31 Comments

>In any financial market, those who have too little info per trade should stay out, relative to those with more info.

"should stay out relative to those with more info", indeed. This does not always mean "stay out completely".

I mean, in many financial markets it is in my interest to participate even though I expect some losses from information asymmetry. Say stock market: The alternative of not using the market at all does not look nice, but I should reduce exposure, e.g. by trying for "mostly neutral" index-funds or something. Or insurance: The non-linearity of utility as a function of money is large enough that people are willing to participate (buy insurance) even though they lose money in expectation. This holds in both of natural disaster insurance (where the insurance company has better info) and in personal insurance like health or driver's (where the customer has better info). Likewise real estate: Even though I lose in expectation (worse info/judgement than real-estate professionals), it may make sense to buy for personal use, for the increased efficiency (I know that I will treat the property well, and want to internalize this), and try to keep the number of transactions / moves to a minimum.

That is, having little info is a big disincentive for market participation ("little info" compared to "expected info of counterparty").

Armed with this viewpoint, I kinda understand why many real-world markets manage to avoid the lemon market equilibrium: The extra pressure for market participation is enough to pay for making info common knowledge/priced in, which reduces costs for participants.

Alas, how do you get market participation in prediction markets?

How can noise traders survive if they must expect their counterparty to be either noise-trader/marketmaker or have secret info (because the counter-party self-selected for market participation)?

With external pressure this problem goes away, because the noise trader can amortize the losses from secret-knowers over profits from the large number of captive participants.

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In any financial market, those who have too little info per trade should stay out, relative to those with more info. But as long as there are noise traders or formal subsidies, most all info gets out anyway.

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Sorry for double post, I failed at disqus UI.

Why this critique does not apply to standard stock markets is the following: Stock markets are positive-sum (you get better expected returns on index-fund compared to treasury bills), which stabilizes an equilibrium of a high-cap/liquidity market, where info that is available to a cheap investigation is expected to be priced in already (and hence to become common knowledge, because it provides fame to the publisher and there are no incentives any longer to keep it secret).

This critique also does not apply to prediction markets where external forces pay for a high lower-bound on publicly available/priced-in knowledge. And it also does not apply to markets that are about feeling smug / fun, like prediction markets for elections (you have many market participants who expect and accept to make a loss, for the sake of fun / theory), or with forced market participants, like subjects in an experimental study.

It does, however, apply to general prediction markets where market participation and capitilization is self-selected, running with monetary profit-motive. I am unsure how to experimentally test such a thing; by definition, it does not help to give a student $100 with the stipulation that he must invest it in your prediction market.

But the general literature must say something about this, I'd guess? This objection cannot be new; do you know a reference?

Sorry for asking such a naive question, I am not an economist, but would surely enjoy reading a paper discussing this failure mode.

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Does this not run the risk of becoming a lemon market?

That is: Once market volume is large enough, it pays to commission a secret investigation to figure out more about the villainy of person X, make profitable trades, and then commission an official investigation (or leak the incriminating details).

On the one hand, this is good: People are incentivized to become insiders, and offer this knowledge to the market.

On the other hand, this disincentivizes people without massive inside information from participating in the market at all, reducing market volume.

I would guess that the resulting limit is something like "tiny market volumes with huge spreads", where everyone is paranoid about potential insiders taking them to the bank, and every possible market-maker trying to profit from spreads risks being taken.

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There is a large literature showing prediction markets to be especially resistant to such attempts at manipulation.

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But election prediction markets don't affect the actual outcome of the election. This "villain market" you propose would be used to allocate investigative resources. That's a powerful incentive to bet on people you want removed, even if you know there are better targets.

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Prediction markets have already been shown to be well calibrated and informative in politically charged situations such as elections.

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Where official corruption or scandals about celebrities are involved, people's judgement would be affected by what they WANT to be true, rather than what they think is actually likely. In the current environment, for instance, you'd have every Democrat betting on investigating Trump, and nobody looking into Menendez.

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Electronic markets can be very cheap to maintain. And the whole point is to make more effective use of a limited investigative resource. Sometimes such resources are spent; this is a way to spend them better.

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Robin, Villain markets strike me as tremendously valuable. But how does one pay for the random inspections and/or maintaining the market?

Investigative reporting and/or forensic auditing is (extremely) expensive and electronic markets require sysadmins.

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Yes, that is possible, and manipulation wouldn't obviously be more problematic there. But it would substantially hinder information aggregation.

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The legal system already gives many parties incentives to frame people, and so we have always needed a system pretty resistant to such framing. Also, typically there is only a small amount to be gained betting on each case.

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Is it possible to have a secret-price market, where traders just submit limit orders without knowing what will execute? Or does this make it too hard to detect and exploit manipulation?

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That would give a very strong incentive to frame good people. If Officer A is squeaky-clean, the payout would be big if he was found to be stinky. That would give a very strong incentive to bet on all the cleanest officers then be ready to put drugs in their pockets when they're investigated. Presumably payout would come before conviction? (Otherwise betting would have more to do with legal particulars than with actual perception of wrongdoing)

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I specified that exactly one case would be investigated. It would be easy for users to check that this constraint is satisfied.

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By default any one market won't have that much money in it.

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