by James M. Klas
Prediction market ventures represent an existential threat to both the gaming industry and to traditional derivatives markets due to their attempts to disguise their true nature to capture large amounts of money from the average person and transfer it to the wealthy with limited regulatory oversight.
It is important to understand that the name “prediction markets” is incorrect. Prediction market ventures are in fact neither predictive, nor markets in either the true technical meaning of the terms or in their practical operation and results. They demonstrate a definite favorite/longshot bias and are too often wrong to be considered a reliable means of anticipating future results. The fact that they can outperform polls is far more damning of polls than supportive of prediction market reliability.
For a prediction market to be effective on a theoretical basis, it is necessary for the individuals in the crowd to be as diverse in viewpoint as possible and for them to not know what the others in the crowd have guessed. If, instead, the members of the crowd are more homogeneous and have extensive or even partial knowledge of what other guesses have been made, the overall average converges of its own accord to an answer that is usually much less accurate or flat wrong. Since prediction market ventures are offering people an opportunity to wager on events over which they have no control and allowing them to see the trend of the wagers by all before them on the same issue, it is no surprise that the results often diverge from what was supposedly predicted by the venture.
Prediction market ventures are also not, in fact, markets. Much confusion has been generated around the many arguments offered by creators and proponents for why prediction market ventures are not gambling, but rather trading markets.
One argument is based upon the fact that wagers on prediction markets are contracts, as though that is somehow different from any bet. The claim is that people have entered into a contract to pay each other a defined amount based upon the outcome of some future event or occurrence. This argument overlooks or ignores the fact that every wager is a contract. When a person puts money into a slot machine, puts chips on the table for a hand of blackjack, wagers on a horse race or sporting event, buys a bingo card or any other form of wagering, they are entering into a contract with the person or entity accepting the money that said entity or person will pay a defined amount if the outcome of the event or occurrence for which the wager was made meets the necessary requirements. The absence of the word contract, the absence of any writing or documentation, the location and conditions under which the wager was made, say a casino or a race track, do not change the fact that every wager is a contract in precisely the same way that a contract on a prediction-style platform is a wager.
A second argument is that the prediction market venture is not “the house” in the traditional sense of a casino where the bettor places their wager directly with the house and the house pays them an agreed upon amount of money if they win or keeps the money in its entirety if they lose. This is both irrelevant and untrue. It is irrelevant in that facilitating gambling between individuals for profit also qualifies as operating a gambling establishment. It is also not true that prediction market ventures have no interest in the outcome of the wager and do not profit from that outcome. Some prediction market ventures have related entities that operate as makers on their own platforms, making wagers directly with individual customers. If the outcome favors that entity, they get paid. If not, the customer gets paid and the entity loses. This is the exact definition of “the house.”
In reality, prediction market ventures include prize, chance and consideration, the long-standing fundamental legal markers of gambling. The rare carveouts from those markers for unique situations have always revolved around the scale, frequency and amount of money involved, none of which apply to prediction market ventures.
Prediction markets are already affecting the gaming industry and the effects will get much worse. But beyond the competitive impacts of prediction market ventures, there is a greater long-term threat to both the gaming industry and to the derivatives markets embodied in the formats of the prediction-style entities. That threat could ultimately result in the demise of the gaming industry and in severe damage to and contraction of the derivatives markets.
From the crash of 1929 (and even earlier, lesser-known crises) through the savings and loan crisis, the dotcom crisis, the mortgage-backed securities crisis and other meltdowns, the pattern has been consistent. Significant investment or financial participation by average people, often those who are disadvantaged and desperate, combines with new and supposedly innovative financial products and markets that rapidly expand the availability of capital. These products and markets offload risk from those closest to the transaction and best positioned to recognize it onto investors farther upstream, who participate more passively in what they believe to be safe, or at least consistently profitable, vehicles. The result is an early surge followed by a major crash that takes down not just the large-position investors but average families as well.
