Intrade No More

At the International Exhibit of 1884 in London, Sir Francis Galton’s curiosity was piqued by a weight-judging competition, in which contestants guessed the weight of an ox to be “butchered and dressed.” About eight hundred people tried their luck at sixpence a ticket. Experts and non-experts alike competed.

Galton, a Victorian polymath, was not so much interested in the competition itself as he was in the collective prediction of the participants. He had set out to prove that there would be no significance to the crowd’s guess, believing as he did that a few dumb people would certainly lead the crowd to a dumb answer. But the result was surprising. On average, the crowd as a whole predicted the ox weighed 1,197 pounds. Butchered and dressed, the ox actually weighed 1,198 pounds. The average was closer than the guess of any individual contestant.

Galton’s impromptu experiment was early support for the view that the aggregation of information for a group results in decisions that are better than the decision of any single member of the group. Today, thanks to technology, this theory is being tested over and over again.

Intrade is an online trading exchange, founded ten years ago in Dublin, that allows individuals to bet on a wide range of outcomes involving future non-sporting events. Intrade participants, taken as a whole, accurately predicted not only the result of the 2012 Presidential Election, but also the results in each state save Florida, which was given a 69% probability of going to Mitt Romney. In fact, Intrade’s predictions of the outcomes of the 2004 and 2008 presidential elections were just as accurate. But how does Intrade really work?

Basically, on the Intrade platform, all events are defined by a “yes” or “no” propositions with a final share price of $10.00 for a “yes” outcome and a final share price of $0.00 for a “no” outcome. The share price fluctuates with the opinion of participants. The Intrade odds on Rick Perry’s winning the Republican nomination fell by 50% during a primary debate only seconds after he forgot the federal department he wanted to eliminate. When you buy shares, you are betting “yes” the event will occur, and when you sell shares, you are betting “no” the event will not occur. The contract may trade in the range of 1-100, where 1 equals $0.10 in value. Because all shares are bought and sold within this range, a participant may either profit or lose at “settlement,” depending on what the share price was when it was bought or sold.

At first glance, Intrade looks like a bookmaker. But the resemblance is superficial. For one thing, Intrade does not charge any transaction fees or commissions. For a flat $4.99 per month, a participant can make an unlimited number of predictions on questions about politics, entertainment, financial indicators, weather, current events and legal affairs. But perhaps more importantly, its prediction capability makes Intrade a valuable information tool. Intrade’s predictions and odds provide governments, academia and the markets with fairly reliable information about the future. So why does the Commodity Futures Trading Commission (CFTC) have a problem with Intrade?

Intrade, the CFTC argued in a complaint filed in a federal court, is taking bets on commodity options (like the prices of gold, crude oil and other things) without listing the contracts on a regulated exchange. Offering commodity option contracts to US customers for trading as well as soliciting, accepting and confirming the execution of orders violate of the Commodity Exchange Act’s ban on off-exchange options trading. Intrade, having been in the CFTC’s crosshairs for several years now, finally decided to shut down its platform to the US market this past November. As of December 23rd, all US Intrade accounts (which comprised approximately 40 percent of all its accounts) have been suspended.

Does Intrade fall within the CFTC’s jurisdiction? A prediction market through which customers buy and sell binary options allowing them to predict whether a future event will happen certainly appears to be within the purview of the Commodity Exchange Act, which regulates a broad range of transactions–futures, swaps, options on futures, swaps and commodities–in connection with commodities, property and events.

But the real question is whether the CFTC should exercise its jurisdiction. A similar prediction market run by the University of Iowa, the Iowa Electronic Markets (IEM), operates pursuant to a CFTC no-action letter. It is largely for academic and research purposes and caps bets at $500, but real bets are being made utilizing IEM every day. Evidently, even the CFTC sees some utility in prediction markets.

Additionally, while some of the betting that Intrade hosts has a connection to traditional commodities (i.e., betting on the future prices of commodities), other topics have no relation to commodities. For example, it is hard to see how a bet on whether Lindsey Lohan will get arrested before June 30 has any real impact on the integrity of our futures markets. In this sense, it seems to us that the CFTC’s actions with respect to Intrade may have been unwise and that the agency probably has better ways to utilize its resources.

Furthermore, given the fact that even the CFTC has recognized the utility of prediction markets, it would seem that there should be some middle ground when it comes to Intrade. One solution could have been for Intrade to simply eliminate its bets on physical commodities, or for the CFTC to regulate only bets on commodities. Regardless, the removal of Intrade from US markets altogether does not, in our view, have sufficient public policy justification. As it stands, with Intrade out of its largest market, its forecasts will undoubtedly have somewhat diminished predictive power.

Galton wrote several years after his experiment, “I know of scarcely anything so apt to impress the imagination as the wonderful form of cosmic order expressed by the law of error. The huger the mob and the greater the anarchy, the more perfect is its sway. Let a large sample of chaotic elements be taken and marshalled in order of their magnitudes, and then, however wildly irregular they appeared, an unexpected and most beautiful form of regularity proves to have been present all along.”

If there ever was a utility for Intrade, it might have been this. And while Intrade may be no more in the US, prediction markets are not going to go away anytime soon.