## Wednesday, May 16, 2007

### What holds back prediction markets

By now, all of us are familiar with `prediction markets', which are organised systems for placing bets on discrete outcomes - ranging from India's performance in world cup cricket to the date of the next general elections. Prediction markets have been proven to be rather effective at obtaining useful information about the future. As with the process of speculative price discovery in financial markets, the basic point seems to be that these markets give incentives to people who command remarkable knowledge to step forward and contribute their knowledge into a publicly visible form, to generate a public good of the price. As an example, I use this page to have a sense of when Apple is going to launch Macbook Pros with the Santa Rosa chipset.

New Economist has a blog post where an illustrious bunch of economists in the US appeal for a more liberal public policy framework which allows these markets to flourish. Their document is very well written and worth reading, as is Steve Levitt's blog post about why he did not sign it. Readers of this blog might recognise the name Michael Gorham. Also see When gambling is good by Robert Hahn and Paul Tetlock.

This got me thinking: Why don't we have prediction markets in India? A natural answer that might come back is: Because they'd be considered gambling and shut down.

I'm not a lawyer, but in my understanding, the legal framework [link] does not prohibit gambling: it only blocks the utilisation of the contract enforcement services of the State in collecting on gambling debt. So if a prediction market is properly collateralised, and if one never needs to resort to the State when an individual defaults, then the legislation should not be an impediment. (Or am I missing something essential? There is a scary provision in IPC where they promise to go after people who run lotteries.)

Another strategy, of course, is to setup a market outside the country and have Indian citizens submitting transactions into it using credit cards. One of the existing prediction market websites could easily come up with a bunch of India-related products, and sell them by advertising through the Internet.

1. How can a bunch of people who are merely speculating signal anything through price in a meaningful way ? How are they different from noise traders ?

2. The default risk will reduce in formal prediction market. Cricket or other sports betting, weather, elections, cureency trades are few things that are not traded in India. Such a prediction market will provide a platform to all such participants.

3. Ajay,

We set up PublicGyan a couple of years ago.

To avoid having to deal with the vagaries of Indian law and regulations on this, we (a) set it up outside India and (b) used play money (called Moolers) as a medium of exchange.

This caused a problem we're still grappling with: how do we solve the incentive problem? What incentives do people have to trade on the exchange? Real money would help. But the fear of regulatory morass deters us from moving ahead.

4. Nitin,
Atleast one virtual reality environment company has announced "convertible" currency at fixed exchange rate and sold banking licenses within the virtual reality world. See Entropia sells banking licenses for virtual world

5. As far as the law regarding gambling and wagering is concerned this is what it seems to be:

S.30 of the Contract Act stems from a wider prohibition of enforcement by the State machinery of contracts that are against public policy. This can be found in S.23 of the Act.

the word used in s.30 and s.23 is void. Now void and voidable mean 2 different things. The most authoritative source on legal meanings, Black's Law Dictionary, defines void as "Of no legal effect; null". furthermore, if it is against public policy, then it is void abinitio (null from the beginning). it has been argued that wagering contracts are against public policy. voidable is defined as "Valid until annulled". Voidable contracts are contracts that either party may annul such as contracts entered into by fraud. Thus, one would understand that these contracts are not just unenforceable but also patently illegal.

