Prediction markets are not without risk. What are prediction markets, and what do you need to know before you take a chance on them?

What are prediction markets?

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Prediction markets are platforms where people can buy or sell instruments that are called “event contracts” because they pay out based on the real-world outcome of a future event. Event contracts usually take the form of yes-or-no type questions. When the event outcome is ultimately determined, anyone who bought a contract will either receive a predetermined fixed cash amount or lose the amount they paid for the contract, depending on the answer they chose.

Event contracts may cover various types of occurrences, including sporting, entertainment, economic, financial, environmental, political and geopolitical events.

For example, an event contract may ride on whether the Bank of Canada decides to raise or not raise the key policy rate during its next policy rate announcement.

Legal aspects

Some event contracts may be classified as derivatives, a type of financial product. However, as announced, neither the AMF nor Canada’s other provincial and territorial securities administrators classify sports or entertainment event contracts as derivatives or as any other financial product.

Furthermore, prediction markets are not authorized to carry on activities in Québec or anywhere else in Canada. However, some dealers in Canada are authorized to facilitate access to a limited range of event contracts offered on non-Canadian prediction markets (i.e., economic, financial and environmental event contracts). Such dealers can therefore be used to buy and sell such contracts.

Risk

Even though certain types of event contracts may, subject to several conditions, be accessed through duly authorized Canadian dealers, there are substantial risks that should be considered first, including:

Volatile and speculative markets

  • The simplicity of yes-or-no type event contracts offered on the prediction markets is reflected in an equally simple settlement outcome that also carries risks: a profit will be made or the amount paid for the contract will be lost.
  • Prediction markets are highly volatile and speculative. Contract prices can rise or fall quickly on new information, rumours, or unexpected events, making them very risky.
  • A prediction market may send signals influencing the course of events. For example, it may promote the spread of rumours that affect a company’s share price.

A handful of winners

  • Playing the prediction markets takes not only considerable expertise, analysis and follow-up but also a lot of luck. According to one study, a handful of users receive the lion’s share of the profits, with virtually everyone else losing money.

Liquidity risk

  • Sometimes the number of event contracts traded is very limited. As a result, someone attempting to resell a block of event contracts could drag down the whole event contracts market and end up incurring substantial losses once they are able to dispose of them.

Contract ambiguity

  • The event description or definition may be worded in such a way as to leave room for interpretation, resulting in a potential protracted legal dispute over how the outcome of the event was determined.

Technological complexity

  • Many platforms rely on blockchain technology and therefore involve risks associated with digital wallets, manipulation errors or cyber attacks.