It's traditionally been understood that financial
markets exist to allocate capital to its most productive
uses. Recently, however, the
definition of a productive use has been expanded to include
betting on whether a reggaeton artist will wear a dress to a
football match. In the past, if you'd wanted to
place a bet on Bad Bunny's wardrobe choices, or perhaps the
precise timing of an Iranian missile strike, you had to find
a man who conducted his business behind a local pub.
Today, the process is a bit smoother to a rather impressive
piece of legal rebranding. What the authorities used to
call gambling is now referred to as trading event contracts.
This means that when you inevitably lose your money on
these platforms, you're no longer a degenerate gambler,
you're a retail liquidity provider contributing to a truth
machine. Which sounds much more
respectable. I wouldn't necessarily put it on
your CV though. Reading up on prediction markets
is somewhat exhausting, unfortunately.
We seem to be determined to financialize every single aspect
of human existence. It used to be that if you wanted
to know if it might rain tomorrow, you'd just look out
the window, but now it seems you have to check the bid ask spread
on a precipitation swap. The advocates for platforms like
Calcium Polymarket argued that they're providing A vital public
good. The theory is that by allowing
people to bed on anything from congressional control to the
next Federal Reserve decision, the information fed back will be
far more accurate than traditional polling.
Which is a lovely idea. But looking closely at how these
markets actually work, it appears that we haven't so much
invented a truth machine as put a glossy user interface on a
1920s betting shop and to make it even better, invited a group
of quantitative algorithms to come in and extract money from
the public. Today we're going to look at how
these markets actually work, the legal absurdities surrounding
them, why the commodities regulator is suddenly interested
in elections, and what whether any of this makes the world a
better place, or if we've just turned the whole world into a
casino. To understand why the US
government is fighting with itself over who gets to regulate
a bet on a football game, we need to go back to the origins
of American financial regulation, and specifically
onions. In the United States, there's a
federal agency called the Commodity Futures Trading
Commission, or the CFTC. They were originally established
to oversee futures contracts on things like wheat and cotton.
The idea was that these markets would allow farmers and factory
owners to hedge their price risks while making sure that
these contracts weren't just illegal gambling.
For a long time, the CFTC applied what it called an
economic purpose test. They only approved contracts
that served some hedging or price discovery function.
But over the years, the exchange exchanges realized that they
could generate significantly more revenue by listing futures
on interest rates and stock indices.
The CFTC went along with this, and the definition of a
commodity future was slowly expanded to include things that
are not really commodities at all.
A few years ago, Bitcoin was even classified as a commodity.
While it's about as far from being a basic raw material,
agricultural product, or physical asset as anything could
be. So almost anything can be
considered a commodity, with one notable exception.
Thanks to the 1958 Onion Futures Act, you can trade futures on
almost anything in America, but it's illegal to trade futures on
onions. This happened because in the
1950s, two traders managed to corner the Chicago onion market,
artificially inflating the price before crashing it entirely.
The chaos led to angry farmers and, naturally, an act of
Congress. So to summarize the current
state of American financial law, you can legally bet on the
outcome of a geopolitical conflict.
You can bet on the future price of an Internet meme token.
And thanks to platforms like Calci, you can now bet on who
will control the United States Congress.
But if you attempt to hedge your exposure to French onion soup,
or really any onion soup, the federal government will step in
to protect the public from you. No soup for you now.
Up until recently, the CFTC has been quite skeptical of what
they call event contracts. They explicitly banned contracts
involving war, terrorism, assassination, and gaming.
They also tried to ban election contracts, arguing quite
sensibly that approving them would effectively turn the
commodities regulator into an election cop.
And this is not an unreasonable concern.
If you allow people to trade contracts on election outcomes,
the CFTC is then responsible for making sure no one is
manipulating those outcomes, which means that they now would
have to worry about whether an election has been rigged or if
foreign governments are getting involved.
The CFTC was set up to make sure that wheat prices are fair.
Election monitoring may be even further outside their mandate
than Bitcoin. One way or another, the
prediction market platforms decided to push back.
