Most people think of prediction markets as simple yes-or-no predictions on whether an event will occur. In reality, these markets are far more complex. They include a variety of contract types, market designs, and even different forms of currency. Below, we break down the main types of prediction markets and explain their purposes.

Contract Types

There are three main types of contracts: binary, index, and spread. Binary contracts are the most common and well-known. For these contracts, traders make yes or no trades on their predicted outcome of an event. This contract can help to show the probability of an event occurring based on market expectations. For index contracts, the payout varies continuously based on the value of a numerical outcome. A common example is the percentage of votes Trump receives in the presidential election. Index contracts show the market’s expectation of the value, mean, of the event with investors split into buckets of potential outcomes. Lastly, spread contracts are binary contracts where a person can invest in a specific event outcome both occurring and exceeding a certain threshold and the cutoff. The profit or loss would deviate based on how close the trader got to the actual outcome. An example of this type of contract is that President Trump will win 66% of the popular vote. Spread contracts show the market’s expectation of the median. This contract type rewards the forecasting accuracy of a trader over mere direction.

Market Design

The type of market design used by a prediction market impacts the liquidity, distributions of winnings, and capital choices. Continuous double-action design is similar to the stock market, as it matches buyers and sellers when the bid and asking price align. The market maintains a ledger to catalog the trades to ensure all contracts are correctly paid out. This style of market is conducive to high-activity markets with frequent trading and allows people to move in and out of investment positions based on the current market price. This peer-to-peer style can often be supplemented by automatic market makers, who can act as counterparties to both sides of trades, while making money by arbitraging different market values and taking fees on spreads. This approach helps provide liquidity in markets where there are not enough buyers or sellers at a given time, ensuring that participants can virtually always find a willing buyer or seller at around the then-current market prices. Pari-mutuel payouts occur when all investments are pooled together into one pot and then are divided out amongst the winners in proportion to the size of their investment.

Currency

The most common type of currency used in prediction markets is real currency, defined as actual assets or money. It is typically used because it incentivizes traders to make accurate predictions. More recently, some markets have begun using platform-specific tokens or coins, where payouts or incentives are awarded based on the number of tokens earned. There are advantages to using platform-specific tokens over real currency, as they lower the barrier to entry and can increase participation and liquidity.

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