Prediction Markets

So once we are interested in prediction markets and would like to try them out, we need to pick one. There are several. I generally ignore the ‘play money’ markets like the Hollywood Stock Exchange, despite their similar levels of accuracy to the real money markets; I just have a prejudice that if I make a killing, then I ought to have a real reward like a nice steak dinner and not just increment some bits on a computer. The primary markets to consider are:

I didn’t want to wager too much money on what was only a lark, and the IEM has the favorable distinction of being clearly legal in the USA. So I chose them.

By the end of the election, I had made a killing on my Obama and McCain shares. My account balance stood at $38; so over the 3 or 4 years of trading I had nearly doubled my investment. $18 is perhaps enough for a steak dinner.

Further, I had learned a valuable lesson in 2004_22ya about my own political biases and irrationality, and had earned the right in 2008_18ya to be smug about foreseeing a McCain and Obama match-up when the majority of pundits were trying to figure out whether Hillary would be running against Huckabee or Romney.

And finally, I’ve concluded that my few observations aside, prediction markets are pretty accurate. I often use them to sanity-check myself by asking ‘If I disagree, what special knowledge do I have?’ Often I have none.

When I got out of the IEM, I reflected on my trades: I learned some valuable lessons, I had a good experience, and I came out a believer. I resolved that one day I’d like to try out a more substantial and varied market, like Intrade.

The following is an edited IEM trading history for me, removing many limit positions and other expired or canceled trades:

In 2010_16ya, I signed up for Intrade since the IEM was too small and had too few contracts to maintain my interest.

Paying Intrade, as a foreign company in Ireland, was a little tricky. I first looked into paying via debit card, but Intrade demanded considerable documentation, so I abandoned that approach. I then tried a bank transfer since that would be quick; but my credit union failed me and said Intrade had not provided enough information (which seemed unlikely to me, and Intrade’s customer service agreed)—and even if they had, they would charge me $10! Finally, I decide to just snail-mail them a check. I was pleasantly surprised to see that postage to Ireland was ~$1, and it made it there without a problem. But very slowly: perhaps 15 days or so before the check finally cleared and my initial $200 was deposited.

Intrade has a considerably less usable system than IEM. In IEM, selling short is very easy: you purchase a pair of contracts (yes/no) which sum to $0, and then you sell off the opposite. If I think DEM08 is too high compared to REP08, I get 1 share of each and sell the DEM08. Intrade, on the other hand, requires you to ‘sell’ a share. I don’t entirely understand it, but it seems to be equivalent.

I wanted to sell short some of the more crazy probabilities such as on Japan going nuclear or the USA attacking North Korea or Iran, but it turned out that to make even small profits on them, I would have to hold them a long time and because their probabilities were so low already, Intrade was demanding large margins—to buy 4 or 5 shorts would lock up half my account!

My first trade was to sell short the Intrade contract on California Proposition 19 (2010_16ya), which would legalize non-medical marijuana possession. I reasoned that California recently banned gay marriage at the polls, and medical marijuana is well-known as a joke (lessening the incentive to pass Prop 19), and that its true probability of passing was more like 30%—well below its current price. The contract would expire in just 2 months, making it even more attractive.

It was at 49 when I shorted it. I put around 20% of my portfolio (or ~$40) after consulting with the Kelly criterion. 2 days later, the price had increased to 53.3, and on 4 October, it had spiked all the way to 76%. I began to seriously consider how confident I was in my prediction, and whether I was faced with a choice between losing the full $40 I had invested or buying shares at 76% (to fulfill my shorting contracts) and eating the loss of ~$20. I meditated, and reasoned that there wasn’t that much liquidity and I had found no germane information online (like a poll registering strong public support), and decided to hold onto my shares. As of 27 October, the price had plummeted all the way to 27%, and continued to bounce around the 25-35% price range. I had at the beginning decided that the true probability was in the 30% decile, and if anything, it was now underpriced. Given that, I was running a risk holding onto my shorts. So on 30 October, I bought 10 shares at 26%, closing out my shorts, and netting me $75.83, for a return of $25.83, or 50% over the month I held it.

