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Manipulation of Prediction Markets
As many people suspected someone was manipulating Intrade to boost John McCain's stock price:
An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president.
Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.
This is big news but not for the reasons that most people think. Although some manipulation is clearly possible in the short run, the manipulation was already suspected due to differences between Intrade and other prediction markets. As a result,
According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts — quickly returning the Obama and McCain futures prices to their previous value.
This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage.
This supports Robin Hanson's and Ryan Oprea's finding that manipulation can improve (!) prediction markets - the reason is that manipulation offers informed investors a free lunch. In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade. But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return. The more manipulation, therefore, the greater the expected profit from betting according to rational expectations. An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating. Notice that the manipulator probably doesn't care about changing the market prediction per se. Instead, a manipulator willing to bet hundreds of thousands to change the prediction of a McCain win must think that the prediction will actually affect the outcome. And if people think prediction markets are this important then can decision markets be far behind? Hat tip to Paul Krugman.
Posted by Alex Tabarrok on October 18, 2008 at 07:41 AM in Economics | Permalink
Comments
Alex: This is very cool.
The next step is to offer an story of how manipulating the prediction could affect the outcome: My conjecture is that raising the specter of a McCain win motivates turnout amongst the Obama supporters, makes McCain voters complacent, and for those voters motivated to vote to temper a liberal Obama mandate by staying at home it pushes them to vote Obama. This, in turn, suggests the politics of the manipulator.
Posted by: John B. Chilton at Oct 18, 2008 8:48:58 AM
According to the Intrade report (http://www.intrade.com/news/news_300.html), the actions were taken to manage risk. In essence, the trader was hedging against an Obama presidency. This is quite different than manipulation (although the results are the same). This shows that prediction markets are socially valuable for both the information and the risk management that they provide.
Posted by: Steven Bass at Oct 18, 2008 8:52:22 AM
Sorry, that should read "hedging against a McCain presidency."
Posted by: Steven Bass at Oct 18, 2008 8:56:39 AM
According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts — quickly returning the Obama and McCain futures prices to their previous value.
Didn't Tyler just have a dream about this?
Posted by: Bob Murphy at Oct 18, 2008 9:06:16 AM
Steve: What can I say but "very cool." For other readers, I repeat the link he gave as a hyperlink,
http://www.intrade.com/news/news_300.html
And some quotes from the Intrade investigation: "The trading that caused the unusual price movements and discrepancies was principally due to a single "institutional" member on Intrade. We [Intrade] have been in contact with the firm on a number of occasions. I have spoken to those involved personally. We are satisfied that they are using our markets in good faith and in the ordinary course of their business and that there has been no contravention of our Exchange Rules. Our investigations lead us to believe that the member is using increased depth in these markets to manage certain risks."
Posted by: John B. Chilton at Oct 18, 2008 9:11:39 AM
This supports Robin Hanson's and Ryan Oprea's finding that manipulation can improve (!) prediction markets - the reason is that manipulation offers informed investors a free lunch. In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade. But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return. The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.
I was so eager to make my lame joke (above) that I didn't realize I have a problem with this. :) Yesterday Tyler had a dream in which people who rectify price discrepancies reduce welfare. That sounded counterintuitive to me.
And now here, on the surface it seems Alex is saying the conventional wisdom, but he's not. He's saying those who cause price discrepancies promote welfare.
I will have to read the paper of course, but Alex, your summary by itself doesn't seal the deal for me. Given that the manipulators are doing that, yes it is good that the other people invest resources in learning about the fundamentals etc. But doesn't that mean there are more resources going into stock studying than would be necessary, without the manipulation?
E.g. what if I said, "People going around, intentionally dumping bottles of flu virus on park benches, actually promote efficiency (!). This is because it provides higher returns to medical research."
Posted by: Bob Murphy at Oct 18, 2008 9:13:42 AM
Steven: I am astonished that the market had enough volume to allow reasonable hedging of political risk. Surely that's the definition of success for a prediction market right there!
Of course one would expect that future such hedgers would coordinate their bets across multiple contracts and markets so as to give away slightly less of a free lunch to more careful and information-oriented traders -- this looks like a singularly badly constructed bet, and they probably substantially overpaid as a result.
Posted by: Grant Gould at Oct 18, 2008 9:20:21 AM
Alex, you're on target that the fact that someone apparently spent hundreds of thousands of dollars to manipulate Intrade prices is a sign that these markets are now influential. That's exciting.
However, to argue that this person "improved" the market is silly. For weeks on end the price was as much as 10 points away from the prices of other markets and even of the "Republican" and "Democratic" values for the winner of the presidency at Intrade itself! As a result, it was a very BAD indicator of the true state of the world.
Saying the manipulation gave other investors a "greater than normal return" and that this automatically self-corrected the manipulation is a bit like saying Enron's manipulation of the electricity markets gave prosecutors and those who fund them a greater than normal return to pursue their careers and perhaps look for other manipulators to prosecute. True, but not exactly a ringing endorsement of the magic of the marketplace to anyone with a slightly open mind.
