning is approximately 70%.

What are the uses of prediction markets?

Prediction markets can be seen as an extension of derivatives markets. Derivatives, such as futures and options, are used to predict the future price of assets such as oil, gold, stocks, and bitcoin. Prediction markets do the same for events.

Read more: What are derivatives?

Derivatives markets are also used to bet on the probability of some future events, but indirectly. For example, if you believe a certain political party will win the US presidency, you might express that belief by buying or selling certain stocks and commodities. Prediction markets allow people to place bets directly on the probability of the election. In this way, prediction markets can be seen as a “cleaner” way to express your views of the future.

Prediction markets might also be a public good. They have proven to be relatively accurate at predicting future events. Companies such as Google have begun to use prediction markets. Financial institutions pay attention to prediction markets on things like Central Bank rate hikes. News organizations and society at large pay attention to prediction markets on political elections.

Prediction markets are still a young industry. It seems likely that their predictive power will only increase as a more and varied group of people participate.

Centralized or decentralized prediction markets

Most prediction markets exist within the legacy finance and web2 framework. There are many centralized prediction markets regulated by government organizations like the SEC. These centralized markets have several problems that impact their predictive power.

The most important problem with these centralized markets is that they have low limits on how much each person can bet. This limits the predictive power of prediction markets, because even if a person has very strong conviction about an outcome and the means to back it up, they are capped at limits well under $1,000. This is especially true when someone believes that the likelihood of an event is very mispriced. They, and like minded people, will be unable to capitalize on the market mispricing, and the prediction market will grossly misrepresent the probabilities.

Legacy prediction markets need to KYC their customers, shutting out many people. A smaller, narrower pool of people likely skews the market's predictive power. Finally, prediction markets have high fees (e.g., a 5% withdrawal fee on PredictIt) — an all too common problem with legacy financial products.

Decentralized crypto prediction markets solve these problems. They do not limit people’s ability to fully express their conviction on an outcome. There are decentralized projects that do no have jurisdictional or KYC requirements. Finally, as is the case when comparing any DeFi protocol to its legacy market counterparts, fees are much lower.

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