They took the regulator to court, arguing that predicting
an election is not gaming, and somewhat surprisingly, a federal
judge agreed with them. Having established the right to
offer election contracts, the prediction market platforms
naturally decided to push their luck.
Their logic is fairly straightforward.
If a presidential election is just an event, then a football
game is surely also just an event too.
So earlier this year Kalci began self certifying sports
contracts. They started offering bets on
the Super Bowl, the NBA and the Masters.
I say bets, but Kalci would obviously prefer if I said event
contracts. The distinction is important to
them, if not to anyone else. This came as something of a
surprise to the individual American states.
Since the Supreme Court struck down the federal ban on sports
betting in 2018, nearly 40 states have spent a great deal
of time and money setting up highly regulated, heavily taxed
sports betting regimes. They have set up state gambling
licenses, compliance departments, tax collection, the
whole thing. No sooner was that done when
these tech companies turned up offering what appears to be
functionally identical bets, but they're claiming that they're
completely exempt from state gambling laws and state taxes
because their bets are technically federal commodity
swaps. If you are a state gaming
regulator who has spent the last six years building out a
licensing framework, you might find this argument somewhat
frustrating. A number of states have
responded by sending cease and desist letters.
Arizona has gone a step further and simply filed criminal
charges against Kalci for operating an illegal gambling
business, which is a bit of a step up from a cease and desist
letter. Ohio has taken an even more
creative approach. A company there is suing Kalci
using the Statute of Anne. This is a British law from 1710,
passed during the reign of Queen Anne, which allows third parties
to sue to recover other people's gambling losses.
The theory is that if Kalci is operating an illegal sports book
in Ohio, any enterprising person can sue them to get the losing
better's money back. It's the sort of 18th century
legal instrument that you would expect to find in a museum and
not in an active federal lawsuit against AY combinator startup.
But this is where we are now. You might expect the federal
commodities regulator to step in at this point and clarify that a
bet on the New York Knicks is not, in fact, a vital financial
derivative. But they have not.
According to the Financial Times, the CFTC has mostly just
been avoiding the question. Well, it's actually a bit worse
than that. Under new administration, the
CFTC and the Department of Justice have gone to federal
court to block the state of Arizona from enforcing its
gambling laws against Kalci. So the federal government now
appears to be deploying its legal resources to defend a tech
platform's right to operate what Arizona considers an unlicensed
sports book, overriding state law in the process.
Whatever your views may be on prediction markets, you have to
agree that this is a rather unusual use of the Department of
Justice's time. Now, if you're wondering why the
new administration might be so accommodating to these
prediction platforms, there's one small detail that's probably
worth mentioning. A fellow named Donald Trump
Junior, who seems to be some sort of relative of the sitting
president, is currently serving as a strategic advisor to both
Calci and Polymarket. I looked up this fellow's
background and he appears to have no real work experience in
either strategy or advice. He seems to be a reality TV star
who also worked for his dad's real estate company.
I can't think of why they hired him, but I suppose it's still
worth noting that the President son advises the companies that
the federal government is currently shielding from state
prosecutors. I'm sure that it's it's all a
coincidence. Anyhow, if you ask the
executives at these firms why they deserve special treatment
from regulators, they won't talk about the strategic advice
they've received. They'll instead talk about the
truth machine. The core argument in favor of
prediction markets is that they provide more accurate
information than traditional polling or expert analysis does.
The idea is that when people have to back their opinions with
their own money, they strip away their biases.
They bet on what they think will happen, not what they hope will
happen. The idea is that the market
absorbs all available information and prices and
objective probability of an event occurring.
It's the efficient markets hypothesis applied to
everything, not just stock prices, but elections, wars,
weather, and apparently Bad Bunny's wardrobe.
Now this might sound great in a university lecture hall, but the
problem is what happens when these ideas meet reality?
Because prediction markets are often quite small and thinly
traded, it doesn't take too much money to move the odds.
And if the media is treating those odds as objective truth,
then buying the odds might be a really efficient way of buying
positive press coverage. This has happened already.
