Prediction Markets and Insider Trading

The NYT reports:

With Internet gambling predicted to surpass $20 billion in 2008, and with illegal wagering accounting for $150 billion in the United States, by some estimates, the temptation for those seeking to influence the outcome of games has never been greater. Now, a raft of gambling scandals in sports, from cricket to soccer and most recently tennis, has raised an uncomfortable question: Are the games we watch fixed?

Part of the reason why sports is more vulnerable to manipulation is that, as I have long argued, they don’t matter:

Who wins these sporting contests is irrelevant. It does not matter, except inasmuch as people choose to make it matter. It does not make the world a better or worse place…Much of the lure of sports lies in the illusion that they are important. It is pretty clear, when you think about it, that they aren’t, but the illusion is strong. After all, an awful lot of people care about them. Our newspapers in the morning and news shows at night have a business segment, a political segment, and a sports segment, implying that these sectors are of equal value. There are magazines devoted to sports…It is no wonder that so many are fooled into taking them with far more seriousness than they deserve.

A CEO who manipulates his firms profits is manipulating something deeply attached to the real world: a measurement of how much value his firm is producing.  Since this value is hard to measure, there are ways to jigger the accounting, but they are inherently temporary.  Accumulated profits should appear in physical form, like cash or securities, or valuable property.  Eventually, Ponzi schemes and companies like Enron get caught, because their accumulated physical assets don’t match their claimed profits.

Sports, on the other hand, are inherently arbitrary and full of random noise.  Any athlete can choke on that crucial shot.  It will affect his career somewhat, but as long as he is careful to do it only occasionally, his career is judged on the basis of all his performance, while his bets are only made on those few times when he knows that he will produce a given outcome by choking deliberately.

But that model suggests a disparity – an efficient fixer will lead to an unusual pattern of bets, with heavier betting on the winning side when the fix is in.  In some cases, this may mean that we can find such fixing.  Prediction markets not only make fixing easier to profit from, by creating a liquid market for insider betting, but they also make it easier to detect, by creating a centralized database of betting for analysis:

The match fixing might never have been discovered had it not been detected by Betfair, which has revolutionized online wagering since its Web site started in June 2000…Betfair has become a focal point for the growing list of match-fixing scandals. Over the past seven years, it has alerted dozens of sports about suspicious betting activity, leading to investigations in horse racing, soccer and now tennis.

So the effects are mixed, and in the end we are left with the Homer Simpson-esque paradox that prediction markets are both the cause of, and the solution to, insider trading.

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  • Ken

    “It does not matter, except inasmuch as people choose to make it matter.”

    Isn’t this true of almost all things? Music doesn’t matter, except that people choose that it matters. But it makes people’s lives better because it makes life more enjoyable. The same can be said of sports. The home team winning makes people’s lives better because it makes their lives more pleasurable. Which is true of almost everything.

    Once we get past the very basics, the only reason anything matters is that it makes our lives more enjoyable, hence better BECAUSE we choose these things to make our lives more enjoyable.

  • http://hanson.gmu.edu Robin Hanson

    Sport doesn’t matter much to me, but I can see it matters to many others.

  • Patri Friedman

    Sports only matters inasmuch as people care about it. What happens in business and politics affects people’s lives directly, whether or not they care about it. If the stock market is down today, that is a meaningful statement that the total wealth of human society is slightly less than we thought, which affects everyone’s life to some degree. If we discover that ten billion dollars in cash were “lost” on the way to Iraq, that has inherent meaning about the allocation of resources between thieves and Iraq reconstruction. It affects the lives of those in Iraq whether or not they hear about it.

    Sports are much more like entertainment. Just as the music industry generates utility through consumption of music, the sports industry generates utility through fans consuming sporting events. But there is a zero-sum nature to sports which is not present in music. The existence of sports may create net positive utility, but is that true of who wins a particular game? There will always be a winner and a loser, why does it matter which is which?

  • Stuart Armstrong

    The match fixing might never have been discovered had it not been detected by Betfair

    Interesting. But if investors and betting organisations become sophisticated enough to detect potential fixing, might not cheats become better at falsely implying match fixing? After all, profits can be made from bets being voided, or from investors pulling out of the betting.

