The Mistaken Identity of Prediction Markets

Prediction markets are all the rage, as their soaring activity and cultural impact clash with growing regulatory resistance and accusations of blatant manipulation. The founder of Kalshi—the market’s second-largest platform—has gone as far as to claim that all financial assets invariably amount to prediction products, and that he has simply unpackaged the raw, underlying forecasting market, un-siloed by the outdated regulations of traditional finance.

Yet, such a perspective—held across financial academia and industry—reveals a profound confusion concerning the nature of finance, insurance, and betting.

Defining Finance

The term finance is almost universally applied to any concept or interaction involving money. The etymology of finance, both in English (from the Old French for end, settlement, payment) and in Chinese (for flow of money), underlines the long-standing linguistic enmeshment between both words. Yet, in any monetary economy (such as those from which our current vocabulary has evolved), the monetary good is economically ubiquitous, and distinguishing a specific economic sector or sub-discipline by its use of money hinders proper understanding. 

As Jörg Guido Hülsmann notes (at around the 8:00 mark), in its verbal form, to finance signifies “to provide the means to accomplish human activity,” rendering finance ultimately the study of the process of investment (in the introduction).

Murray Rothbard identified investment as “the transfer of labor and land to the formation of capital goods,” where an investor “must give up satisfactions in the present to increase his production in the future.”

Financial assets are understood succinctly as contracts pertaining to the exchange of present goods for the ownership of future goods (i.e., investment contracts relating to the market production process).

The financial cornerstones of debt and equity are immediately recognizable within such a description, where capital is initially provided to an individual or entity in exchange for a contract promising the ownership of future goods through interest payments, dividends, share repurchases, principal repayments, claims in liquidation and bankruptcy, etc.

Evolution of Finance

All investment requires entrepreneurship, which fundamentally involves acting in the face of uncertainty and, by necessity, engaging in the act of prediction. As Rothbard stated, “The entrepreneur…is not creating uncertainties for the fun of it. On the contrary, he tries to reduce them as much as possible. The uncertainties he confronts are already inherent in the market situation.” Said efforts amount to much more than the purchase of capital goods, the employment of land and labor and the issuance of debt and equity, as modern entrepreneurs enter into a myriad of agreements and contractual relationships.

Financial derivative contracts, such as options and forwards, constitute claims of ownership on (the economic value of) future goods and generally require the sacrifice of present goods, in the form of initial margin and premiums.

Derivative markets arise (as all markets do) because of their mutually-advantageous gains from exchange and are in no way zero-sum games.

Even as liabilities (i.e., losing positions), such contracts permit entrepreneurs to optimize production timing and exchange the burden of uncertainty (hedging, also problematically labeled as the transfer of risk).

Far from parasitical, speculation within equity, debt, and derivative financial markets, both primary and secondary, incentivizes sound entrepreneurial decision-making, stimulates production in response to changing preferences and enforces rigorous economic calculation in the efficient use of society’s scarce resources.

Insurance

Insurance contracts, event-tied derivatives, and other non-market-related contracts are also regularly arranged by entrepreneurs. While they might superficially resemble financial contracts and are often classified as such, several important distinctions arise which distinguish them from financial assets, most importantly their relation to risk as opposed to uncertainty. 

Hans-Hermann Hoppe identified the payment of insurance as reflecting “a man’s subjectively felt certainty concerning (predictable) future contingencies (risks).” He further explained that, “Risks (instances of class probability) are contingencies against which it is possible to take out insurance, because objective long-run probability distributions concerning all possible outcomes are known and predictable.”

Insurance and insurance-style derivatives pertain to non-market events which tend to functionally-stable frequencies (weather fluctuations, natural disasters, theft, etc.) within the realm of class probability.

Prices, consumer preferences, and market processes, meanwhile, aren’t homogenous, don’t tend towards stable outcomes and thus fall under the application of case probability.

As to their similarity to so-called “risk transfers”, Rothbard distinguished hedging as that which “allows buyers and sellers…to shift the risk of future price changes” whereas insurance allows them “to pool their risks of loss.”

Insurance contracts and non-market-related derivatives can thus concisely be differentiated from financial assets as those employed in the relinquishment and pooling of economic exposure to calculable risks governed by the actuarial sciences.

Betting

What of cash flow-promising, outcome-related contracts not clearly belonging to the categories of finance or insurance (i.e., bets)?

Mises recognized bets as games, delineating them from other forms of action,

It is not permissible to call every action a game… The immediate aim in playing a game is to defeat the partner according to the rules of the game… Most actions do not aim at anybody’s defeat or loss. They aim at an improvement in conditions… The characteristic feature of games is the antagonism of two or more players or groups of players.

Rothbard keenly observed that in a bet “new risks or uncertainties are created for the enjoyment of the uncertainties themselves,” where betting involves “the deliberate creation by the bettor or gambler of new uncertainties which otherwise would not have existed.”

While financial assets engage with existing uncertainty inherent to market economies and the production process, bets spawn new, synthetic economic exposure to uncertainty. Competition within speculation on financial assets influences the structure of production through market mechanisms and directly contributes to the optimal arrangement of resources according to consumer preferences. Betting contracts, meanwhile, remain strictly observational to the market process, only potentially influencing economic outcomes as external data (e.g., posted odds, betting volume, etc.).

Prediction Markets

The contracts traded on Polymarket and Kalshi straightforwardly reassemble traditionally-offered gambling products: a participant can purchase a “yes” or “no” contract tied to a binary-outcome event with a payoff of a par value of $1. As in traditional betting, the likelihood of either outcome’s occurrence is given by the cost of a bet on said outcome, while the return if one wagers correctly is given by the return of $1 on the bet’s initial cost.

Distinctively, the prices of prediction market contracts are freely determined by the forces of supply and demand, and thus displayed probabilities of binary outcomes are (problematically) said to be the market-given probabilities of occurrence. If such a contract is related to a market process such as goods prices or asset values, it can certainly be employed by entrepreneurs in hedging activities and/or financial speculation, directly affecting economic conditions through arbitrage effects (similar to binary options).

Prediction market-style contracts could potentially act as a disruptive replacement for an overregulated global insurance industry, as the risk of insurable events could be freely sold and pooled for fractions of current administrative cost. Nonetheless, any prediction market contracts which neither relate to market phenomena nor actuarial events must be explicitly distinguished as what they are, innovatively-arranged wagers, as opposed to financial assets or insurance contracts.

Conclusion

It is no great intellectual leap to claim that economic contracts constitute vehicles for prediction, as human experience is one defined by an uncertain future, the forecast of which (correct or not) all action is ultimately built upon. Yet, in addressing finance’s pivotal role in facing market-specific uncertainty, mainstream financial academia almost completely forgoes the vital, uncertainty-bearing perspective of the entrepreneur in favor of those of the actuary, the gambler and the bettor.

It is imperative that our definitions for economic concepts be derived from sound economic principles, logically deduced from the irrefutable axioms of human action, and not their purely mechanical characteristics. And to those who might skeptically reject this article’s content as excessively semantic, Confucius’s warning should be heeded, that, “If names are not correct, meaning cannot be understood.”