During the 2012 U.S. presidential election, a single
trader lost around $7,000,000 systematically buying contracts
on Mitt Romney to artificially inflate his chances on a
platform called Intrade. The goal wasn't to win the bet.
The goal was to make the race look closer than it actually was
and to keep voter enthusiasm high, $7,000,000 is a lot of
money to spend on something that isn't a bad, but as a media
strategy, it's not bad. Cable news covered in trades
odds constantly. More recently, in 2021, a
YouTuber named Brian Rose ran for Mayor of London.
During the campaign, he was accused of gaming the odds on
the betting exchange markets by allegedly having people place
bets on his unlikely victory. He could then point to those
betting markets as evidence that he was a serious candidate with
real momentum, which journalists then reported.
So if a wealthy individual or a political campaign can spend a
few $1,000,000 to move the odds on a thinly traded prediction
market, and then point to those odds as evidence of public
support, you haven't really built a truth machine.
You've built APR tool, but one that comes with a chart.
So if prediction markets are not entirely reliable as truth
machines, what are they actually for?
To understand the current boom, it helps to look at the broader
shift in retail investing over the last few years.
Dimitri Kofinis of the Hidden Forces podcast uses the term
financial nihilism to describe what's been going on.
The idea is the traditional paths to building wealth feel
increasingly out of reach for a lot of young people.
So instead of saving and investing carefully, they try to
get rich quickly by putting money into crypto tokens
featuring pictures of dogs that were pitched to them by edgy
billionaires or buying shares in bankrupt companies.
Prediction markets slot in perfectly here.
If you go back five years, crypto was the exciting product
that everyone was talking about. But crypto is kind of dull
today. Bitcoin is up about 25% / 5
years, which sounds OK until you realize that a money market fund
paying 4% with no at all would have gotten you most of the way
there. Your dad has achieved triple the
return of Bitcoin over the last five years with his index fund,
and he didn't have to check his phone at 3:00 in the morning or
pretend to understand what a layer 2 roll up is.
Michael Saylor is desperately trying to make crypto seem
exciting again by structuring leveraged payouts that could
give you a return of 10% or wipe you out entirely, which might
not be the kind of excitement most people need.
At least with prediction markets, you can watch the
sports you've bet on and have something exciting to talk
about, like the fact that someone just bet $100,000 that
the US government will announce the existence of aliens at some
point this year. The problem with all of this is
that whenever a large pool of enthusiastic retail money shows
up somewhere, the professionals are usually not far behind.
According to the Financial Times, large quantitative
trading firms like Susquehanna and DRW, firms that normally act
as market makers on stock exchanges, are now setting up
dedicated prediction market desks.
They're reportedly paying traders base salaries of
$200,000 a year to build algorithms that systematically
identify mispriced contracts on these platforms.
So on one side of the trade, you have a person betting on the
Super Bowl because it seemed like fun, and on the other side
you have a machine that does this 24 hours a day and never
gets excited about anything. This brings us to what the
gambling industry calls the sharks and fish problem.
In the early 2000s, there was a huge boom in online poker.
Millions of amateurs. The fish logged on to play, but
it didn't take long for the professionals or the sharks to
show up. The professionals didn't play
for fun. They played the odds
methodically, and eventually they deployed bots to do it for
them around the clock. The survival time of new
recreational player on these sites was eventually reduced to
not very long. The amateurs worked out that
they were no longer really playing a game.
They were donating their money to a server farm in New Jersey.
They stopped logging in, the liquidity dried up and the whole
ecosystem collapsed. The sharks had eaten all of the
fish and then starved. Today prediction markets are
full of retail money and the platforms are growing quickly.
But unlike trading a meme stock where the price is just whatever
the next person is willing to pay, an event contract
eventually resolves to either true or false.
There is an actual answer. And if you're a retail trader
betting on a geopolitical event based on a feeling, and the
person on the other side of your trade is a gamma neutral
algorithm being run by a multi $50 billion hedge fund, the odds
are not in your favor. This is not a skill gap that can
be closed by doing more research.
