The idle speculation that TradeSports' betting contracts on the SCOTUS vacancy might have been affected by insider information got me to thinking about the role of insider information in prediction markets generally.
On the one hand, just as Henry Manne justified insider trading in stock markets by arguing that it improved the accuracy of stock market prices, bets by knowledgeable insiders will significantly enhance the predictive power of markets like the TradeSports contracts. Indeed, given the limits on the power of insiders to affect prices in the stock market, the effect is likely to be much stronger in prediction markets, where the ratio of activity by informed traders to that of uninformed ones is likely to be much higher than in stock markets. (See my review of the policy issues associated with insider trading in stocks.) In noncommercial prediction markets, you therefore presumably want to encourage trading by informed insiders. (See, e..g., this analysis of Policy Analysis Markets.)
On the other hand, in commercial prediction markets like TradeSports contracts, the proprietor of the market presumably has an incentive to eliminate informed insider trading. If there's a fairly high probability that you'd be betting against somebody with inside information, who thus can't lose, would you bet? Me neither. At a Vegas craps table, gamblers expect to be protected from the house using loaded dice, but insider trading amounts to the use of loaded dice by the insider because of his informational advantage. Assuming a commercial prediction market makes money by taking a rake out of every wager, it is in that market's interest to maximize the number of bets placed.
... amateurs serve a purpose in the ruthless ecosystem of the market. They are the sheep who attract the wolves. The amateurs' money entices serious investors to spend time scouring cardinals' past statements and other sources. The sheep's money also offers a temptation for those with inside knowledge to cash in .... ( Link)
At first blush, it would seem that these considerations should induce commercial prediction markets to ban trading by knowledgeable insiders. Indeed, given that tracing such traders may require law enforcement tools, just as is often the case with insider trading in corporate stocks, the prediction markets likely would seek laws against trading by insiders. Curiously, however, I have been unable to find a ban on insider trading by TradeSports on their rules website.
An alternative strategy is suggested by this paper's analysis of the role of uninformed traders. The authors recognize that trading by uninformed investors is essential to the success of a prediction market, but also appear to believe that achieving adequate levels of such trading requires irrationality on the part of uninformed investors:
Prediction markets are too small for meaningful hedging, and are likely to remain so for some time, so the primary motivations for uninformed order flow are likely to be entertainment and overconfidence. (P.7)
Other aspects of their analysis, however, suggest to me that it may be possible for a commercial prediction market to offer enough inducements, in terms of high interest contracts (e.g., Presidential elections), low transaction costs, etc...., for uninformed bettors to be willing to gamble even in the presence of trading by informed traders. Obviously, this strategy works best when the contracts are those as to which inside information provides merely strong probabilities rather than certainties. Compare, for example, the case in which a campaign staffer trades on the basis of internal polling suggesting that her candidate is going down the tubes with that of a White House staffer who has been told by the President that he intends to nominate Alberto Gonzales to the Supreme Court. The insider's advantage is significant in the former case, but only in the latter does the insider's informational advantage make the wager a certainty. If the latter class of contracts are rare, trading by informed investors may provide significant enhancements in the predictive power of the market, while reducing the risk of scaring off uninformed traders.
