Introduction to Prediction Markets
Level 2 - Value Investor
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Political events have been causing wild swings in the crypto markets - paid subscribers will receive our updated market views on Saturday, when we will also hold a Q&A.
You may have heard the terms “composability” or “money Legos” - these are references to the concept that different DeFi primitives can be combined (or stacked, like Lego bricks) to create new and innovative financial services.
What can you build by combining token permissionless smart contracts, decentralized exchanges, and an oracle? One example is a prediction market, where any user can create and trade tokens which are valued based on the outcome of real world events.
Prediction markets have been discussed since the earliest days of crypto, but have remained a niche interest, until recently when Polymarket has become one of the fastest growing crypto apps. Financial speculation and hedging opportunities cover:
interest rate markets - crypto prices are affected by borrowing costs, and the most liquid market to predict the US Federal Funds rate is off-chain. Traders can price an on-chain prediction market using off-chain price data, allowing crypto users to speculate on rates or hedge their exposure.
binary options - prediction markets can be used to construct a touch/no-touch option on the price of any market: for example “Will Ethereum make new record highs in 2024”. Like rates, traders can run a pricing model to determine fair value, and speculators/hedgers can express a view by trading against these quotes.
politics and political risk - crypto prices have incurred significant swings during July, due in part to political events. Donald Trump became the favorite to win the election after surviving an assassination attempt. Crypto prices rose as a Trump administration is perceived to be pro-crypto / light touch regulation. When the opposition replaced their nominee with a candidate viewed as more likely to defeat Trump (and crack down on crypto), prices then fell significantly. Crypto owners could use prediction markets to hedge against tail events which could impact their portfolio
geopolitical risk - popular prediction markets include wagers on military action and nuclear weapons use
Product-market fit has been established this US election cycle, with users wagering almost $400 million in crypto on the Polymarket exchange. As this election is critical for US regulatory policy towards crypto it is logical both that crypto prices will be significantly affected by the outcome, and that crypto owners will want to either take a view on election odds or hedge their risk. Once familiar with the platform, we’d expect a crypto native audience to be somewhat “sticky” and engage with other markets to some extent after November. Polymarket is also rumored to be airdropping a token to users and liquidity providers, and rewards for market making are available.
On-Chain Prediction Markets: Technical Overview
Token Creation. On a permissionless blockchain anyone can create a smart contract which issues tokens representing shares in a particular prediction market. In reality, these markets are accessed through somewhat centralized web-based frontends which provide an opportunity to ‘gate’ the display of tokens, restricting to an approved/team managed universe of markets. Events are binary (yes/no) and settle at a price of 100 or 0 respectively. Users can trade Yes or No shares, which are fungible.
Oracle Integration. The prediction market smart contract integrates with an oracle provider, which is responsible for informing the smart contract whether shares settle at 0 or 100.
Market Creation. A liquidity pool is set up to trade the Yes/No shares. Liquidity can be provided via an AMM pool, or a Limit Order Book can be used. Polymarket offers both options. Users can post bids and offers, for example if a user believes that the probability of a market resolving to “Yes” is 30%, he may post a bid at a price of 20, or buy shares at the market price (if it is lower than 30), or offer to buy “No” shares at a price of 70 or better. Limit Orders are matched on Price - Time priority similar to other order driven markets. Participants view trades, bids, and offers to observe market views on the probability of the event.
Outcome Determination. Polymarket integrates with UMA, an optimistic oracle. Any user can post a bond and submit a resolution of the market, which is either Yes/No together with supporting evidence. The bond is at risk if the information is false, and can be claimed by anyone who lodges a successful dispute. Cryptoeconomic incentives and voting are used to determine the outcome in case of dispute. If no dispute is entered in the time limit, the oracle resolves optimistically and the smart contract purchases either the Yes or No shares at 100.
Overview of Polymarket
The most important things to know about Polymarket:
backed by Ethereum’s co-founder Vitamin Butane
explosive growth in users and trade volume driven by the election
Polymarket is hosted on the Polygon (Matic) blockchain, and accepts USDC deposits only. Funds are self custodied, deposited in a Gnosis safe contract associated with your deposit address. Polymarket is built on battle tested Gnosis infrastructure. Deposits and withdrawals are fast and nearly frictionless due to low gas fees. Polymarket uses UMA optimistic oracles to settle markets.
Polymarket order books matched 549,516 trades in the last 28 days, worth $304,843,430, for an average trade size of $555. While this is tiny in comparison to trading volume for crypto tokens, it shows clear product-market fit and should provide sufficient future revenue to continue to operate the platform. In theory, the more liquid a prediction market, the more informative it should be - for now, Polymarket doesn’t have enough trading activity to predict events well, but this is an opportunity for informed traders to get paid to make the markets more accurate.
Other highlights include that the project has survived enforcement action from the CFTC (paying a modest fine, before appointing a former CFTC chair as an advisor).
If you plan on trading large stakes, it’s worth investigating in detail how markets are resolved, including wording of rules and how edge cases and disputes have been handled in the past.