It's a structural disadvantage. When the quants have extracted
enough money from the retail public, the excitement will wear
off. The platforms will likely be
left with sports betting, which the states will eventually
either regulate or shut down, and a few novelty contracts that
exist entirely for marketing purposes.
You'll still be able to bet on whether Bad Bunny wears a dress
to a football match, but the truth machine will be mostly
empty. Now, in fairness, there is one
thing prediction markets do better than the traditional
alternative. If you walk into a sports book
or open a DraftKings account and you start winning consistently,
the sports book will reduce your bet size, restrict which markets
you can access, or simply close your account.
This is standard practice. The house is your counterparty,
and a winning better is bad for business.
Several states have tried to pass laws making this illegal,
which tells you how widespread it is.
Prediction markets don't do this because the platform isn't your
counterparty, it's a peer-to-peer exchange.
It just matches buyers and sellers and takes a small fee.
If you're winning, the platform doesn't care.
Someone on the other side of your trade is losing, and the
platform collects its fee either way.
So in that sense, prediction markets are structurally fairer
than sports books. Of course, the reason you're
winning on a prediction market is most likely that you're a
quantitative algorithm, so this is primarily good news for
quantitative algorithms. The traditional sports books
have noticed all of this, by the way.
DraftKings, FanDuel, and Fanatics have all quietly
launched their own prediction market products while
simultaneously spending $48 million on a super PAC to push
for sports betting legalization in states like Texas and
Georgia. So they're fighting prediction
markets with one hand and copying them with the other,
which is a reasonably common strategy in American business.
If you are a retail trader who's tired of losing money to hedge
fund algorithms, you might be tempted to look for an edge.
In traditional financial markets, acquiring non public
material information and trading on it will generally result in a
conversation with the authorities and eventually a
lengthy stay in a federal facility.
In prediction markets, however, insider trading is often
described by proponents as a feature, not a bug.
That's right, a feature. If we look at recent events,
this feature appears to be working remarkably well.
Last summer, a polymarket user operating under the pseudonym
Rico Suave 666 made a series of highly precise and highly
lucrative bets regarding the exact timing of military strikes
in the Middle East. It later turned out that Rico
Suave 666 was not just a very astute reader of geopolitical
tea leaves. The Israeli government arrested
two men, including an army reservist, for allegedly placing
bets using classified military intelligence.
So to be clear, a soldier would advance knowledge of when bombs
were going to be dropped. Use that information to win
money on what is essentially A crypto gambling website, which
is not really what people have in mind when they talk about the
wisdom of crowds. We saw something similar with
the capture of Nicolas Maduro. Shortly after the United States
announced the operation, someone placed a series of very large
and very confident bets on Polymarket that he would be
removed from office, walking away with a few $100,000.
It's not clear who placed those bets, but they appear to have
had a better understanding of US foreign policy than most of the
US Senate. Now, if you ask the operators
and advocates of these markets about this sort of thing, they
are surprisingly relaxed. They argue that insider trading
is actually a good thing. The logic is that the insider
brings valuable information to the market, which makes the
price more accurate. The market absorbs the leak, the
odds adjust, and society gets a more accurate forecast.
This, they say, is the truth machine working exactly as
intended. It's a rather creative argument.
If a military officer leaks classified operational plans so
that his friend can win a few $100,000 on a crypto betting
site, we should apparently all be grateful for the positive or
externality of slightly more accurate price discovery.
I'm sure that the soldiers involved in those operations
would be reassured to learn that their safety was compromised in
the noble pursuit of market efficiency.
The reason insider trading is banned in the stock market is
fairly simple. If ordinary investors believe
the game is rigged, that only insiders can win, they will stop
investing. And if people stop investing,
companies can't raise capital to build factories, fund research,
or hire workers. The whole system depends on
participants knowing that the market is at least roughly fair.
One of the reasons the US economy has been so successful
over the last 90 years is that it's had some of the best
institutions in the world, fair securities regulation, good
consumer protections, and a functioning legal system.
Americans invest confidently because they broadly trust the
system, and American businesses have access to capital because
investors are willing to put money in.