My second trade dipped into the highly liquid 2012_14ya US presidential elections. The partisan contracts were trading at ~36% for the Republicans and ~73% for the Democrats. I would agree that the true odds are >50% for the Democrats since presidents are usually re-elected and the Republicans have few good-looking candidates compared to Obama, who has accomplished quite a bit in office. However, I think 73% is overstated, and further, that the markets always panic during an election and squish the ratio to around 50:50. So I sold Democrat and bought Republican. (I wound up purchasing more Republican contracts than selling Democrat contracts because of the aforementioned margin issues.)

I bought 5 Reps at 39, and shorted 1 Dem at 60.8. 2 days later, they had changed to 37.5 and 62.8 respectively. By 2010-11-26, it was 42 and 56.4. By 2011-01-01, Republicans was at 39.8 and Democrats at 56.8.

Finally, I decided that Sarah Palin has next to no chance at the Republican nomination since she blew a major hole in her credentials by her bizarre resignation as governor, and her shares at 18% were just crazy.

I shorted 10 at 18% since I thought the true odds were more like 10%. 2 days later, they had risen to 19%. By 26 November, they were still at 19%, but the odds of her announcing a candidacy had risen to 75%. I’d put the odds of her announcing a run at ~90% (a mistake, given that she ultimately decided against running in October 2011_15ya), but I don’t have any spare cash to buy contracts. I could sell out of the anti-nomination contracts and put that money into announcement, but I’m not sure this is a good idea—the announcement is very volatile, and I dislike eating the fees. She hasn’t done too well as the Tea Party eminence grise, but maybe she prefers it to the hard work of a national campaign?

By 2011-01-01, the nominee odds were still stuck at 18% but the announcement had fallen to 62%. The latter is dramatic enough that I’m wondering whether my 90% odds really are correct (it probably wasn’t). By June, I’ve begun to think that Palin knows she has little chance of winning either the nomination or presidency, and is just milking the speculation for all its worth. Checking on 8 June, I see that the odds of an announcement have fallen from 62% to 33% and a nomination from 18% to 5.9%—so I would have made out very nicely on the nomination contract had I held the short, but been mauled if I had made any shorts on the announcement. I am not sure what lesson to draw from this observation; probably that I am better at assessing outcomes based on a great many people (like a nomination) than outcomes based on a single individual person’s psychology (like whether to announce a run or not).

In January 2011, Intrade announced a new fee structure—instead of paying a few cents per trade, one has free trading but your account is charged $5 every month or $60 a year (see also the forum announcement). Fees have been a problem with Intrade in the past due to the small amounts usually wagered—see for example financial journalist Felix Salmon’s 2008 complaints.

Initially, the new changes didn’t seem so bad to me, but then I compared the annual cost of this fee to my trading stake, ~$200. I would have to earn a return of 30% just to cover the fee! (This is also pointed out by many in the forum thread above.)

I don’t trade very often since I think I’m best at spotting mispricings over the long-term (the CA Proposition 19 contract (WP) being a case in point; despite being ultimately correct, I could have been mauled by some of the spikes if I had tried only short-term trades). If this fee had been in place since I joined, I would be down by $30 or $40.

I’m confident that I can earn a good return like 10 or 20%, but I can’t do >30% without taking tremendous risks and wiping myself out.

And more generally, assuming that this isn’t raiding accounts as a prelude to shutting down (as a number of forumers claim), Intrade is no longer useful for LessWrongers like me as it is heavily penalizing small long-term bets like the ones we are usually concerned with—bets intended to be educational or informative. It may be time to investigate other prediction markets like Betfair, or just resign ourselves to non-monetary/play-money sites like PredictionBook.com.

Fortunately for my decision to cash out (I didn’t see anything I wanted to risk holding for more than a few weeks), prices had moved enough that I didn’t have to take any losses on any positions, and I wound up with $223.32. The $5 for January had already been assessed, and there is a 5 euro fee for a check withdrawal, so my check will actually be for something more like $217, a net profit of $17.

I requested my account be closed on 5 January and the check arrived 16 January; the fee for withdrawal was $5.16 and my sum total $218.16 (a little higher than the $217 I had guessed).

