Focus Areas:    Insider Trading | Securities Regulation

On rigged(?) markets, casinos and Steve Bainbridge

Greetings loyal fans (i.e., “hi mom”) (actually, I’ve made this gag before, and so I think it’s time to set the record straight:   My mom has almost certainly — nay, certainly — never, ever read this blog.  I’m pretty sure she has no idea what a blog is at all.  She may not even be sure what a computer is.).

Apologies for my prolonged absence — I’ve been swamped with moving, new job, selling/buying houses, a sick baby, the flu and grading exams.  

Which also means I’m a little late to the party with this comment, but here goes: 

A week or so ago, my dad had an op-ed in the WSJ, mentioned by several bloggers, including Josh and Thom.  Steve Bainbridge also commented on the article.  As his comments turned to his thoughts on insider trading in prediction markets, Steve wrote this:

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.

It’s an argument he’s proffered before, but I just don’t get it.

I just don’t think the conclusion about the unattractiveness of “rigged” commercial markets holds, at least not across the board.  In the stock market, when it comes to uninformed, diversified investors for whom every investment in every stock is effectively a 50-50 proposition, the presence of insider trading should not matter.  Why would these people care one bit whether there were insiders trading in the market?  Each also has a 50-50 chance of benefitting from the insider trading (as from being harmed), but if insider trading also increases returns across the market, they will surely prefer the “rigged” market.

As to the commercial prediction markets, the question, “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?” and the analogy to a casino are really not appropriate here:  First, who says the probability of betting against a perfectly-informed insider is “fairly high?”  Insiders aren’t binary; it’s not the perfectly informed betting against the ignorant.  A market that permits insiders to trade permits not only the perfectly informed, but also the less-than-perfectly-informed, the mistaken, the over-confident, and the stgupid to trade, as well.  It is simply not the case that particpating in a prediction market that permits insider trading is a losing proposition for everyone but the insiders.

Second, you’re not betting against the house and its loaded dice in the market.  Unlike at the craps table where odds and payoffs are fixed, market prices fluctuate, in part taking account of the likelihood indsiders are trading (hence many people’s arguments in favor of opt-in, disclosed insider trading).  What’s more, you are almost as likely to be betting with the “loaded dice” as against them in the market, and the thumb on the scale (to mix metaphors) is as likely to help as it is to hurt.  (And, to return to stock markets again, for the diversified investor the “thumb on the scale is more likely to help:  Those who buy and hold are never on “the other side” of an insider transaction after the initial buy-in, and, again, if insider informed trading improves overall efficiency, the buy-and-holders should be net beneficiaries.)

So I just don’t get the aversion to insider trading in prediction (or any other) markets.  But perhaps that’s just a function of my genes — what am I missing?