Prediction market ventures are the newest version of that kind of supposed innovation. They are specifically and intentionally designed to capture money from average individuals not normally available to derivative markets, thereby increasing the amount of capital those markets can access. From the day they were first formed, that has represented a risk to commodity and derivative trading markets. With the recent expansion into gambling, they now also represent a risk to the gaming industry.
All of the elements for a catastrophic collapse are there: a massive upswing in participation by unsophisticated participants; a nationwide reach for a limited number of entities operating at huge volumes; a single regulatory body, the CFTC, ill-equipped to deal with a new platform that they do not recognize as substantially different from their normal responsibilities (and inexperienced at managing risk for large numbers of unsophisticated participants); creators and high-wealth participants with incentive to push the boundaries as far as possible to maximize their own profits; and finally, a structure that offers easily exploitable opportunities for cheating and manipulation and is vulnerable to unanticipated shocks that disrupt its normal operating patterns.
Given the combination of circumstances, a crash is highly likely, if not inevitable. When it happens, it could easily result in a rapid change in public acceptance of gaming and of derivatives markets that could significantly curtail both industries. Any person, entity or government that has a vested interest in the success of legal gaming and/or traditional derivative trading should be actively seeking to limit the risk posed by the prediction market ventures and to do whatever they can to insulate themselves from their demise.
The collapse of prediction market ventures as currently structured will come from one of or, most likely, a combination of three potential crises. One version would be the catastrophic failure of one or more major “makers” due to some combination of bad bets or overextension of debt to increase their betting positions. While the large-position makers have significant advantages over average investors and under normal circumstances make nearly all of the profits available, they are not immune to bad bets. In the rush to maximize the profitability of their positions, they are even more likely to overexpose themselves by leveraging debt to increase their positions. If one or more large makers suddenly collapses or is forced to curtail their participation, the overall market for wagering through prediction market ventures would likely fall with it.
A second version would be a massive cheating or manipulation scandal that ensnares popular figures, costs individual bettors large sums of money and calls into question the validity and security of the entire system. Essentially a “say it ain’t so, Joe” moment. If enough scandals occur or if one or two major ones occur, they could be sufficient in their own right to change public sentiment. It is not difficult to imagine such an occurrence given the already well-publicized small-scale cheating scandals that have occurred. The longer the prediction market ventures are in place and the greater their reach, the more likely it is that a cheating or manipulation scandal will go beyond one of minor concern to one of market shaking import.
The third likely version would be the accumulated losses of average people over time to the point that their ability to sustain themselves and their families is compromised. The structure of prediction market ventures naturally concentrates winnings amongst a small number of ultra rich people. The prediction market ventures are too new, especially their sports betting components, to have caused enough economic damage to individuals and families at this point to generate a nationwide wave of resentment. However, the pattern will quite possibly lead to a much more visible and unpopular amount of consumer losses as the ventures grow in size and geographic reach. Legal online sports betting under state and tribal regulation includes measures to mitigate such risks. No such measures exist for prediction market ventures.
Most likely, there will be a combination or accumulation of more than one of these possible outcomes, perhaps all three, that leads to such a change in public tolerance. If that shift led only to restrictions on or elimination of prediction market ventures, that would be less of an issue. But it is very likely to be accompanied by corresponding resentment toward legal gaming and established derivative markets that become guilty by association through no fault of their own. That risk, in the end is the greatest, if not necessarily the most immediate economic danger of prediction market ventures.
IGA, the AGA and many other governmental entities and industry professionals are already fighting aggressively to rein in the spread of prediction market ventures and to establish the authority of states and tribes to regulate their activities on their lands. The fight to sustain tribal and state sovereignty and reject the notion that prediction markets for sporting events are in any way not gaming must continue aggressively.
James M. Klas is Co-Founder and Principal of KlasRobinson Q.E.D., a national consulting firm specializing in the economic impact and feasibility of casinos, hotels and other related ancillary developments in Indian Country. He can be reached by calling (800) 475-8140 or email [email protected].