Versus Decentralized Prediction Markets for Financial Assets

Wolfgang Pacher Centralized- versus Decentralized Prediction Markets for Financial Assets Are blockchain-based prediction market applications simply the better solution to forecasting financial assets? MASTER THESIS submitted in fulfilment of the requirements for the degree of Master of Science Programme: Master's programme Applied Business Administration Branch of study: General Management Alpen-Adria-Universität Klagenfurt Evaluator Assoc.Prof.Mag.Dr. Alexander Brauneis Alpen-Adria-Universität Klagenfurt Institut für Finanzmanagement Klagenfurt, May 2019 Affidavit I hereby declare in lieu of an oath that - the submitted academic paper is entirely my own work and that no auxiliary materials have been used other than those indicated, - I have fully disclosed all assistance received from third parties during the process of writing the thesis, including any significant advice from supervisors, - any contents taken from the works of third parties or my own works that have been included either literally or in spirit have been appropriately marked and the respective source of the information has been clearly identified with precise bibliographical references (e.g. in footnotes), - to date, I have not submitted this paper to an examining authority either in Austria or abroad and that - when passing on copies of the academic thesis (e.g. in bound, printed or digital form), I will ensure that each copy is fully consistent with the submitted digital version. I understand that the digital version of the academic thesis submitted will be used for the purpose of conducting a plagiarism assessment. I am aware that a declaration contrary to the facts will have legal consequences. Wolfgang Pacher m.p. Klagenfurt, May 2019 ii Abstract This thesis intends to examine if currently emerging decentralized prediction markets for financial assets are “better” than their incumbent centrally administered counterparts. After an extensive literature discussion, introducing prediction markets and proving why they work, the main focus shifts onto an in-depth investigation and subsequent comparison of Vetr and Augur. Two prediction market platforms, where it is feasible to collect information regarding financial assets, primarily differing by their process of finding consensus. This core difference is made possible by an innovative technology called the blockchain, which will be discussed in chapter 8. However, the “highlight” of this paper will be a utility value analysis which aims to compare both service offerings from the practical standpoint of an average investor based on several predetermined criteria. The work continues with an interpretation of the freshly gathered insights and a brief glimpse into the possible future of prediction markets, before concluding with a section where personal takeaways as well as recommendations for further research are presented. iii Table of Contents Affidavit ..................................................................................................................................... ii Abstract .................................................................................................................................... iii List of Figures ........................................................................................................................... vi List of Tables ........................................................................................................................... vii List of Equations .................................................................................................................... viii Abbreviations ............................................................................................................................ ix 1. Introduction ........................................................................................................................ 1 2. A Definition of Prediction Markets .................................................................................... 4 3. The History of Prediction Markets ..................................................................................... 6 4. Prediction Markets in Theory ........................................................................................... 12 4.1. Information Aggregation ....................................................................................... 12 4.2. The Wisdom of the Crowds ................................................................................... 15 4.3. Types of Contracts ................................................................................................. 18 4.4. Administering Formats of Prediction Markets ...................................................... 20 5. Prediction Markets in Practice .......................................................................................... 22 5.1. What Makes a Prediction Market? ........................................................................ 22 5.2. How Prediction Markets Operate .......................................................................... 23 5.3. Why They (sometimes) Fail .................................................................................. 28 5.4. Cutting-Edge Design ............................................................................................. 32 5.5. Evidence on Forecast Accuracy ............................................................................ 34 5.5.1. Macro Derivatives .............................................................................................. 34 5.5.2. Politics................................................................................................................ 38 5.5.3. Business ............................................................................................................. 41 6. Outlining the Research Methodology ............................................................................... 43 iv 7. Centralized Prediction Markets for Financial Assets ....................................................... 45 7.1. General Overview .................................................................................................. 45 7.2. Vetr ........................................................................................................................ 45 7.2.1. History of the Company ..................................................................................... 46 7.2.2. Service Description ............................................................................................ 48 7.2.3. User Interface ..................................................................................................... 50 8. The Blockchain Technology ............................................................................................. 53 8.1. Description............................................................................................................. 53 8.2. Brief Historical Background .................................................................................. 55 8.3. Types of Blockchains ............................................................................................ 56 8.4. Defining Cryptocurrencies: Coins versus Tokens ................................................. 57 9. Decentralized Prediction Markets for Financial Assets ................................................... 60 9.1. General Overview .................................................................................................. 60 9.2. Augur ..................................................................................................................... 62 9.2.1. History................................................................................................................ 63 9.2.2. Service Description ............................................................................................ 65 9.2.3. Potential Issues and Risks .................................................................................. 70 9.2.4. User Interface ..................................................................................................... 72 10. Utility Value Analysis................................................................................................... 77 10.1. Augur versus Vetr .................................................................................................. 77 10.2. Interpretation of Results ........................................................................................ 83 11. The Future of Prediction Markets ................................................................................. 85 12. Conclusion .................................................................................................................... 89 Bibliography ............................................................................................................................ 94 v List of Figures Figure 1: The Gartner Hype Cycle for Emerging Technologies of 2005 .................................. 9 Figure 2: The Ideal Balance of Information Diversity and Network Connectivity ................. 17 Figure 3: Operation Principle of Prediction Markets ............................................................. 23 Figure 4: Information becomes quickly incorporated. ............................................................ 24 Figure 5: New information is continuously aggregated across time. ...................................... 25 Figure 6: Prediction markets show very little arbitrage potential. ........................................

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