Prediction markets like Augur harness the wisdom of the crowds to predict the outcomes of current events. They also give crypto traders a chance to profit from those results. Our Augur 101 Guide will explain how crowdsourced predictions work, introduce you to the new decentralized platforms and show you the dangerous regulatory waters these platforms swim in.
Prediction Markets Explained
In his book The Wisdom of Crowds, James Surowiecki describes a series of sociology experiments in “group intelligence.” Whether the experiment asked people to guess the room temperature or how many beans were in a jar, the average answer was remarkably accurate. Even in situations where participants have little technical understanding of the topic, the combined wisdom of a group can be better than an expert opinion. “Under the right circumstances,” Surowiecki wrote, “groups are remarkably intelligent, and are often smarter than the smartest people in them.”
In a way, that is what a stock market or a casino’s sportsbook does. Millions of people every day use money to declare their opinion on the direction of a stock price or the results of a tennis match.
Prediction markets work the same way, using market dynamics to predict the results of current events. At the dawn of the internet, the University of Iowa created the Iowa Electronic Markets (IEM) which let people invest small amounts on the outcome of political elections. More often than not, the IEM was more accurate than opinion polls. (The 2016 election was a rare exception where the IEM predicted a Clinton victory.)
The first commercial prediction market was a company called InTrade. Founded in 1999, the Ireland-based company’s success earned it citations in academic studies and serious attention from political pundits. By 2012, InTrade users were making more than a million trades. The year ended on a sour note amid allegations that supporters of Mitt Romney’s presidential campaign tried to manipulate the election’s prediction market. Less than a month later, the US Commodity Futures Trading Commission (CFTC) sued InTrade for trading unregistered futures contracts and for ignoring a 2005 order to stop selling the contracts to US citizens. The company shut down shortly afterward.
Prediction Markets and Regulations
In the world of commodities trading, there’s this thing called the binary option. The option asks whether a commodity at a certain date will be above a certain price. Because binary options are almost synonymous with gambling, and because they are a popular vehicle for con artists, financial regulators around the world tightly regulate their trading.
A prediction market is not too different from a binary options market. This is what triggered the CFTC’s actions against InTrade. It is also the reason that the IEM only lets people invest up to $500 in its elections markets. The CFTC gave the University of Iowa a special dispensation given the IEM’s educational purpose.
The CFTC has issued several bans against certain kinds of prediction markets. In 2012, the commission rejected a request for unlimited trading on the results of US federal elections. The commission called the practice gambling. A formal rule, CFTC Regulation 40-11 bans the trading in a so-called events contract “that involves, relates to, or references terrorism, assassination, war, gaming, or an activity that is unlawful under any State or Federal law.”
Put in on the blockchain
In the eyes of their developers, decentralized prediction markets have an advantage in they can’t be regulated. The blockchain eliminates the central authority and places responsibility for the decisions in the hands of users. If the blockchain exists everywhere, then the markets aren’t in the jurisdiction of any one government.
Read the FAQ page published on the Augur website. Almost all of it consists of statements from the project’s developers to the effect that they are not responsible for any illegality.
“Users of the Augur protocol must themselves ensure that the actions they are performing are compliant with the laws in all applicable jurisdictions and must acknowledge that others’ use of the Augur protocol may not be compliant.”
That may not work when regulators get fed up. In an interview with MIT’s Technology Review, Cardozo School of Law professor Aaron Wright pointed out that Augur’s founders could get prosecuted for trades made on the platform just as malware developers get prosecuted for the actions of others. “Just because there is no center doesn’t mean there aren’t indirect ways to attack lawless activity.”
Decentralized Prediction Markets
Not too long after the cryptocurrency movement started, people began dreaming of decentralized prediction markets running on the blockchain. Here are four new and emerging prediction market platforms that could let you profit from the future.
Jack Peterson and Joey Krug founded Augur in 2014, but it took another four years before the prediction market opened its doors. After four years of shepherding the project through their Forecast Foundation, Peterson and Krug no longer have control over the decentralized project. But they do have influence as the founding developers.
Augur launched in early July 2018. Nine days later, participants created more than 480 prediction markets with “open interest” of almost 2,000 ETH. Open interest is a measure of the order volume in Augur’s prediction markets. By mid-September, the number of prediction markets exceeded 1,100 and the open interest approached 5,000 ETH. The fall in ether’s value relative to the US dollar, however, means the dollar value of Augur’s markets only rose about 10% over the past four months.