Arbitrage, Market Making, and Airdrop Farming
Here’s a few ideas on how you could make money on prediction markets:
find a market you can quote accurately from other data sources, create a bot to provide two way liquidity, earn market maker rewards. Ideas are options on financial markets and interest rate predictions.
stale order abuse: get a faster news feed than the competition. When an event occurs which influences the odds, trade against the resting orders - usually these are manual orders and don’t get pulled quickly enough in response to events. e.g. the “will Obama endorse Harris” market was mispriced for around 5 minutes after NBC reported that he was likely to make an endorsement soon.
inter-market arbitrage. Some bets are mispriced relative to other bets.
Take advantage of the fee free political markets to drive some volume, and earn rewards for providing liquidity in order to possibly qualify for a future airdrop.
Hedging Political Risks
Assuming you think Trump is going to win and this will be good for your crypto portfolio, how can you use prediction markets to give some downside protection in the result of a tail event?
Betting that Trump will lose is expensive and will only pay out around 2:1. However, it was possible to hedge Biden being replaced by a stronger candidate. Either by betting that Biden would drop out when odds were below 10%, or betting on Harris as the nominee, also when odds were below 10%. Why take such a long shot bet with a small percentage of portfolio? If Trump wins, your crypto will likely go up > 10%, but if he loses you’re looking at a major swing down. Consider both crypto and equity markets falling heavily in the week since Biden withdrew - we’d say this is the market pricing in some chance of President Harris.
Buying some cheap insurance in the prediction markets would have been a smart move in hindsight. However the prices have changed and no longer offer the payoff needed for a cheap “tail hedge”. We think this situation is fairly rare, but it illustrates a practical use of crypto prediction markets. Keep an eye for markets which could be used to hedge your risks - ideas for the future include tax rates/policies, trade tariffs, interest rates, and whether Ethereum staking is approved.
Coins vs. Prediction Markets: Which is the better betting tool?
While it may not seem like it at first glance, memecoins and prediction markets are both used in the crypto market to express views around an event. For example, a number of political coins (Trump/MAGA, BODEN, Harris, etc.) are circulating. There are pros and cons to each approach.
Pros of memecoins as a betting tool:
Uncapped upside: The uncapped upside potential of memecoins can lead to significant profits, especially if they gain viral attention
Broader thematic exposure: Memecoins can capture broader political or social sentiments, letting you invest in a general theme instead of a specific event outcome
Ride and benefit from broader crypto market performance
Cons of memecoins as a betting tool:
There is always risk of attention leakage to copycat and derivative coins
In the case of “fan” coins like TRUMP, the original creator or someone affiliated could create a coin of their own and hurt the coin price (like what happened with the creation of DJT)
Your view of how the coin expresses an outcome may not translate to how the rest of the market views it
Example: Many holders of the coin BODEN viewed it as a satirical expression of President Joe Biden, while others viewed it as a coin that went up based on his chances of becoming President. There’s no “correct” answer here.
You can’t bet on a specific outcome, only the broader theme surrounding that potential outcome
May be difficult to realize profits due to illiquidity
Pros of prediction markets:
Bet with more specificity rather than a broad meta (i.e. bet on who will endorse Kamala Harris rather than long/short a Kamala Harris coin)
Fundamentally sound: Prediction markets are typically driven by data and information related to the event in question, leading to more fundamentally sound pricing
No ambiguity around what you are betting on (was BODEN a bet for or against Joe Biden?)
Cons of prediction markets:
Capped upside
Time-gated bets, meaning you could be right about the outcome but wrong about the timing
Resolutions can miss edge cases, leaving you exposed to a third party determinant
Potential for market manipulation due to market size
The answer to whether you should use memecoins or prediction markets as a betting tool depends on what view you’re trying to express. Anything with a high degree of specificity is going to be better served by prediction markets. Memecoins are a better way to bet on the popularity of broad social thematics, such as a famous brand, person, and of course, meme.
A good rule of thumb is anything that is highly emotional or cultish is a good candidate for memecoins, while anything involving nuance is a better fit for prediction markets. These are general rules, and there are going to be exceptions.
Case Study: Trump vs MAGA
If you had a view that Donald Trump would win the 2024 election you could express this by either buying on prediction markets at a price around 20-30 (upside of 5x to 3.3x your stake) or buying the MAGA token at a price of $0.80-$2 (uncapped upside).
Elections can be close, and its rare for bookmarker or prediction market odds to go much more than 75% in favor of a candidate until the result is known. A realistic expectation is for the bet placed at 20-30 to trade at 60-70 as Trump becomes the candidate and then resolve to 100 or 0 on election night. The memecoin had no such cap and reached a price of $11 in March and $17 in June.
Of course to realize these multiples on a memecoin you have to sell into a liquidity pool, and with only 1.5% of the market cap value as pooled ETH, not everyone can sell at these values. In contrast, prediction markets are fully backed. Every “No” share needs to be fully paid up, allowing the corresponding Yes share buyer to receive 100 if the market settles to Yes. Even if Trump wins the election, the MAGA token might not have sufficient liquidity to pay out everyone in full, and traders could suffer slippage when realizing gains. Holders would be relying on new buyers entering to allow them to exit without pushing the price down.
If you believe Trump will win but the result will be a “sell the news” event it might be better to use the prediction market. However, both tools have their use, and someone who bought MAGA at $1, sold for multiples, and rolled profits into a prediction market around 50 can have the best of both worlds - profit on the meme leg and no friction on payout if Trump wins the election.
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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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