The dream scenario for prediction markets
Polymarket and Kalshi are soaring in popularity. With a few tweaks, they could really take off
If you could invent something to fulfill an economist’s dream, it would look an awful lot like a prediction market.
A world where every uncertain future can be priced, hedged and insured against?
Kenneth Arrow and Gérard Debreu would approve.
A market mechanism to co-ordinate the decentralised wisdom of crowds, ensuring the accuracy of such prices?
Adam Smith and Friedrich Hayek sought just that.
In recent years, the fantasy has crept closer to reality.
Platforms that allow users to speculate on current affairs and more have seen remarkable surges in volume and visibility.
On Polymarket, the largest, traders wagered over $1bn last month, up from $63m a year before.
In both the court of public opinion and the actual courts, exchanges have scored significant victories.
Most important, their forecasts have held up: where opinion polls cast November’s presidential election as a toss-up, prediction markets priced in a victory for Donald Trump.
More recently, they did a better job than other sources at predicting Israel’s strikes on Iran and the result of New York City’s Democratic mayoral primary.
Yet despite having proved their worth as a way to discover information, prediction markets have further to go when it comes to fulfilling their full economic promise.
That is true both in their ability to help financial institutions hedge and share risk, and as a meaningful addition to capital markets.
Goldman Sachs, a bank, may cite prediction markets in its research, but active trading by institutions of its size remains virtually non-existent on the platforms.
The absence of serious capital reflects several factors.
One is scale.
Although presidential races draw widespread interest—some $3.7bn was wagered on Polymarket in the most recent—other events attract less action.
Consider inflation, an important economic variable.
The market for Treasury inflation-protected securities, which reflect investors’ expectations for consumer prices, is worth nearly $2trn.
By contrast, the most active financial market on Polymarket (“What price will bitcoin hit in June?”) has welcomed wagers worth just $22m.
Low liquidity poses a number of challenges.
The biggest investors may have hedging needs that exceed the size of the markets themselves.
Moreover, thin markets are vulnerable to price manipulation by large traders, as has happened several times in prediction markets.
Traditional finance may not offer markets for all possibilities, but it comes closer than is often appreciated.
Inflation swaps and federal funds futures forecast inflation and interest rates, respectively.
Even non-financial events are well-priced by traditional markets.
Commodity futures predict the weather; the price of Brent crude closely tracks geopolitical developments.
For many in finance, prediction markets offer, at best, marginal improvements on existing tools.
If they are to take up this offer, financiers need a firmer regulatory footing.
Polymarket is off-limits to Americans, having been accused of running an unregistered derivatives-trading platform.
Kalshi, though approved, is mired in disputes over which contracts are legitimate futures and which are gambling.
Wrinkles are to be expected as regulators confront hard questions, such as whether insider trading should be allowed to improve accuracy. Although regulators under Mr Trump have become more open to prediction markets, it is uncertain whether future administrations will follow his lead.
Some platforms are not helping their cause.
They have, for instance, lobbied regulators to put sports betting and event contracts on an equal legal basis, which may boost revenues, but risks tying economically meaningful markets to more controversial retail offerings.
Many real-world risks—ranging from surprise GDP readings and legislative outcomes to rare climatic events and the cost of compute for artificial-intelligence firms—could be emphasised.
Doing so might mean curtailing other markets.
Credibility suffers when contracts about future interest-rate cuts sit alongside such wagers as “Will Jesus Christ return in 2025?” (3%) or “Will the ‘Smurfs’ Rotten Tomatoes score be above 60?” (26%).
What odds should you put on prediction markets taking these steps?
Your columnist would say about 10%.
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