Prediction Markets: Forecasting Tools or Casinos?

PATTERSON:
The world is looking more and more like a casino. Today, you can legally bet on just about anything.

MALLABY:
Yep, thanks to prediction markets, people can wager on elections, geopolitics, sports, and some seriously niche one-off events. And these markets have exploded into a multi-billion dollar industry almost overnight.

PATTERSON:
But are these markets actually useful? Or are they just gambling dressed up as forecasting? I’m Rebecca Patterson.

MALLABY:
And I’m Sebastian Mallaby.

PATTERSON:
And this is The Spillover. In the last two years, prediction markets have become an increasingly controversial and booming industry, where if you are 18 years of age, you can legally bet on just about almost anything. President Trump put it pretty bluntly last month.

As he said, the whole world, unfortunately, has become somewhat of a casino. It’s an interesting comment from a man who once owned a casino and whose family has financial interest in prediction markets today. Sebastian, I think you and I already have some ideas to share with our listeners about some actual and potential spillovers from these markets, both good and bad.

But they’re so new, and they’re changing and growing so quickly. Maybe before we get to spillovers, we can step back and set the stage a bit. How did these markets get to where they are today?

MALLABY:
Yeah, so the growth in the last year or so has just been phenomenal. If you take the two biggest platforms, which are Kalshi and Polymarket, the two of them combined recorded about 24 billion worth of bets just last month. And that’s about 12 times more than they recorded a year earlier.

So it’s really been explosive. And on the other hand, the beginnings were almost comically humble. American prediction markets started in academia back in 1988, when three economists at the University of Iowa were hanging out in a bar and spitballing about the lack of accuracy in traditional opinion polling.

And they sketched out the idea for a presidential stock market. They wanted to test if market prices could do a better job of predicting elections. So they got an exemption from Iowa’s gambling laws.

And by 1992, they had approval from the CFTC to operate a non-profit research experiment across 20 universities.

PATTERSON:
Right. And the CFTC got involved because it oversees all trading of futures and options and other derivatives, with the exception, I believe, of onions. But that’s another story we will leave for another time.

The prediction contracts we’re talking about today derive from elections. And so they were too structured as derivatives.

MALLABY:
What is it with you and onions? You brought up onions when we were talking about the European Union. You bring up onions when we’re talking about prediction markets.

PATTERSON:
I don’t know. They just keep cropping up. I’m not trying to.

It just happens.

MALLABY:
Okay. Well, I’m not going to cry about it. But anyway, let’s go on.

So, yes. So the Iowa experiment, these three economists in the bar, their experiment turned out really pretty well. So these prediction markets now do predict election outcomes exactly as they want and they wanted.

And the Iowa electronic markets, which is sort of the organization that they spawned, outperformed traditional polls in forecasting election outcomes about three quarters of the time. And because they update pretty much continuously, they give you a faster incorporation of new information into the prediction. But despite the success, prediction markets remained, until recently, a niche academic exercise.

Interesting to some financial traders and maybe political scientists, but pretty limited beyond that.

PATTERSON:
Yeah. Maybe I can speak as a former market participant here. I remember in at least two of my prior roles, we would sometimes look at an offshore prediction market called PredictIt, and we used it as an analytical input.

But back then, those markets were with people taking bets on a wide variety of events, political and otherwise. They were not allowed in the US, at least as they were structured at the time. But even then, I could start to see the idea that you’re talking about, that the markets could give you a way of seeing what others thought were probabilities on different events, like elections, like the Brexit referendum in 2016.

MALLABY:
Right. So as I was saying, you and your Wall Street colleagues, you were early adopters. But it was really only much more recently that these prediction markets started spreading and having a larger commercial and maybe also societal significance.

Kalshi and Polymarket, the leading prediction markets in the US, only started operating a few years ago. Polymarket started in 2020, Kalshi in 2021. And initially, they were kept in their boxes by the regulators.

Polymarket was fined by the CFTC in 2022 and told to keep its operations offshore and not serve US users. But then things changed. Kalshi sued the CFTC in late 2023 over the right to offer election contracts and won in the DC Circuit Court in September 2024.

And that really opened the floodgates. Last year, Polymarket followed up by buying a CFTC licensed onshore American exchange called QCEX. So it could come and operate onshore, serve American customers onshore.

So the big takeoff point for these markets is really, you know, less than two years ago.

