The Death of Intrade
Can prediction markets survive government assault?
If you've heard of Intrade, you probably know about the site's impressive record predicting the outcome of the last several U.S. presidential elections. Last November, traders at the online prediction market correctly called every state except Florida and Virginia. In 2008, Intrade missed Barack Obama's final Electoral College tally by just a single vote.
Trading volume in 2012 was high, with eager speculators making more than a million transactions involving 23.8 million shares. (Buying a share is essentially making a bet that a certain event will occur.) In addition to political prediction markets, Intrade offered contracts on everything from Oscar nominations to the price of gold to the birth dates of celebrity babies.
But just 20 days after Intrade's electoral triumph, the federal government launched proceedings that would eventually shut the site down. On November 26, the U.S. Commodity Futures Trading Commission (CFTC) filed suit in a Washington, D.C., district court against the Ireland-based firm, alleging that Intrade had violated a ban on unregulated options trading.
"It is against the law to solicit U.S. persons to buy and sell commodity options, even if they are called 'prediction' contracts, unless they are listed for trading and traded on a CFTC-registered exchange or unless legally exempt," David Meister, director of the commission's enforcement division, wrote in a statement heavy on both legalese and sneer quotes. The statement specifically mentioned Intrade markets pertaining to the price of gold and currencies-turf that traditional commodities markets usually occupy.
While the government cited no evidence of harm, it claimed that the rules Intrade broke "enable the CFTC to police market activity and protect market integrity." The CFTC said it would seek "civil monetary penalties, disgorgement of ill-gotten gains, and permanent injunctions against further violations of federal commodities law."
The following Monday, citing "legal and regulatory pressures," Intrade announced that U.S. traders had little more than a month to empty their accounts. "We understand this announcement may come as a surprise and a disappointment, and we apologize for the short notice and haste required to deal with this."
With the Americans out, Intrade quickly dwindled to a shadow of its former self. By March volume had fallen to a meager 50,000 trades for the year. On the 10th of that month, a somewhat cryptic message appeared on the site's main page announcing that all trading had been shut down after the discovery of "financial irregularities" that ran afoul of Irish law.
And that was that. The Intrade experiment-and much of the promise of public prediction markets-had been squashed by overzealous regulators.
Gambling for Information
"The history of financial regulation is that everything was illegal gambling to start with," says the George Mason University economist and entrepreneur Robin Hanson, one of the founders of the field of prediction markets. "Then exceptions were carved out for things that were no longer gambling. Insurance, stocks, commodities futures, options-if you look back, you'll see that all of these things were illegal. In a world where people don't see a point to it, they saw it as gambling and banned it."
Wagering and speculation have been around for a long time. A Vedic poem called The Gambler's Lament documents betting by Iron Age Indians, while records show that ancient Egyptian gambling fanatics frequently wound up working in stone quarries. But as anyone who has ever spun a dreidel on Hanukkah knows, religions have mixed views on the subject. The Greek word for justice, dike, has roots in the word for "to throw," as in dice. The Catholic Church OKs gambling in moderation as long as the games are not rigged. Officially sanctioned sports betting dates to late-18th-century Europe.
In more recent times, the technology to facilitate speculation has improved, making for faster, more accurate trading and record-keeping, and expanding the potential market of gamblers to anyone with an Internet connection. Intrade markets were little more than simple up-or-down binary contracts-a price of $0 meant the event would not occur before the date, $10 that it would-aggregated at a large scale.
If Intrade was still operating, for example, it's quite likely a market like this would be on offer: "Miley Cyrus will serve time in prison on or before January 1, 2014." Say that contract was trading at $4.99/share. Traders who think Hannah Montana's slutty alter ego is headed for the Big House should buy shares. Those who think she's already hit rock bottom and is going to turn her life around should sell.
As in all markets, more buyers drive prices up and more sellers drive them down. In the simplest reckoning, a share price of $6 was equivalent to a 60 percent probability that an event would occur. Traders could buy and sell at any time, with prices skyrocketing or collapsing based on breaking news. (Mitt's stock was suddenly a hot potato, for instance, after Ann Romney declared that her family would not be disclosing further financial data to "you people.") At the set deadline for the event, though, every market closed either at $0 or $10. On November 6, 2012, the price for "Barack Obama to be re-elected president" hovered just below $7, but the market closed on the 7th at $10.
Intrade provided something more beneficial than cheap thrills and occasional profits for participants: It generated information. As the economist F.A. Hayek explained in his seminal 1945 essay "The Use of Knowledge in Society," the prices produced by a decentralized marketplace can be a better source of information than whatever emanates from powerful central planners or even acknowledged experts. "Without an order being issued, without more than perhaps a handful of people knowing the cause," Hayek marveled, "tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction."
But until recently, Hanson notes, "information aggregation has been a side effect of markets. The main effect has been risk hedging or speculation for entertainment." By democratizing the process beyond institutional hedgers and those actively buying and selling the underlying product, Intrade attached prices to widely held political-market beliefs, generating vast troves of interesting and useful information from crowds.
Among the site's most notable predictions were correctly predicting the capture of Saddam Hussein in 2003 and the elevation of Joseph Ratzinger to the papacy in 2005. The future Pope Benedict's share price spiked in the final day before the white smoke appeared, despite the fact that the decision took place inside the notoriously secretive conclave of cardinals.
Intrade's record is far from perfect, of course. Traders at the site famously miscalled the Supreme Court's decision about ObamaCare in June 2012, showing a 75 percent likelihood that the law would be declared unconstitutional. And in the 2012 election, predictions by 538.com number-cruncher Nate Silver were generally considered to be more accurate and informative than Intrade's results, a fact touted widely by prediction-market skeptics.
Hollywood Ending
Intrade has always existed on somewhat shaky legal ground. Since John Delaney founded the original incarnation of the firm, TradeSports, in 1999, the company's eclectic prediction markets have operated just inside various interpretations of American commodities and gambling laws. New rules frequently encroached on the company's existing turf. In 2006, for instance, the Unlawful Internet Gambling Enforcement Act added additional hoops for U.S. customers to jump through when making payments to the site. (For more about that law, read Jacob Sullum's "How Poker Became a Crime," page 62.)
Intrade itself hosted a series of markets where traders could bet on the continued existence of the site, offering possible shutdown dates of June 2009, December 2009, June 2010, and December 2010. As the founder explained on his blog about the new markets: "Intrade has always strived to list innovative markets that give maximum transparency in real-time on uncertain future events."
What's more, the firm was not a model of good corporate governance. In May 2011, Delaney was found dead at age 42, having fallen just 50 yards shy of the summit on Mt. Everest. He left behind a wife, two sons, and a daughter born prematurely while he was on the mountain. The March shutdown two years later was hastened not only by the CFTC suit, but a simultaneous inquiry by the Irish government into nearly $1.5 million in suspect payments to Delaney's personal accounts two years earlier from a pool of money that should have been held in trust for traders. No malfeasance has been demonstrated, but the money-transfers and Himalayan adventuring raised many eyebrows.
Even as regulators and legislators chipped away at the business, Intrade also began to face competition. The North American Derivatives Exchange, or Nadex, launched in 2004 as a CFTC-regulated market allowing investors to hedge against various economic events in binary trades similar to Intrade's. Nadex mostly confines itself to much drier subject matter, resulting in lower volume and fewer splashy headlines, but also a more legally secure position.
In fact, Nedex explicitly pitched itself to regulators and the general public as a safer alternative to offshore companies like Intrade. "If the information is going to be reported to the public on such a wide basis, shouldn't it be coming from a regulated exchange rather than an unregulated overseas trading platform?" Timothy McDermott, the firm's general counsel, suggested to The New York Times in March 2012.
Nadex dropped its bid to open political markets that year after the CFTC said in April that contracts on political elections "involve gaming and are contrary to the public interest." Nadex backed off before things got too hot, which may have given regulators the incentive and time to turn their attention to the booming Intrade markets.
Intrade wasn't the first futures market to go down in a blaze of sudden attention from concerned government officials. Consider the deaths of two enterprises focused on Hollywood. In the early '00s the investment firm Cantor-Fitzgerald purchased an online game called the Hollywood Stock Exchange. At the time, players in the game used fake money to speculate on the box office of major motion pictures. The boys at Cantor thought it might be worth injecting some real money into this fantasy film league. Four months after the purchase, however, 658 Cantor employees were killed in the World Trade Center and the project was put on hold.
The idea reemerged in 2008, but by that time it had company. A competitor, Veriana Networks, planned to offer similar markets with a more conservative approach. While Cantor hoped to make the fictional game's base of 200,000 players into real-life futures traders, Veriana targeted only institutional investors. Both ventures were well along in development-Cantor had spent four years and several million dollars on the project and Veriana had already cleared the majority of its regulatory hurdles, including the required period of public comment-when the Hollywood studio system suddenly got wise.
In May 2010, Big Hollywood called in the big guns. California Sens. Barbara Boxer and Dianne Feinstein sent the CFTC a letter denouncing both operations. "We are writing to request that you delay approval of designated contract markets that intend to facilitate trading of 'movie futures contracts,"Š" the two Democratic senators declared. "The film industry has raised serious questions about whether these proposed markets are consistent with the public interest as defined by the Commodity Exchange Act. The Commodity Futures Trading Commission should fully consider and address these concerns before it acts."
A bipartisan team of Reps. Lamar Smith (R-Texas), Robert W. Goodlatte (R-Va.), and Henry A. Waxman (D-Calif.) chimed in, singing the same tune. The Motion Picture Association of America (MPAA) and other industry powerhouses denounced the markets as "legalized gambling" in press releases and letters to the CFTC, ironically citing the gossipy opacity of their industry as the primary reason futures markets should be banned.
The New York Times obligingly credited MPAA President Bob Pisano's concerns about "the risk of market manipulation in the rumor-fueled film world, conflicts of interest among studio employees and myriad contractors who might bet with or against their own films, the possibility that box-office performance would be hurt by short-sellers, difficulty in getting or holding screens for films if trading activity indicated weakness and the need for costly internal monitoring to block insider trades." In other words, markets could be bad news for the messy and inefficient status quo.
