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A Bloomberg analysis of trading data on Kalshi and Polymarket reveals that many traders are heavily buying longshot contracts that lose about 98% of the time. This revelation casts prediction markets in a new light and could have negative impacts in what’s becoming an increasingly rough legal landscape for the platforms.
Trading resembles casino-style wagering
Many traders are going for longshot bets mostly because of their high payout potential, with returns of 1,000% or more. However, while the potential payouts are high, the outcomes have a low probability. To this end, many of the traders buying into these bets approach them from a speculative angle rather than an objective angle.
Additionally, since the contracts are priced low, traders treat them as disposable entertainment spend – money they are willing to lose. They treat the contracts as a form of interactive entertainment rather than hedging.
Ideally, prediction markets, which market themselves as mechanisms for efficient price discovery, are designed to leverage the “crowd’s wisdom” where trades are based on objective information. However, the report by Bloomberg reveals that traders are driven by speculation over substance, resembling the betting mechanics of a casino or sportsbook.
Contracts are systematically overpriced
Notably, while event contracts on prediction markets supposedly price themselves, they are usually systematically overpriced. Ideally, a contract priced at $0.10 should have a “Yes” outcome exactly 10% of the time. However, analysis reveals that these contracts usually have a much lower probability of winning.
The systematic overpricing is a result of various factors. For starters, the favorite-longshot bias causes traders to overvalue low-probability outcomes because the potential payouts are huge. Moreover, there is a powerful structural “Yes Bias” among most traders, whereby they mostly bet on “yes” outcomes, based on an extensive analysis of millions of trades. It is also worth noting that all trades have a bid-ask spread that inflates their prices – for example, a trade with a statistical probability worth $0.02 can have a spread of $0.03, increasing the price to $0.05.
What this means for prediction market operators
The revelation by Bloomberg is a setback for prediction markets, which are currently facing intense legal pushback by state governments and other parties. Notably, one of the main pillars of prediction markets’ credibility narrative is that they produce accurate forecasts. However, the report reveals that this isn’t the case, since the majority of trades don’t pan out.
The main risk that prediction market operators face is that they will lose their credibility narrative against state authorities. Notably, while prediction markets argue that they fall under the exclusive jurisdiction of the Commodity Futures Trading Commission (CFTC), many states have branded them as gambling platforms. To this end, many states have sued prediction markets for operating illegal gambling platforms.
Bloomberg’s report reveals that traders view event contracts at prediction markets as a form of interactive entertainment. Moreover, their trading decisions are based more on speculation than objective information. Notably, analysis also reveals that most of the trades on prediction markets focus on sports and cryptocurrency. Overall, all of this supports states’ argument that prediction markets are nothing more than illegal gambling platforms.
In addition to the potential regulatory setback, this information could also cost prediction markets because liquidity providers will likely price in wider spreads or exit. Considering that the majority of trades are essentially speculative bets, LPs will look to protect themselves against the intense directional flows. To this end, they may price in wider spreads, which would push up the contract prices. Alternatively, they can exit the markets, leaving operators at a loss.