PATTERSON:
That September 2024 court decision was really important. And there are a few other things in addition to that, that also helped bring gambling and gambling like activity more into the mainstream. And it created the conditions for these markets to take off.

First, we had the Supreme Court ruling in 2018. It struck down a law that had effectively banned sports betting in most of the country. That set the stage for a number of states to allow sports betting and importantly, get tax revenue from the activity.

We also have a public that during the pandemic in particular, got much more exposed to gambling and short term betting. And we also had technology that improved. It got this more to the masses and we had fees that came down substantially.

So a lot of financial trading over the last several years has become increasingly gamified and available cheaply to the masses. And then I guess the last thing, Sebastian, I’d add to the list that kind of set the stage for where we are in prediction markets specifically today is the current administration. It definitely has taken a much more relaxed approach than the previous Biden administration to financial regulation more broadly.

And I think that’s also played a role. So the prediction markets really entered the mainstream with all these tailwinds. And as you said at the top of our episode today, Sebastian, the growth has been absolutely staggering.

I would highlight within that growth that the bulk of it is sports betting. The reports I’ve read suggested that sports accounted for more than 80% of Kalshi’s monthly trading volume last year.

MALLABY:
Right. And off the back of that, the valuation of these two big platforms is booming. They’re attracting capital from the best known venture capital firms, Sequoia, Andreessen Horowitz, General Catalyst, Founders Fund.

And Kalshi recently closed its most recent financing with a valuation of $22 billion. So we’re not just a unicorn here. We’re like a double-decker unicorn or something.

And that doubles the valuation from just about six months ago, which was $11 billion. And then if you look at Polymarket, Polymarket is a bit smaller, but it’s still growing fast. It’s in talks right now to raise the next round at a $15 billion valuation, which will be up from $9 billion just last October.

And the seductive idea behind all these markets, of course, which partly accounts for the legal headway that they’ve won for themselves and the market valuations that they’re gaining, is that they could be socially useful, right? That they’re not just about sports, that they actually might signal outcomes of important stuff like military events, elections, some other event. And that actually is helpful to the economy and to the society because it allows businesses or investors or other people to prepare for what’s going to happen.

They won’t be blindsided by results. So maybe in preparation, they can get ready to absorb a shock and the shock will be less painful. Or to put the same point differently, Rebecca, when the line between forecasting and gambling blurs, do these prediction markets really act as high-quality oracles?

PATTERSON:
Well, let’s think about who’s participating in those markets for a minute. We don’t have a lot of data yet. Again, these markets are relatively new.

But a poll in February by a firm called Echelon Insights found that 38% of 18 to 34-year-olds had placed bets on prediction markets versus 28% for 35 to 49-year-olds and 3% for over 65. So this is clearly skewing younger in terms of the people using these markets. It also skews pretty male.

The same poll showed 46% of men versus 31% for women taking part in these markets.

MALLABY:
Right. So I feel like almost the premise for these markets is that 18 to 34-year-old men are better oracles than the rest of us.

PATTERSON:
Well, there’s something. I don’t know if they’re better oracles, but they definitely enjoy spending time with these markets. I think we can give them that at least.

But just remember that a big chunk of this is sports betting. So maybe it’s just that young men are more inclined to do sports and spend time on sports than women. We’ll see.

But Kalshi sees more trades on college football than on pro-national football or basketball games. And that also suggests that maybe it’s young men betting on these types of sports that they’re closest to, that they’re spending time in every week. But beyond the sports factor, the youthful profile of these bettors, it doesn’t really surprise me.

The cohort has been shaped by the pandemic and by social media. A lot of these people are also gamers. And again, we’re gamifying everything.

Even if the young man isn’t surprising, it could be something that we see as a cautionary tale. In most U.S. states, you have to be 21 years old to legally bet on sports. And we have those rules, presumably for a reason.

People under 21 might be more likely to be less responsible. Maybe they’re more likely to become addicted. Maybe they might be gambling their parents‘ money or money they don’t really have and so forth.

But prediction markets, in contrast to the state overseeing sports markets, you only have to be 18. So it’s a loophole. The under 21s now have a way of doing sports betting legally.

It’s legal, according to the CFTC, because it is set up as a derivatives market. The contract is what’s being regulated. One challenge is that minors are finding ways to get on these and other platforms through parents and whatever.