In the end, the regulatory process proved too slow, so Congress took matters in its own hands. Hidden among the massive raft of new financial regulations passed just a few months later in July 2010 as a response to the financial crisis was a blanket ban on the trading of box-office futures. This kind of highly specific ban is very unusual: Onions are the only other commodity specifically excluded from futures trading. (Onion futures became verboten in the late 1950s, when then-congressman Gerald Ford introduced the Onion Futures Act in response to a market crash that followed a couple of enterprising Chicagoans cornering the market.)
In addition to squelching two promising ventures that could have allowed armchair speculators to put real money on their preferred bankable stars, the crony capitalists of Big Hollywood wound up depriving themselves of a powerful tool to hedge their own risks and operate more efficiently. The move also served as notice to the CFTC and other regulators: You'd better step up (and step on) prediction markets that threaten established industries-including the industry located on Capitol Hill-or else we'll do it for you.
More Bettors, Less Problems
Prediction markets are a really good, useful idea, which makes them hard to snuff out entirely. Many Intrade competitors continue to operate overseas, including a Gibraltar-based firm called BetFair and a New Zealand-based outfit called iPredict. The more innovative Bets on Bitcoin has managed to evade regulation so far through the simple but clever expedient of operating entirely without employing U.S. currency. (For more on the potential of Bitcoin technology to circumvent regulation, see Jerry Brito, "Bitcoin: More than Money," page 34.)
But those markets lack the volume and prominence that made Intrade so attractive-and accurate. Large, diverse pools of traders help balance out each other's biases and blind spots. And large, accessible pools of money incentivize people to jump into the fray. Lots of folks are willing to spitball with their buddies about how the latest Marvel movie will do, but they'll only bother to share those speculations with the markets if the mechanism to do so is easy and the prospect for profit is real.
Regulators and politicians tend to find prediction markets less threatening when they are deployed in the service of academic inquiry rather than electoral handicapping or plain old moneymaking. The Robert Wood Johnson Foundation has used prediction markets to aid decision-making about where to move medical personnel and supplies in preparation for flu season, for instance. The Iowa Electronic Markets, founded at the University of Iowa in 1988, continue to operate with impunity, despite facilitating betting on political elections as well as the behavior of the Federal Reserve. Their immunity is due in large part to the fact nobody can really make much money on them. Accounts are capped at $500, which keeps the markets genteel and inoffensive but also robs them of much of their information-generating power.
In 2007, 25 economists signed a letter asking that small-stakes prediction markets be exempt from anti-gambling laws, in order to broaden and deepen the pools of people who could contribute information (in the form of cash) to their academic endeavors. The signatories included four Nobel Prize winners, but not Steven Levitt of Freakonomics fame, who thought that the statement actually didn't go far enough.
"To me, there is no difference between a 'prediction' market and a 'gambling' market," Levitt wrote on his blog. "If there is demand for people who either want financial risk surrounding an event or want to hedge risk, why should the government get in the way? It doesn't matter whether it's the value of a bond, a share of stock, a presidential election, a firm's likelihood of hitting its quarterly numbers, or the chances that the White Sox will win the pennant. In general I am not much of a libertarian, but our government's policy towards gambling is completely idiotic and rife with internal contradictions."
Markets need sheep and wolves to function properly, and they need enough diversity to escape the trap of conventional wisdom. (One of the criticisms of Intrade's political markets was that they were dominated by insiders who were overly swayed by poll results and cable news chatter.)
For now, prediction markets thrive in areas outside the reach of regulators. Google uses internal prediction markets to aggregate information on whether projects will be completed on deadline or on budget. The U.S. government itself has experimented with prediction markets, most famously as part of the Defense Department's Total Information Awareness project, which was formally shuttered in 2003 after a public outcry. One component of that project was the FutureMAP effort, which created markets designed to help predict events of geopolitical significance. Then-Senate Minority Leader Tom Daschle (D-S.D.) said on the floor of the Senate: "I couldn't believe that we would actually commit $8 million to create a Web site that would encourage investors to bet on futures involving terrorist attacks and public assassinations.…I can't believe that anybody would seriously propose that we trade in death."
Overcoming our collective squeamishness about betting on events as important as the use of nuclear weapons or as insignificant as the fate of Miley Cyrus' career is an ongoing process. As usual, politicians are lagging behind the masses who flocked to sites like Intrade for the fun, money, and information on offer. Intrade offered a breath of fresh air in the stale echo chamber of political prediction, one that will not be so easily replaced. The Washington Post's Wonkblog published a lament the day after the shutdown notice: "RIP Intrade: The last, best hope for pundit accountability." In September, Wikipedia founder Jimmy Wales posted on Facebook: "I miss intrade…is there alternative for market-like odds for things like US Syria vote?" The answer, for now, is not really.
But Hanson remains hopeful even in the post-Intrade era. "It took a long time for stock to become accepted and for people to see it as a useful thing to do," he says. "The same with life insurance. That leaves you some hope that new areas could eventually be carved out, that we aren't at the end of that trail."