As the Presidential primary elections continue, news outlets have been reporting the accuracy of prediction markets used to predict which candidates will win. A prediction market is like a securities exchange; but instead of trading stocks, market participants trade “contracts” that designate whether an unambiguous future event will occur. The contracts trade among market participants with bid and ask prices the same way that stocks trade on a stock exchange. The bid and ask “prices” are typically limited to between 1 and 100 “points,” which represent money on some prediction markets. The 1-100 scale allows market participants to think of the trading price as the percentage likelihood that an event will occur.
For example, one such contract available on RasmussenMarkets.org, which is a prediction market that does not use money, is whether Hillary Clinton will receive the Democratic Presidential nomination in 2008. Currently, this contract is trading at around 60 points, which means that market participants collectively think there is a 60% chance that Clinton will receive the nomination.
The theory of a prediction market is that by giving individuals an incentive (often monetary), they will collectively use the information available to them to predict an accurate outcome. For example, RasmussenMarkets.org accurately predicted that Barack Obama and Mike Huckabee would each win in the Iowa caucuses.
Prediction markets implicate securities laws because the markets are particularly vulnerable to inside information, as evident by the fact that the price of a contract often increases or decreases dramatically in the days preceding a scheduled outcome. If people are trading on inside information, this begs the question of whether the SEC could intervene, which would first require determining that the contracts traded are securities. Interestingly, the Iowa Electronic Markets, a non-profit, research-based prediction market created by faculty at the University of Iowa, uses real money but operates under a “no-action” letter from the Commodity Futures Trading Commission.
Below are some other popular prediction markets: