Julian Jonker (University of Pennsylvania, Legal Studies Department) and Violet Victoria (West Virginia University) have posted Chaos Contracts: Outcome Manipulation in Prediction Markets, and How to Regulate It on SSRN. Here is the abstract:
Prediction markets are ordinarily defended for their ability to aggregate dispersed information into a price that tracks an event’s probability. This defense assumes act-state independence: that trading a contract does not influence the probability of its outcome. Where this assumption doesn’t hold, contracts are act-sensitive, and the price of an event contract is not a forecast but an incentive. We call such instruments “chaos contracts” because they incentivize traders to disrupt settled institutions. The incentive created by such contracts is especially high when the act of influencing the outcome is otherwise innocent.
We argue that three common regulatory strategies are insufficient to deal with chaos contracts: classifying contracts by subject matter, policing the conduct of traders, and excluding parties from trading them on the basis of their ex ante identifiable roles and relationships. Attempts to classify subject matter miss the long tail of chaos contracts that do not obviously involve problematic activities. Policing the conduct of traders either misses innocent acts of influence, or is overbroad and prohibits useful activities and contracts. Unlike insider trading law, it is difficult to identify ex ante who will be in a position to influence an outcome.
We propose instead that regulators aim to constrain act-sensitive contracts using principles of contract design inspired by the history of insurance law. While event contracts lack the equivalent of an insurable interest, we suggest tools for increasing the costs and decreasing the payoffs of influencing outcomes, ranging from hardening resolution bases to position limits and ultimately nonlisting. This approach fits comfortably within the existing commodities regulatory framework, and requires only being explicit about this novel threat and the tools available to contain it.
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