The bottom line is that, contrary to Hanson and Oprea's strained model with its unrealistic assumptions, the other traders at Intrade did NOT adequately correct for the manipulator's trades. A fair reading of the evidence shows that the data squarely refute Hanson and Oprea's wishful thinking.
Posted by: a student of economics at Oct 18, 2008 9:29:13 AM
Alex, reread my favourite ever post on the Marginal Revolution page. http://www.marginalrevolution.com/marginalrevolution/2008/01/prediction-mark.html
Punchline: Betting large amounts on 'the other candidate' is similar to donating large amounts of money to your candidate if it incentivises people on the other side of the bet to vote (and persuade others to vote) for your candidate. Think of it as campaign contributions without the red tape.
i.e. those bets could (rationally) have been placed by an Obama supporter.
Posted by: Daniel Clarke at Oct 18, 2008 9:50:52 AM
An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating.
Alex, I think this is jumping the gun by a great deal. A single individual (which is the case here) is hardly a trend. What you're doing here is showing your confirmation bias. A single data point. A single action. Clearly an outlier. And you proclaim that the prediction markets have now truly arrived. I think the key phrase in your post is "when people". If we begin to see a regular trend and more than a single incident, then we can say that perhaps the prediction markets have truly arrived.
However, singular people think all sorts of wacky things are worth manipulating - even, I'm sure will surprise everyone, rich people. The fact that one of them decides to try manipulate the prediction market could also be interpreted - more likely, imho - as evidence of delusion. Why on earth someone would waste their money trying to influence a market which by all measures has zero effect on moving actual votes? Perhaps because they believe buying vitamins will make them live forever, or that magnetic bracelets will cure their arthritis or that investing in swampland will give them huge returns.
Whatever the reason, clearly a single individual doesn't mean the trading markets have "arrived". It merely means that there is a serious fool out there and he's proving the adage that he and his money are soon parted.
Posted by: Hal at Oct 18, 2008 10:49:09 AM
It shouldn't be true both that 1) manipulation can improve markets because it allows informed investors to bet against the manipulator, and 2) prediction markets can affect the outcome of elections. If people are influenced by prediction markets in their election choices then presumably they would be equally influenced in their trading. In other words if predicting a certain outcome more likely can move other people to vote in the same way, then it should be equally plausible that manipulating trades in any market can beget other trades in the same direction.
Posted by: Peter Klein at Oct 18, 2008 11:29:48 AM
Grant Gould writes: I am astonished that the market had enough volume to allow reasonable hedging of political risk.
I may be misunderstanding what intrade is saying about the individual's hedge, but my interpretation is they are saying the trader is large relative to the market (thereby drives up the price) and yet still find it to be an expected value increasing transaction.
Posted by: John B. Chilton at Oct 18, 2008 11:40:39 AM
McCain is trading at 16... You pay $1.60 per contract, if McCain wins, you get $8.40 per contract. And according to the pundits, this election is "close". So if Intrade is representative of McCains odds to win, then his stock is highly undervalued at 16% chance to win. If I traded, I would definitely buy McCain right now as part of my portfolio.
Posted by: brainwarped at Oct 18, 2008 12:06:53 PM
I'm not sure if we can tell from Intrade's statement what said investor was hedging against. It might have been a different issue altogether. I just don't think we have enough info now to say more on this example. But I would assume not Obama, but McCain.
Usually when hedging, investors will say, go long on the preferred and then short the common. Thus I would assume that the Intrade investor would have strongly shorted McCain, and have been going long on him in a desired proportion to manage risk. That this is so heavily noticeable may say more about the lack of liquidity in that particular contract; I don't have enough specifics to say more, so I could be wrong.
However, in general, on the subject of prediction market manipulation, let me say that my experience running one has actually proven Hanson's thesis - I must say, all of his theses. Attempted manipulation of the contracts has never succeeded.
In one famous case I discussed in public last year, all those attempting manipulation and momentum trading based on that were wiped out of the market, completely bankrupted, by the 1 trader who came back time after time with correct information and a rational trading approach. As a result, that trader won a vacation to Florida. Nice!
As a result, I've become quite Hansonian in my worldview, much to my own original surprise.
Posted by: MarketManager at Oct 18, 2008 12:41:24 PM
"This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage"
Did the investor already get out of this position? If not, they haven't lost a dime yet, and, as brainwarped points out, stand to profit handsoomely if McCain wins. Disclaimer: I happen to think McCain will win if Obama isn't at least 9 points ahead in the polls on election day.
Posted by: J at Oct 18, 2008 12:49:29 PM
How do we know this was an attempt at manipulation and not actual hedging? For example, using the intrade tax contracts, you can basically remove all uncertainty about your future tax liabilities (assuming your income is not stochastic). Perhaps this is an Obama supporter that stands to lose if McCain wins and is trying to hedge.
Posted by: Ryan at Oct 18, 2008 1:10:52 PM
McCain is trading at 16... You pay $1.60 per contract, if McCain wins, you get $8.40 per contract. And according to the pundits, this election is "close".