Nonetheless, judicial decisions in India as well as the UK are to the contrary. Firstly, as far as the ambit of public policy is concerned, Chitty on Contract, 26th ed., Vol. I at. p.686, para 1134 says thus:
"Objects which on grounds of public policy invalidate contracts may, for convenience, be generally classified into five groups; first, objects which are illegal by common law or by legislation; secondly, objects injurious to good government either in the field of domestic or foreign affairs: thirdly, objects which interfere with the proper working of the machinery of justice; fourthly, objects injurious to marriage and morality and fifthly, objects economicaly against the public interest." Now, as far as grounds 2 to 5, are concerned, i don't see how a predictions market would contravene them. Rather, it would be in furtherance of ground 5. With regard to the 1st ground, illegal under the law of the land, the Supreme Court in a case called Gherulal Parekh v. Mahadeodas (reported AIR1959SC781 and [1959] (Suppl.) 2 SCR 406) has upheld the UK position. The summary of the case is that both primary wagering contracts are only void (not enforceable) and not illegal. furthermore, collateral contracts that arise from wagering contracts are enforceable.
the relevant portion of the judgment is below:
"Para 43: The aforesaid discussion yields the following results : (1) Under the common law of England a contract of wager is valid and therefore both the primary contract as well as the collateral agreement in respect thereof are enforceable; (2) after the enactment of the Gaming Act, 1845 [UK law], a wager is made void but not illegal in the sense of being forbidden by law, and thereafter a primary agreement of wager is void but a collateral agreement is enforceable; (3) there was a conflict on the question whether the second part of s. 18 of the Gaming Act, 1845, would cover a case for the recovery of money or valuable thing alleged to be won upon any wager under a substituted contract between the same parties : the House of Lords in Hill's Case ((1921) 2 K.B. 351.) had finally resolved the conflict by holding that such a claim was not sustainable whether it was made under the original contract of wager between the parties or under a substituted agreement between them; (4) under the Gaming Act, 1892, in view of its wide and comprehensive phraseology, even collateral contracts, including partnership agreements, are not enforceable; (5) s. 30 of the Indian Contract Act is based upon the provisions of s. 18 of the Gaming Act, 1845, and though a wager is void and unenforceable, it is not forbidden by law and therefore the object of a collateral agreement is not unlawful under s. 23 of the Contract Act; and (6) partnership being an agreement within the meaning of s. 23 of the Indian Contract Act, it is not unlawful, though its object is to carry on wagering transactions. We, therefore, hold that in the present case the partnership is not unlawful within the meaning of s. 23(A) of the Contract Act."

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7. in the earlier comment, in the 3rd para, in the last sentence, "these contracts" refers to void contracts.

Also, in the last para discussing the case, the line that reads "The summary of the case is that both primary wagering contracts are only void" should read "The summary of the case is that only primary wagering contracts are void

8. So if collateral contracts are valid, one can use margin requirements and registration requirements (to know who one is entering the contract with and remember past actions) to maintain the integrity of the market?

I was lost in the legalese there...

9. all of them are valid. it's just that in case of the wagering one, the courts won't help you enforce it if the people you contract with, go against the terms of the contract. as far as collateral contracts are concerned (like the ones for registration etc...), even if they are for this predictions market, they are both valid and enforceable, just like ordinary contracts.

10. interesting post. hedgestreet is another such market. they do serve a purpose if the 'liquidity' per prediction is large enough. but I do think that when it comes to predictions related to public companies (the Apple example you give for instance) this can become a back door for insider trading. Which means that it needs to be regulated.

I also followed your link to Steven Levitt's post. I agree with his thesis - there is no bright line separating gambling from prediction markets. Or for that matter KBC from a lottery! My post on this here http://tinyurl.com/2vdt6h

11. If you can prove that betting on sport does involve skill - it should not fall under the perview of gambling, under the legal definition of gambling in India. Doing so - should not be difficult. A non-random event, with market valuations. In concept, not really different at all from markets for derivatives, etc.

Unfortunately what is purely logical would struggle to be upheld in a court of law. Horse race betting was however legalized under the 'skill' criteria.

What is bewildering to me is this. The estimated illgeal betting market stands at Rs. 100,000 Crores. Surely, bookmaker profit would be at least 7% of the turnover. That's 7000 Crores. 30% tax on just the bookmaker's profits - if we take the British style would result in 2100 Crores in taxes under current circumstances. That's a lot of money to pass up. But the payments to various policemen and politicians would then stop, so I suppose it's to be expected.

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17. Hey Dude,
Go Check IndiaPX.com

Its in development right now.

It is supposed to be the first real money prediction market for india.

Thanks,
VIpul

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