The Iowa Electronic Markets and Tradesports.com allow people to trade contracts that pay off based on the outcome of the 2008 US presidential campaign. Prices in these 'prediction markets' appear to be superior to traditional polls. This superiority is consistent with economic theory, because traders' price influence is tied to their trading aggressiveness, which in turn reflects their confidence. As long traders' confidence is tied closely enough to the quality of their information, prices in prediction markets will be superior to an equally-weighted average of people’s beliefs.
In this post, I throw down the gauntlet to those running (or considering running) a trading exchange in Second Life—create a 'Second Life Indicator Contract' (SLIC) that would predict the future user base or economic activity in Second Life.
Prediction markets could provide very useful information for individuals and businesses debating whether develop a presence in a virtual world, and choosing which one. World selection is a difficult issue, because the metaverse is so fragmented. And lack of portability makes the stakes very high—it isn’t possible to transfer assets across worlds, so whether you are an individual looking for a social network, game play or profit, or a corporation looking for teleconferencing or marketing opportunities, your investment comes with a serious risk: your fortunes rise and fall with the particular platform you have chosen.
If virtual worlds do become an important engine of global business, prediction markets could be an important economic force, and could even allow those investing heavily in a world to hedge their investments (offsetting the risk of their investments by taking positions that would be profitable in the event of a downturn in the prospects of the world they chose). SLIC markets within SL would be an excellent way to provide proof-of-concept for this idea, at a low-stakes level.
To make my proposal a little more specific, let’s assume that we can get a reasonable measure of Second Life’s economy by measuring the total US dollar value of all Linden’s currently in circulation—currently around $13M. An exchange could create a futures contracts in which one party agrees to pay another party L$100*(M-$13), where M represents how many millions of Lindens are in circulation on March 30th, 2008. For example, if there were 15.4 million Lindens in circulation on March 30th, the party buying the contract would receive a payment of L$240 from the seller. The price paid by the buyer today would therefore indicate the markets’ expectation of the money supply in March. Introducing a new 6-month contract every 3 months would guarantee a look-ahead of at least 3 months every day.
Anyone trying to create a futures market like this will face a few challenges. One hurdle will be to develop metrics of virtual world success that are relevant, and not too subject to manipulation either by the game developer or its residents. The supply of Lindens seems reasonably objective and hard to manipulate, but doubtless there are better measures of the success of Linden’s economy that would capture the value of land, the user base, etc.
Another challenge is that, for everyone who takes the winning side of a contract, someone else takes the losing side, and losses can be larger than the initial investment. Thus, people would probably need to deposit collateral to cover losses.
Finally, the exchange would need to make sure that they don’t face trouble from the Commodities and Futures Commission. The IEM received a no-action letter from the CFTC, but they have a purely educational mission. Tradesports is now viewed as an illegal gaming site by the US. However, my understanding is that the extensive sports betting is the real problem; the contracts they create based on stock indexes could be legal, if only they could convince the CFTC that there is a real business reason for someone to hold them. I believe the hedging argument I laid out above might justify the existence of the market.
Despite these challenges, I encourage exchanges in Second Life to take up the challenge. My guess is that they would be far higher volume than what we see now, because what is traded would be a known quantity. A small commission on each trade, and someone can probably make a fair bit of profit.
Anyone interested?
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