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Why economists love Intrade — and why the government hates it

Economists love prediction markets like Intrade. But the U.S. government has long been skeptical of such sites. Is it time for that change?

That question popped up again this week after federal regulators filed a lawsuit against Intrade, a popular Web site that allows people to wager on the outcome of elections and other political events. In response, Intrade announced that it would close its doors to all American customers (the site is based in Ireland). That will almost certainly put a damper on Intrade's much-watched U.S. election markets when 2016 rolls around.

Economists quickly turned their ire toward the regulators going after Intrade. "Why prohibit something so harmless?" asked Dartmouth's Eric Zitzewitz.

On the surface, the Commodity Futures Trading Commission, which filed the lawsuit, appeared to have a case. Intrade wasn’t simply allowing participants to bet on the outcome of events like elections or the Oscars. The site was also allowing U.S. customers to bet on the future price of things like gold or oil between 2007 and 2012, the CFTC said. If that’s true, it would mean Americans were essentially able to buy and sell commodity options on Intrade away from regulated exchanges. That’s against the law.

But there was an easy way around this problem, says Rajiv Sethi, a professor of economics at Barnard College. The CFTC could have just granted Intrade a license and allowed it to operate inside the United States as a regulated market. "That would have been the simplest option," Sethi says.

Yet federal regulators don't appear inclined to grant licenses to prediction markets like Intrade. Back in April, the CFTC denied a license to a similar firm, Nadex, that wanted to trade "political event derivatives contracts." In turning Nadex down, federal regulators said that such prediction markets "involve gaming and are contrary to the public interest."

Many experts strongly disagree with this assessment. In a 2008 paper, a group of 19 economists, including Nobel laureate Kenneth Arrow, argued that prediction markets could potentially prove extremely useful. They are often more accurate than traditional forecasting tools — in part because they aggregate a wide range of informed opinions. "The range of applications is virtually limitless," the economists wrote, "from helping businesses make better investment decisions to helping governments make better fiscal and monetary policy decisions."

Over on his blog, Barnard's Rajiv Sethi added that prediction markets have also become a valuable research tool. A growing number of academic papers use data from Intrade, particularly because its contracts tend to be simple and easy to study. "One big thing these markets can do is allow researchers to test the hypothesis of the 'wisdom of crowds'," Sethi told me.

To be sure, prediction markets do have potential pitfalls. Sites like Intrade tend to be used mostly for speculation, which is arguably not in the public interest, rather than hedging. What's more, Sethi points out, since traders have to post enough money to cover their worst-case losses — and these exchanges have to keep this money close at hand in case the bets suddenly close — markets like Intrade arguably tie up funds that could be put to more constructive uses. (This is known as "capital diversion.")

But Sethi's not convinced that these are good reasons to crack down on sites like Intrade. For one, if the CFTC is really so worried about speculation, it could start paying closer attention to, say, trillions of dollars worth of credit derivatives and swaps trading that no longer appear to have any useful purpose, rather than worrying about tiny sites like Intrade. What's more, allowing prediction markets to operate as licensed exchanges would allow more government oversight of what happens to the money. (Right now, Intrade's deposits are backed by the Irish banking system, which isn't exactly the world's most secure.)

But if federal regulators still feel squeamish about major prediction markets like Intrade, there are still more modest measures they could take. In their 2008 paper, Arrow and his colleagues suggested that the CFTC create rules that allow certain small-scale prediction markets to form, such as those run by universities or by corporations that simply wish to conduct research. This tiny step could allow experts to collect more data on how these markets work and how best to structure them.

So far, the CFTC has only allowed given its blessing to one prediction market — the Iowa Electronic Markets, which is run out of the University of Iowa and is used to forecast presidential elections. (The CFTC sent a letter basically promising the university that it wouldn't take any action against the exchange.) But if prediction markets are really as valuable as economists think, then a little more experimentation could prove worthwhile.