In countries where investors know they'll be ripped off, they
behave like the fish on the poker websites did and log off.
This is extremely economically harmful.
Prediction markets don't raise capital for anything.
They don't fund new businesses or build infrastructure.
They just move money from the pockets of retail betters into
the pockets of quantitative algorithms and apparently people
with high level security clearances, which is a rather
elegant system if you think about it, just not for the
retail betters. You might think that it doesn't
matter. Prediction markets aren't the
stock market. But if this market is overseen
by the same securities and commodities regulators that
oversee investment markets, and the public decide that it's all
rigged, they might not just log off from prediction markets.
They might start to wonder if the entire system is rigged too.
And that kind of distrust, once it sets in, is very difficult to
reverse. So if the retail better is
structurally disadvantaged against quantitative hedge funds
and people with high level security clearances, the obvious
question is what happens to them when their money runs out.
Since 2018, when the Supreme Court cleared the way for states
to legalize sports betting, the United States has essentially
been running a large scale experiment in what happens when
you make it very easy for people to gamble from their phones.
Now that we've added prediction markets to the mix, that
experiment has now been expanded to cover politics, pop culture
and monetary bets. You can now lose money on almost
anything at any time of the day without even getting out of bed.
The results of this experiment are starting to come in too, and
they are not great. Recent academic researcher
highlighted by The Economist shows that the introduction of
online betting in a state is associated with a roughly 12
point drop in average credit scores, along with higher rates
of personal bankruptcy and loan delinquencies.
If you make it incredibly easy for people to gamble from their
smartphones 24 hours a day, it turns out that a rather large
number of them will do exactly that, right up until the point
where their credit cards are declined.
Now, you could argue that adults in a free society should be able
to spend their money however they like, and I mostly agree
with that. I don't want to be told how I
can spend my money. It's mine.
If someone wants to bet their rent money on a basketball game
or the exact date of a Federal Reserve rate cut, that's their
right. The prediction market platforms
would certainly agree with this. They describe themselves as
neutral marketplaces facilitating price discovery,
which is a very dignified way of describing a website where you
can bet on whether it'll snow in April.
The problem is that when millions of people
simultaneously damage their personal finances, it stops
being a private problem. Loans start to go unpaid,
mortgages default, and eventually the costs get
absorbed by the broader financial system.
And the individuals who fall into bankruptcy end up relying
on state and federal safety Nets funded by taxpayers who in many
cases were sensible enough not to gamble their rent money on a
basket basketball game. So when you look at the
mechanics of the whole thing, prediction markets start to look
less like a truth machine and more like a wealth transfer
mechanism. The platform takes a transaction
fee, the quantitative algorithms extract capital from retail
betters, the insiders extract capital from everyone, and
society picks up the tab for the bankruptcies and the unpaid
bills. It's a wonderful business model
for everyone except the people using it.
Look, prediction markets are not going to destroy the American
financial system. The stock market survived bucket
shops in the 1920s, penny stock boiler rooms in the 1980s, and
whatever was going on with crypto in 2021.
It'll likely survive this too. But it's worth noticing what has
actually been built here. A set of platforms that are
regulated as commodity exchanges, advised by the
president's son, populated by hedge fund algorithms and the
occasional military insider, and marketed to 25 year olds as a
fun way to make sports more exciting.
You can bet on elections, wars, the weather, and the wardrobe
choices of reggaeton artists. You just can't bet on onions
because that would be irresponsible.
The advocates call it a truth machine.
The states call it an illegal sports book.
The Quans call it a new source of alpha.
The retail betters call it entertainment.
The reality is probably somewhere between all of these A
financial product that is too sophisticated to be called
gambling and too simple to be called investing.
Operating in a regulatory Gray zone that exists mainly because
no one in Washington can agree on what it actually is.
We haven't really invented a truth machine.
We've just found a more elaborate way of losing money
and giving it a chart. Thanks for tuning into this
week's podcast. The podcast is entirely
supported by viewers like you on Patreon.
If you'd like to support it, you can sign up using the link in
the show note. Have a great week and talk to
you again soon. Bye.