In May-June 2011_15ya, Bitcoin, an online currency, underwent approximately 5-6 doublings of its exchange rate against the US dollar, drawing the interest of much of the tech world and myself. (I had first heard of it when it was at 50 cents to the dollar, but had written it off as not worth my time to investigate in detail.)

During the first doubling, when it hit parity with the dollar, I began reading up on it and acquired a Bitcoin of my own—a donation from Kiba to try out Witcoin, which was a social news site where votes are worth fractions of bitcoins. I then gave my thoughts on LessWrong when the topic came up:

After thinking about it and looking at the current community and the surprising amount of activity being conducted in bitcoins, I estimate that bitcoin has somewhere between 0 and 0.1% chance of eventually replacing a decent size fiat currency, which would put the value of a bitcoin at anywhere upwards of $10,000 a bitcoin. (Match the existing outstanding number of whatever currency to 21m bitcoins. Many currencies have billions or trillions outstanding.) Cut that in half to $5,000, and call the probability an even 0.05% (average of 0 and 0.1%), and my expected utility/value for possessing a coin is $25 a bitcoin (5,000⋅0.005).

I was more than a little surprised that by June, my expected value had already been surpassed by the market value of bitcoins. Which leads to a tricky question: should I sell now? If Bitcoin is a bubble as frequently argued, then I would be foolish not to sell my 5 bitcoins for a cool $130 (excluding transaction costs). But… I had not expected Bitcoin to rise so much, and if Bitcoin did better than I expected, doesn’t it follow that I should no longer believe the probability of success is merely 0.05%? Shouldn’t it have increased a bit? Even if it increased only to 0.07%, that would make the EV more like $35 and so I would continue to hold bitcoins.

The stakes are high. It is a curious problem, but it’s also a prediction market. One is simply predicting what the ultimate price of bitcoins will be. Will they be worthless, or a global currency? The current price is the probability, against an unknown payoff. To predict the latter, one simply holds bitcoins. To predict the former, one simply sells bitcoins. Bitcoins are not commodities in any sense. Buying a cow is not a prediction market on beef because the value of beef can’t drop to literally 0: you can always eat it. You can’t eat bitcoins or do anything at all with them. They are even more purely money than fiat money (the US government having perpetual problems with the zinc or nickel or copper in its coins being worth more as metal than as coins, and dollars are a tough linen fabric).

Mencius Moldbug turns out to have a similar analysis of the situation:

If Bitcoin becomes the new global monetary system, one bitcoin purchased today (for 90 cents, last time I checked) will make you a very wealthy individual. You are essentially buying Manhattan for a quarter. There are only 21 million bitcoins (including those not yet minted). (In my design, this was a far more elegant 2⁶⁴, with quantities in exponential notation. Just sayin’.) Mapped to $100 trillion of global money, to pull a random number out of the air, you become a millionaire. Wow!

So even if the probability of Bitcoin succeeding is epsilon, a million to one, it’s still worthwhile for anyone to buy at least a few bitcoins now. The currency thus derives an initial value from this probability, and boots itself into existence from pure worthlessness—becoming a viable repository of savings. If a very strange, dangerous and unstable one. I think the probability of Bitcoin succeeding is very low. I would not put it at a million to one, though, so I recommend that you go out and buy a few bitcoins if you have the technical chops. My financial advice is to not buy more than ten, which should be F-U money if Bitcoin wins.

