Most Important Regulation of the Year?
A revolution may be in the making on ways to get and act on new information through the use of prediction markets.
Two important events slipped by practically unnoticed in the last few weeks.
The Commodity Futures Trading Commission asked for comments (pdf) May 7 on prediction markets. After the comment period closes July 7, hopefully the Commission will publish useful guidance to allow these markets to flourish.
“What public purpose is served in the oversight of these markets and what differentiates these markets from pure gambling outside the CFTC’s jurisdiction?” asked CFTC Acting chairman Walt Lukken" in a press release.
This generated a quick answer from Prof. Vernon Smith, the 2002 Nobel Laureate in Economics. Excerpt:
The information priced in these markets enables actions to be taken that create wealth. Similarly in event markets, better information made possible by trading event contracts produces social gains that make such activity wealth enhancing. Thus if a futures market in Florida orange juice enables improved predictions of frost, better crop decisions enhance wealth creation and potential improvements in technology. Moreover, all these issues are important generators of testable hypotheses, which can help to inform both the extent to which they create social and economic value and whether new regulations are desirable.
Bear in mind that any limitation on the emergence of new market forms must necessarily run the risk of also limiting new forms of specialization and wealth creation. We need always to be open to such new possibilities.
Then the May 16 issue of Science published a critically important article titled "The Promise of Prediction Markets" (free version here (pdf)).
Excerpt:
The use of prediction markets has been greatly deterred by state and federal laws restricting Internet gambling because at least some of these laws are plausibly understood to cast serious doubts on prediction markets. Currently, eight states bar Internet gambling outright. In 2006, President Bush signed the Unlawful Internet Gambling Enforcement Act, designed to crack down on such gambling.
The legal questions here are complex, but to create a prediction market in the United States that is unambiguously legal, one must run a regulatory gauntlet. In principle, these difficulties could be avoided by creating prediction markets outside the United States, but this approach could suppress innovation and reduce opportunities to aggregate information and improve decisions. It would be better for U.S. authorities to clarify the circumstances under which prediction markets are plainly legal.Their proposals?
[The CFTC] should establish safe-harbor rules for selected small-stakes markets. One limited safe harbor is the no-action letter, in which the CFTC market oversight staff confirms in writing that it will not recommend enforcement action if the recipient acts in specified ways.
[T]hree types of entities be eligible for safe harbor treatment. The first would be not-for-profit research institutions, including universities, colleges, and think tanks wishing to operate exchanges similar to the Iowa Electronic Markets. The second would be government agencies seeking to do research similar to that of nongovernmental research institutions. The third group would consist of private businesses and not-forprofits that are not primarily engaged in research, which would only be allowed to operate internal prediction markets with their employees or contractors.
In all cases, markets would be limited to small-stakes contracts.
Clearly this would greatly improve the current situation, but I don't think this adequately liberates this important new information tool.
Let's urge the CFTC and Congress to quickly act to allow for vibrant prediction markets.
For those of you new to this, here are some resources to get you started.
John Stossel's 20/20 Report on prediction markets.
Midas Oracle.org
Betting to Improve the Odds, NY Times, April 9, 2008
The Wisdom of Crowds by James Surowiecki
Information Markets: A New Way of Making Decisions by AEI Center for Regulatory and Market Studies
Special Interest Group on Prediction Markets
Prediction market, From Wikipedia