    Will this result in a cycle of escalating cheaters and cheater detectors, or will the cheaters hit a wall? My feeling is that the returns for cheaters would diminish as the system gets more advanced; but that’s just a gut feeling.

  • Stuart Armstrong

    Sports only matters inasmuch as people care about it. What happens in business and politics affects people’s lives directly, whether or not they care about it.

    The fact that a not-insignificant proportion of our economies are consumed by sport affects my life directly, whether or not I care about it.

  • http://riskmarkets.blogspot.com/ Jason Ruspini

    Hear you, but sports possess entertainment value like music, drama and literature, not to mention cultivating fit bodies. Not sure why you would bin them as zero-sum, even given the technical winning and losing.

    Also would differentiate insider trading from manipulation of outcome or prices.

  • http://riskmarkets.blogspot.com/ Jason Ruspini

    I guess I’m not challenging that sports markets might be relatively easy to fix given the relative lack of inherent interest in any one game. I never understood the utility of sports bettors though, who seem to lever instead of hedging the home team!

  • http://www.hopeanon.typepad.com Hopefully Anonymous

    “Eventually, Ponzi schemes and companies like Enron get caught, because their accumulated physical assets don’t match their claimed profits.”

    That just-so story simply isn’t true, in my observation. Lots of “Ponzi schemes” transition to legitimate profitability and pull it off. A good argument could be made that Enron was attempting the same thing, and with better and luckier timing could have pulled it off, too. Beware of any “eventually” narrative, because it leaves room for intervention and transition before the purported inevitable outcome.

  • Douglas Knight

    HA,
    how does a Ponzi scheme transition to profitability?
    Are there prominent examples you’re thinking of?

    I suppose a company can try to create reputation and legitimacy during a Ponzi scheme, but it’s hard to imagine that Enron needed any more. I also suppose it’s possible that Enron expected to pay its operating losses with occasional windfalls, like in CA, but that was just too small to be a serious business model.

    Enron was a case of bad incentives. The salesmen cooked the books and exited. The behavior of the executives makes me doubt they knew they were playing a Ponzi scheme (until the prosecuted fraud) and ever had an exit plan.

  • ad

    Eventually, Ponzi schemes and companies like Enron get caught, because their accumulated physical assets don’t match their claimed profits.

    And bubbles eventually burst. That does not prevent them all from being formed in the first place.

  • Michael Sullivan

    “Hear you, but sports possess entertainment value like music, drama and literature, not to mention cultivating fit bodies. Not sure why you would bin them as zero-sum, even given the technical winning and losing.”

    I’m pretty sure Patri is not claiming that sports as a whole are zero-sum. But the outcome on which we typically *bet*, is zero-sum.

    The total value produced in the world by an NBA season in which Detroit wins the eastern conference championship is little different from that produced when Boston does. In addition, the difference is completely intangible. In this sense, a bet on this series is a bet that has little connection to the real world.

    Now that I say that, though, I have to back off a bit. There is surely a redistribution that happens depending on who is in the finals, or wins the championship, in that that team will sell more paraphernalia etc. It’s not a big a difference as 10 billion stolen in Iraq in that the people who get the money in either situation are investing it in roughly similar ways. But it is a difference.

  • scted

    Regarding insider trading, the following notion occurred to me the other day: maybe it would be more fair to the “little guy” if we placed zero trading restrictions on all company employees. That way, insider trading statistics might actually become a valuable indicator about the prospects for a particular company and its stock.

    What happens today is that any impending news, good or bad, must be bottled up until some official news is released, typically a quarterly report. The result in the market is always an underdamped reaction to the delta function. The little guy, and even the big guy, has limited control of his destiny during this rude shock.

    I submit that allowing for insider trading might lead to a properly damped response to the change in condition. Maybe you make things fairer by taxing gains made by execs on their own stock at a higher rate, but you don’t stop the information transfer. You might argue against the implementing the proposal if you think that the underdamped nature of securities is somehow preferrable … I’d bet that the CBOE would take that side.