Bitcoin cumulatively represents my largest ever wager in a prediction market; at stake was >$130 in losses (if bitcoins go to zero), or indefinite thousands. It will be very interesting to see what happens. By 2011-08-05, Bitcoin has worked its way down to around $10/₿, making my net worth $26; I did spend several bitcoins on the Silk Road 1, though. By 2011-11-23, it had trended down to $2.35/₿, but due to a large donation of 20 bitcoins, I spent most of my balance at the Silk Road, leaving me with 4.7 bitcoins. Overall, not a good start. By July 2012, donations brought my stock up to ₿12.5 with prices trading at $5-7. After an unexpected spike on 17 July to $9, I did some reading and learned that “pirateat40” (the operator of a possible Ponzi scheme) was boasting in #bitcoin (Reddit discussion) of using the funds to manipulate the market in an apparent pump and dump scheme and also mocking the ignorance of most buyers and sellers for not paying attention to the Bitcoin forums or IRC channel. pirateat40’s manipulation and insinuation of future plans sourced me on holding many bitcoins, and I resolved to sell if the price on MtGox went quickly back up to >$9; it did so the next day (18 July), I sold at $9.17. Withdrawing from MtGox turns out to be a major pain, with Dwolla withdrawal requiring providing documentation like a passport and a bank transfer costing $25. I ultimately used the #bitcoin-otc channel to arrange a swap with “nanotube” of my $115 MtGox dollars for an equivalent donation to my Paypal account. The next day, the price had fallen to $7.77; demonstrating why I don’t try to time markets, by 11 August, the price had jumped to $11.50. This was a little worrisome for my long-term views that there’s a good chance the Ponzi scheme will be used in market manipulation or collapse, but there’s still much time left. A few days later, the price had spiked as high as $15, and I felt like quite a fool; but that’s the marvelous thing about markets, one day you are a genius and the next you are fool. Unexpectedly, pirateat40 announced the dissolution of his BTCST. Was it a Ponzi or not? No one knew. Perhaps on fears of that, or perhaps because pirateat40 was fleeing with the funds, on the 18-19 August, the price began dropping, and kept dropping, all the way through $10, then $9, then $8. Watching this, I resolved to buy back in. It was very difficult to find anyone who would accept PayPal on #bitcoin-otc, but ultimately Namegduf agreed to a MtGox voucher swap, and I got $60 which I then spent at $7.8 for ₿7.6. In late February 2013, Bitcoin was almost at its all-time high of $31, and I happened to also need cash badly; I had received additional donations, so I sold out my ₿5.79 at $31.5 even as the price reached $32—I just wanted to be out of what might have been another bubble. I then watched slackjawed as the bubble failed to pop, failed to keep its price-level, but instead doubled to $60, doubled again to $120, hit $159 on 2013-04-07, having quintupled since I decided to sell out, and finally peaked at $266 2 days later before falling back down to a steady-state of ~$100. That sale was not a great testament to my market timing skills, and prompted me to rethink my opinions about Bitcoin. At various points through August 2013, I sold on #bitcoin-otc ₿0.5 for $52, ₿0.28 for $50, & ₿1.15 for $120, ₿0.5 for $66 & $64, ₿0.25 for $32, ₿0.1 for $13, and ₿1.0 for $127 & $129—leaving me uncomfortably exposed at ₿18 (having had difficulty finding trustworthy buyers). On 2013-10-02, the news burst that Silk Road had been busted & DPR arrested & charged; Bitcoin immediately began dropping by $20–$40 from ~$127 (depending on exchange), so I purchased ₿2.7 for $105 each.

(One might wonder why I don’t use the fairly active Bets of Bitcoin prediction market; that is because the payout rules are insane and I have no idea how to translate the “total weighted bets” into actual probabilities—Betting blind is never a good idea. And I have no interest in ever using BitBet as they brazenly steal from users.)

A research paper (overview) introduced zero-knowledge proofs for the destruction of coins in a hypothetical Bitcoin variant (Zerocoin); this allowed the creation of new coins out of nothing while still keeping total coins constant (simply require a proof that for every new coin, an older coin was destroyed). In other words, truly anonymous coins rather than the pseudonymity and trackability of Bitcoin. Existing coin mixes are not guaranteed to work & to not steal your coins, so this scheme could be useful to Bitcoin users and worth adding. Efficiency concerns meant that the original version was impossible to add, but the researchers/developers kept working on it and shrunk the proofs to the point where they should be feasible to use. But they also announced they were looking into launching the functionality into an altcoin.

This raises a question: would this potential “Zerocoin” altcoin be worth possessing? That is, might it be more than simply a testbed for the zero-knowledge proofs to see how they perform before merging into Bitcoin proper?