How Augur works
The Augur system automatically manages the order book for each market. As traders place orders, the system finds match orders or places open orders on the order book. Augur users are the ones that create, trade and close the prediction markets.
Market creators start the process off by opening a new prediction market. They phrase the prediction, define the criteria for success or failure and declare what independent source the market’s resolution should come from.
Only holders of reputation tokens may create a prediction market on Augur. To encourage the creation of high-quality markets, Creators must put up an amount of ether as a validity bond. As long as the market closes with a valid resolution, the bond returns to the creator.
Market creators earn ether from their prediction markets through the creator fees charged at settlement. Creators can also earn ether by providing liquidity to their prediction markets.
Traders on the prediction market use ether to go long (buy) or short (sell) one side of the event or another.
Reporters finalize a prediction market by declaring which of the two possible outcomes occurred. Reputation token-holders can stake their tokens to become reporters. They buy participation tokens on a one-for-one basis. When reporters decide to stop, they redeem their participation tokens one-for-own for reputation.
While active, reporters provide the answers for as each prediction event happens or fails. The consensus answer among the reporters decides the outcome of the market. In exchange for their participation, the reporters earn the reporting fees proportional to the amount of reputation they staked.
Augur ensures the credibility of the reporter community by penalizing reporters who give wrong answers. Traders can appeal the reporter’s decision and, if they win, the reporters lose the reputation tokens they staked.
Augur’s Settlement Fees consist of two separate charges. The market creators define Creator Fees of between 0 and 50% at the time they create their prediction markets. Traders must also pay a Reporting Fee to support the reporters who close the market. The Augur system calculates the Reporting Fee based on the market cap of reputation and the trading volume with Augur itself.
Since ether is Augur’s operating currency, traders also pay Ethereum’s gas fee to get their transactions processed.
All of this activity happens through the Augur desktop app, which includes a local Ethereum node to make the app run faster. A browser version of Augur’s app is available, but only on Augur’s testnet.
Augur’s approach to app design does impose a penalty at setup time. You must wait for hours while the app downloads the Ethereum blockchain to your computer and then extracts the Augur market data from the blockchain.
Use the browser version if you just want to look around.
Augur’s decentralized structure creates several advantages over the original prediction markets. Trading fees are lower, since there’s no third party skimming off the top. In addition, Augur’s protocols automatically pay out as soon as each market reaches its outcome.
Decentralization also makes Augur more open. There is no central authority dictating what predictions users may trade in. Augur’s use of ether as a trading currency reinforces that openness. While many exchanges list the reputation token, the numbers pale in comparison to the exchanges that deal in ether.
Criticisms of Augur
It only took two weeks after Augur’s launch for users to open prediction markets on political assassinations. Despite the fact that few if any people bothered to trade on these markets, the mainstream media ran with their sensationalist headlines. Newsweek’s was a case in point: “Welcome to Augur, the Cryptocurrency Death Market Where You Can Bet On A Donald Trump Assassination.”
The Augur community seems to have quashed these kinds of predictions, however. None of the 200 markets with the most money at stake speculate about Donald Trump’s lifespan.
More damaging, perhaps, is the dramatic falloff in user activity following Augur’s launch. Data from DappRadar indicates that fewer than 34 people per day have used Augur in September.
A related weakness is the lack of diversity among the people who do use Augur. According to data from Predictions.Global, “cryptocurrency” is the largest category of prediction markets. With a third of the active prediction markets, bets on cryptocurrency movements comprise more than 80% of the funds at stake. With so little at stake in other areas of interest, more mainstream users may find little going for Augur.
Martin Köppelmann and Stefan George founded Gnosis in 2015. By 2017, enough progress had been made on the Ethereum-based platform that the founders decided to crowdfund Gnosis’ development. Rather than conducting an initial coin offering, they used a Dutch auction in which the token price starts high and declines until it matches the demand from bidders. Within 15 minutes of launching their auction, Gnosis raised $12.5 million and established a valuation of more than $300 billion.
Gnosis’ prediction market platform only reached the alpha testing phase, codenamed Gnosis Olympia, at the end of 2017. The project is simultaneously developing the platform, a multisig wallet and a decentralized exchange for ERC-20 tokens. The Gnosis roadmap only extends through the end of 2018, so there’s no telling when its prediction markets will actually appear.
