Prediction markets use the “wisdom of the crowd” philosophy to make decisions on future events or outcomes. The events predicted can be extremely diverse, such as – crypto or asset prices, elections, sales of a company, price fluctuations of stocks, etc. In this article, we will talk about DeFi prediction markets. These are prediction markets that use the advent of decentralized finance to drive the prediction systems.
So, first thing’s first….
What is Decentralized Finance (DeFi)?
DeFi stands for decentralized finance. It’s a movement that aims to utilize protocols like smart contracts to create decentralized versions of traditional financial products and instruments. A DeFi can be anything from a digital asset, decentralized applications (DApps), financial smart contracts, and protocols that run on top of public blockchains. Some features of these DeFi applications are as follows:
Decentralized: There are no intermediaries that take up control of your funds. A central administrative body does not control Defi products.
Transparent: Since the system is open and decentralized, anyone can see all the stored data inside it.
Permissionless: An open system where anyone can participate without restrictions from any government.
No Censorship: Since there are no centralized governance bodies, the protocol is resistant to central censorship.
Innovative: DeFi products have often been called lego pieces because of their limitless potential for innovation. It is possible to join together multiple DeFi protocols to create a whole new product.
What are Prediction Markets?
Prediction markets are collections of people that are speculating on the outcome of an event, or price of a commodity or asset. To better illustrate how this works, let’s take a slight detour.
At its very core, what is a market? It is a group of people buying and selling things. Pretty straightforward, right? Similarly, a prediction market is a marketplace where you can buy and sell predictions. Or, to put it more accurately, shares in the outcome of an event.
Speaking of prediction market shares, let’s take a quick look at how it works.
There are two types of shares in a prediction market – “YES”, or long shares and “NO”, or short shares.
YES: Gives you a payout if an event occurs and nothing if the event doesn’t occur.
NO: It gives you a payout if an event doesn’t occur and nothing if it does occur.
The payout given is dependent solely on how much the buyers are willing to buy and how much the sellers are willing to accept.
You can think of prediction markets as event derivatives. The value of these derivatives is directly proportional to the probability of a particular outcome.
To gain a better understanding of how this works, consider the following example.
Example of a prediction market
Imagine a simple dice. Upon a roll, it can show one of 6 results. Suppose the bet is that the dice will display one of three outcomes – 1,2, or 3. So in a prediction market, The weight of “Yes” shares will be equal to the weight of “No” shares. So, if the payout for a correct prediction is one dollar, both the buyers and sellers agree to pay 50 cents each.
However, what if we have a four-sided dice instead of a six-sided one? Now the chance of getting a roll that’s 1,2,3, or 4 suddenly jumps from 50% to 75%. This means buyers will now have to pay 75 cents for Yes and 25 cents for No.
DeFi prediction markets basis – Wisdom of the crowd
Wisdom of crowds is the idea that large groups of people can collectively make smarter decisions than individuals. This is the core concept behind decentralized finance prediction markets. Wisdom of the crowd was first observed by the great philosopher Aristotle. As per his observations, a potluck dinner, wherein people collectively bring food, results in a much more satisfying meal than a feast produced by just one person.
For this theory to work correctly, the following conditions are necessary:
– The crowd itself must be diverse.
– They must have incentives to participate in the market.
– They must come up with their own decision and shouldn’t be influenced by each other.
So, now that we know the theory, let’s look at some practical examples now, shall we? In fact, let’s look at three examples of the wisdom of crowds:
Imagine we have an object whose weight we have to guess. Taking the average of the individual guesses of a large group will be closer to the real number than those of individual experts who are familiar with the object.
Studies show that in a major sports event, like the World Cup Final or World Series, a group of people who are knowledgeable about the sport but not fans of the teams involved can accurately predict the result more often than not.
The last example is the “Ask the Audience” lifeline of “Who Wants to Be a Millionaire.” You are probably aware of how this goes. The studio audience is polled, and the most popular question turns out to be the correct one, 91% of the time.
Why DeFi prediction markets? The limitations of centralized markets
Before we get into the DeFi price predictions markets, let’s understand why we needed them in the first place. What are the problems with centralized prediction markets?
Borders and regulations silo all the centralized prediction markets. The problem here is that the strength of a prediction market is directly proportional to its size. The more operators and regulators you have, the more you limit access to the markets, reducing its effectiveness.
Centralized markets also have a low betting cap, preventing the participation of actors who want to make high risk/high reward investments.
Being an intermediary, these markets usually charge trading fees and take cuts from your profits. If you are a regular user, then all these fees tend to add up.
Finally, the lack of users leads to reduced participation, which, in turn, makes these markets extremely illiquid.
Advantages of DeFi prediction markets
The core component of decentralized finance is the lack of centralized ownership. This gives it several advantages over their centralized counterparts.
The lack of a central overseer opens up the markets for free and open participation. Anyone anywhere can bet on any outcome, anytime they want. Do you want a free and open market with zero friction? This is how you get it.
Assets that were formerly closed to you are accessible via DeFi prediction markets. For example, certain countries can’t usually access American stocks. However, decentralized finance applications can allow you to do so.
Users can also create their own markets if they want to.
DeFi prediction markets lack intermediaries, which is why it eliminates counterparty risk, and the fees collected are noticeably lesser.
Open and free participation increases the liquidity available in the pool, drastically improving the potency of DeFi predictions markets.
DeFi predictions – The rise of decentralized finance
The core innovation crucial for the creation of DeFi prediction markets is smart contracts. A smart contract is an automated agreement between two parties. These smart contracts are a bunch of instructions that execute using the IF-THEN-ELSE logic. In other words, instructions can only be executed after the completion of the previous ones. This ensures that two people can enter a binding agreement that’s governed by code, instead of a third-party, like a lawyer.
Predictions Markets are becoming a central part of Decentralized Finance (DeFi)
However, smart contracts themselves aren’t enough to properly execute these prediction markets. Another vital piece of this puzzle is oracles. Decentralized prediction markets like Augur and Gnosis have smart contracts that decide how much the participants get paid if a particular event occurs. However, how do they know that the event has indeed occurred, or not? For this, we require oracles.
Enabling DeFi predictions via blockchain oracles
An oracle is a third-party service that provides smart contracts. DeFi prediction markets capture knowledge about a particular event via multiple oracles. Think of them as a bridge between the fiat world and the decentralized world. The relationship between the smart contract and oracles works like this:
Smart contracts and the blockchain, in general, live in an isolated reality. As such, they are oblivious to the rest of the world.
Therefore, the oracle’s job is to sign off and validate the state of the world and upload it periodically to the blockchain.
More than one oracles can obtain the required information from more than multiple sources.
The truly wonderful thing about DeFi is that it allows for more innovative and decentralized versions of legacy financial structures – like prediction markets. Decentralized finance prediction markets can circumnavigate the shortcomings of centralized markets and allow for more participation and higher liquidity.
Alright, now let’s bring everything together and see how smart contracts and oracles work together to create a prediction market.
Imagine a hypothetical market with just two members – Alice and Bob.
In a match between Manchester United and Arsenal, Alice believes United will win while Bob is with Arsenal.
The two of them enter into a smart contract and lock up their payments.
Upon getting the results, the smart contract releases the funds to the victor.
The oracle queries a trusted API to find out which team won.
Finally, it then relays the information to the smart contract, releasing the funds to Alice or Bob, depending on who won.