I am generally extremely cynical about altcoins as being generally pump-and-dump schemes like Litecoin; I except Namecoin because distributed domain names is an interesting application of the global ledger and the proof-of-stake altcoins as interesting experiments on alternatives to Bitcoin’s proof-of-work solution. Anonymity seems to me to be even more important than Namecoin’s DNS functionality—witness the willingness of people to pay the fees to laundries like Bitcoin Fog without even guarantee they will receive safe bitcoins back (or look at the Tor network itself). So I see basically a few possible long-term outcomes:

1. Zerocoin fizzles out and the network disintegrates because no one cares

2. Zerocoin core functionality is captured in Bitcoin and it disintegrates because it is now redundant

3. Zerocoin survives as an anonymity layer: people buy zerocoins with tainted bitcoins, then sell the zerocoins for unlinked bitcoins

4. Zerocoin replaces Bitcoin

Probability-wise, I’d rank outcome #1 as the most likely, #2 is likely but not very likely because the Bitcoin Foundation seems increasingly beholden to corporate and government overseers and even if not actively opposed, will engage in motivated reasoning looking for reasons to reject Zerocoin functionality and avoid rocking its boat; #3 seems a little less likely since people can use the laundries or alternative tumbling solutions like CoinJoin but still fairly probable; #4 very improbable, like 1%.

To elaborate a little more on the reasoning for believing #2 unlikely: my belief that the Foundation & core developers are not keen on Zerocoin is based on my personal intuition about a number of things:

• the decision by the Zerocoin developers to pursue an altcoin at all, which is a massive waste of effort if they had no reason to expect it to be hard to merge it in (or if the barriers to Zerocoin use were purely technical); the altcoin is a very recent decision, and they were clear upfront that “Zerocoin is not intended as a replacement for Bitcoin” (written 2013-04-11).

• the iron law of oligarchy, which suggests that the Foundation & core developers may be gradually shifting into an accommodationist modes of thought—attending government hearings to defend Bitcoin, repeatedly stating Bitcoin is not anonymous but pseudonymous and so is no threat to the status quo (which is misleading, and even technically interpreted, would be torpedoed by Zerocoin and related approaches), and discussing whitelisting addresses. To put it crudely, we may be in the early stages of them “selling out”: moderating their positions and cooperating with the Powers That Be to avoid rocking the boat and achieve things they value more like mainstream acceptance & praise. (I believe something very similar happened to Wikipedia’s WikiMedia Foundation after the Seigenthaler incident.)

• the lack of any really positive statements about Zerocoin, despite the technical implications: the holy grail achieved—truly anonymous decentralized digital cash! With Zerocoin added in, the impossible will have become possible. It says a lot about how far from the libertarian cryptopunk roots Bitcoin has drifted that Zerocoin is not a top priority.

Price-wise, #1 and #2 mean zerocoins go to zero, but on the plus side mining or buying at least signals support and may have positive effects on the Foundation or Bitcoin community. Outcome #4 (replacing Bitcoin) means obviously ludicrous profits as Zerocoin goes from pennies or a dollar each to $500+ (assuming for convenience Zerocoin also sets 21m coins). Interestingly, outcome #3 (anonymity layer) also means substantial profits: because the price of zerocoins will be more than pennies due to the float from Bitcoin users washing coins. Imagine that there are 1m zerocoins actively traded, and Bitcoin users want to launder $10m of bitcoins a year, and it on average takes a day for each Bitcoin user to finish moving in and out of zerocoins; then each day there’s $27,378 locked up in zerocoins and spread over the 1m zerocoins, then solely from the float alone, each zerocoin must be worth 3¢ (which is a nice profit for anyone who, say, bought zerocoins at 1¢ after the Zerocoin genesis block).

I personally think Bitcoin should incorporate Zerocoin if the resource requirements are not too severe, and supporting Zerocoin may help this. And if it doesn’t, then it may well be profitable. In either case, I benefit. So if/when the Zerocoin genesis block is released, I will consider trying to mine it or establishing a price floor (eg. publicly committing $100 to buying zerocoins at 1¢ from any and all comers).

Predictions:

• Zerocoin as functioning altcoin network within a year: 65%

• Zerocoin market cap >$7,700,000,000 within 5 years (conditional on launch): 1%

• Zerocoin market cap >$7,000,000 within 5 years (conditional on launch): 7%

• Zerocoin functionality incorporated into Bitcoin within 1 year: 33%

• Zerocoin functionality incorporated into Bitcoin within 5 years: 45%