How Gnosis works
The only indication for how Gnosis will work is the Gnosis Olympia alpha test which ran from October 2017 through early-January 2018. Gnosis structured the testing program as a contest. Participants received 200 units of play-money, the OLY token, to begin creating and trading on prediction markets. Every couple of days, Gnosis topped up the participants’ OLY accounts to keep them in the game. At the end of the contest, Gnosis awarded GNO tokens based on participants’ play-money profits.
The most notable difference between Gnosis and other prediction market platforms is the way traders place their orders. Gnosis will use a Dutch auction to match prices to demand.
Israeli fintech startup invest.com decided to launch its own predictions market, called Stox, last year. Stox launched its ICO in mid-2017 with support from celebrity endorser, heavyweight boxer Floyd Mayweather. The company raised more than $30 million. Although the STX token now trades at a fraction of its sales price, Stox has had a successful 12 months since then. More than 200,000 users created and traded on 1,000 prediction markets worth more than 210 million STX.
One reason for that success was the aggressive pace of development Stox set. Compared to other prediction markets whose timelines extend for years, Stox went from ICO to alpha test in 3 months, to the open beta phase 3 months after that. The roadmap targets full product launch for Q3 2018.
Liquidity and regulation
Generating liquidity has been as important to the Stox team as executing the technology. As a result, Stox implemented several marketing programs to help drive user adoption. Prediction Tournaments built around sporting events like the FIFA World Cup and Wimbledon offer STX-based prizes. Sponsored ICO Predictions lets ICO teams promote their projects and get feedback from the prediction market.
Finally, Stox smoothed over a big friction point by integrating with Changelly. This makes it easy for new users to purchase STX tokens without having to join lesser-known exchanges.
The company’s lawyers have been just as fast-paced as its developers and marketers. In October 2017, Stox acquired European developer Commologic, which already has licenses from gambling regulators in the UK and Malta. In an interview with VentureBeat, Gertner said that “Stox is predicting that they will be needed in the near future.”
How Stox works
Participants in Stox can assume any of three roles: provider, operator and user. Providers generate traffic and develop apps on the Stox platform. Operators create the prediction markets and manage the results. In what may be an unfortunate example of poor proofreading, Stox’s FAQ says “Last but least are the users, who are the investors taking part in events.”
Participants can use the Stox web app. The company also has a beta version of its mobile apps for Android which users can sideload.
Blockchain developer Xiahong Lin founded Bodhi in 2017 as China’s first distributed predictions market.
A seed round raised $1.5 million. By mid-2017, Bodhi was ready to launch its ICO and closed a token presale of $10 million. Then, China’s government banned ICOs. Bodhi had to refund the investors and go to Plan B: an initial exchange offering. Bodhi placed 40 million of its Qtum-based token, the BOT, on five Asian exchanges in late 2017. Like every other crypto asset, the price for BOT declined since then. To be fair, though, the 30% drop from its original listing price isn’t as bad as other junk coins.
Bodhi’s developers chose to build the prediction platform on the Qtum blockchain rather than Ethereum because of the worsening transaction delays on Proof-of-Work blockchains like Ethereum. Qtum’s Proof-of-Stake platform promised faster, more efficient execution.
Bodhi went live in April 2018, beating Augur and Stox to the market. “It’s a major milestone for us,” Lin said in the announcement, “While other prediction markets are still not live, we already have a fully-decentralized blockchain application for the public to use.”
How Bodhi works
Bodhi runs on a combination of qtum tokens and the prediction market’s own BOT staking tokens.
As with other prediction markets, Bodhi divides responsibilities between three roles. Event Creators initiate new prediction markets, staking their BOT holdings in the process. Result Setters, who also stake BOT, define the event’s result through consensus. General Participants stake their BOT holdings on the event’s outcome.
Note that due to regulatory issues, Bodhi blocks people in China, Singapore and the United States from signing up.
The potential benefits of prediction markets are real. But so is the murky regulatory environment. Making things worse, the decentralized nature of blockchain-based platforms may turn out to be a weakness. Just for the fun of it, blockchain developers are creating the specific kinds of prediction markets that regulators hate the most. The people joining these platforms know little about futures regulations in their own countries, much less other countries.
Can a completely decentralized platform like Augur survive? Or will a more centralized platform like Stox that can police the markets and work with regulators have the upper hand? In the words of the Jedi master, “Impossible to see, the future is.”