Do you believe the pundits? Why would you pay attention to them? Would you trust their stock picks?
http://electoral-vote.com/
If these guys are right about the polling, Obama will win unless he loses everywhere he's currently less than 5 points ahead, and also at least one state where he's 6 or more points ahead.
If we figure a state is "close" when nobody's ahead more than 4 points, there are 8 states like that. McCain would have to take all of them plus at least one more, probably VA MN or CO.
If you believe the polls are honest and the election is honest, then 16% is probably high. But if you agree with J that the elections are rigged to overcome an 8 point lead, then McCain will probably win. How much would you bet that US elections are honest?
(The polls aren't definitive. Pollsters pay most attention to the close races. Many of the lopsided contests haven't been polled in october at all. Could solid red states go against McCain due to the economy? Could solid blue states go against Obama for campaigning to give Bush/Paulson a trillion dollars to bail out their friends? The solid states that have october polls mostly haven't changed. Presumably each blames their villain of choice.)
Posted by: J Thomas at Oct 18, 2008 1:47:05 PM
This manipulation is rather remarkable. Credit definitely goes to Nate Silver for picking up on this early. And yes, if they're worth manipulating, they're worth recognizing. However, isn't it great that's still technically illegal to participate in these markets here in the US. Sure, we can lose everything in our 401K, but we can't wager on who will win the next election. Total protectionist bs.
http://demockracy.com/the-end-of-the-american-honeymoon/
Posted by: Kevin at Oct 19, 2008 5:46:35 AM
This is fishy. When McCain caught Obama in the polls after the convention, the Intrade odds mirrored that move. Now, McCain's odds have continued to drop even as the polls tighten. I think the manipulation has been running against McCain.
Posted by: Rich Berger at Oct 19, 2008 6:58:20 AM
Fantastic, Alex.
"An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating." - I think this is spot on. Intrade seems to have been, $ for $, by far the best opportunity for influencing opinion about how the election is going. Several news sources were citing the Intrade probability at regular intervals. Think of how many millions it costs to change the polls just 1% in a particular state with dedicated ad campaigns - for a few hundred thousand, you could apparently have gotten several % nationally for many weeks, in a very influential "poll".
It's safe to say that in 2012 (or for the rest of 2008) it will be much more expensive to manipulate the market - because of the publicity of this story, you will have people lining up to arbitrage discrepancies.
Posted by: Paul N. at Oct 19, 2008 7:20:19 AM
"If you believe the polls are honest and the election is honest, then 16% is probably high. But if you agree with J that the elections are rigged to overcome an 8 point lead, then McCain will probably win. How much would you bet that US elections are honest?"
Just to clarify, I don't think anything is "rigged" here - I think the polls understate support for McCain, a chronic problem when a black democrat runs against a white republican, and in some other situations too. Obama himself pointed out the other day that he lost the NH primary despite being 11 points up in the polls. Actually, his RCP average was 8.3 ahead, though the spread was 10.9: http://www.realclearpolitics.com/epolls/2008/president/nh/new_hampshire_democratic_primary-194.html . A lot of people, particularly democrats, simply will not tell a pollster that they're voting against a black democrat.
Yes, I expect to see the same phenomenon in the general election.
Posted by: J at Oct 19, 2008 8:06:34 AM
J, I suppose that's a possibility. It might be that 4% or more of the public is lying to pollsters because they're ashamed of the way they're going to vote.
But if we get that result I'm going to apply Occams Razor and proceed on the conclusion it was election fraud.
Posted by: J Thomas at Oct 19, 2008 10:31:50 AM
The comment about manipulation improving markets seems off to me. Isn't this just broken windows in the context of a market? It tends to improve profit potential in the market, at the cost of better allocation of capital and short-term price information. It's a point optimization rather than a system optimization.
Posted by: Greg at Oct 19, 2008 11:17:00 AM
Greg, it's an attempt to optimise multiple variables at the same time. Many outcomes can be interpreted as optimising some combination of them.
As the market gets bigger it will be harder for one contrarian gambler to greatly affect the odds. Not to say the contrarian gambler might not be correct, but he won't have enough capital to change the odds much. The market will reflect the opinions of the mass of gamblers, apart from the effects of hedging etc.
Entirely apart from the possibility that price information reveals something useful about the gamblers' inside information, I approve of the concept. Legal gambling with very very low vigorish. Far better than casinos.
I've talked to some people who go to casinos, and they all emphasise the great food and great entertainment. They say those things are worth what they spend. And you don't get great food or shows from Intrade. But unless you play pretty ferociously the returns are a lot better than a slot machine. So I think it's a better place for people to do their gambling, if they're going to gamble.
Posted by: J Thomas at Oct 19, 2008 12:06:13 PM
"But if we get that result I'm going to apply Occams Razor and proceed on the conclusion it was election fraud"
Given the consistency of the behavior, do you really think fraud is the simplest answer? If you look at past elections, it isn't that the black democrat's numbers drop - by much - but that "undecided" voters go overwhelmingly for the white republican. I'd argue it demonstrates that most of those claiming to be undecided really aren't; I've never come across anyone I truly believed was undecided on a political contest in my life (and I'm not a kid).
Posted by: J at Oct 19, 2008 11:19:50 PM