There was a study last July that came out from Common Sense Media. It found 36 percent of 11 to 17-year-old boys say they had gambled in the previous year, including almost 50 percent of 17-year-olds. We’ll take that with a grain of salt, but it does suggest that people are finding ways to do this legally or not.

And I know we’ll get into this later, but sports betting is one of the biggest points of controversy for these prediction markets. Again, back to what I said a second ago, should it be regulated at the state level like sports betting and casinos, or should it be at the federal level because it is a derivative contract and derivatives fall under the CFTC, which is federal? The states don’t want to see sports gambling revenue go away.

They’re counting on that tax revenue. They don’t want to see that money going to Kalshi, Polymarket. But, you know, we’ll see there’s a lot of lawsuits out there now between the states, between the prediction markets and even with the CFTC.

So there’s a big jurisdictional battle going on here.

MALLABY:
Okay. So we’ve got underage gambling. We’ve got legal loopholes.

We’ve got some fights over who gets the revenues. It’s a messy evolution for sure. But let’s go back to that question about the value of the predictions themselves.

So the theory, just to reiterate, is that if people, you know, enough different people with information about what might happen with judgments about what might happen, and with putting money on their views, so that kind of forces them to take you seriously and put some work into developing an informed view, that if you incorporate all that into a market price, you get a good forecast. And, you know, the efficient market hypothesis for the stock market is precisely that, that, you know, the stock price efficiently incorporates all possible information into it. And the idea of the prediction market is the same thing, right?

PATTERSON:
Yeah, I think the theory is the same. And, you know, to me, it means that for the prediction markets to really have value, they need pretty broad participation. And for some things like central bank decisions, elections, or even a recession call, the prediction markets are showing themselves to be informative.

But on the other hand, you have some niche prediction markets that, I mean, frankly, they’re barely bets at all. On thinner contracts, you’ve got a couple of traders, a few bots, maybe someone for a TikTok video having their, you know, St. Bernard or Labrador tapping the yes key or something. You know, if there’s no depth to a market, the price you see doesn’t really tell you much about the reality.

It’s just telling you who was online that morning. I was poking around Kalshi this past Sunday just to look for good examples for our episode today. And, and one, you know, that just made me smile.

There was a bet on whether the song Swag by Justin Bieber will rank number six, very specific, on the Billboard 200 chart this coming Saturday. So the volume was less than $6,000. So this is not a large market.

And there were just a handful of people trading these contracts. You know, there were some other illiquid bets over the weekend, things like what a certain policymaker or corporate executive might say their next big event. But this one kind of stood out to me.

It seemed very specific and very random, no offense, of course, to Justin Bieber. But, you know, the question for me isn’t whether prediction markets can work and have value. I think they clearly can.

I think the question is, when are they revealing collective intelligence, the wisdom of crowds, and when are they just giving us a very precise looking price to what’s really not a very good signal?

MALLABY:
Yeah, I take your point. There might be a sort of self-calibrating, you know, corrective mechanism here in the sense that we probably agree that, you know, niche bets on Justin Bieber may not tell us much real information, but maybe they’re just harmless. I mean, the markets may be thin, predictions may be inaccurate, but who cares apart from Mr. Bieber, right?

I guess there’s also larger worries that we probably also agree on, which is not just that markets can be thin and generate, you know, not very valuable signals, they actually might be scammed. And that’s a whole different level of problem. So if you take what happened, for example, in Paris last month, there was a great story in the New York Times about this.

France is currently investigating a possibility that a weather sensor at the Charles de Gaulle airport was physically tampered with. So on two occasions in April, the temperature reading spiked several degrees in a matter of seconds. And that sort of set a daily high for the temperature, just the moment by coincidence, when certain wagers on the temperature forecast were going to pay out on Polymarket.

So nearly 1.4 million was bet on Paris daily temperatures on the two days when there were the suspicious spikes in the temperature, which was way more than the normal amount of betting on temperature. So the suspicion is that someone held a heating device up to the heat sensor. I mean, it’s easy to win a bet on the temperature if you take control of the thermometer.

PATTERSON:
Right. No, that’s a great example of somebody rigging the game by tampering with an umpire, so to speak. And then you have other cases that aren’t about rigging the market, but they’re about inside information, which I think is is just as nefarious.

You know, you had a case just recently where a U.S. Army special forces soldier who had helped plan the capture of Venezuela’s President Maduro was charged with using classified information to bet on outcomes related to the events in Venezuela, like whether U.S. troops would be in the country or whether the president would be removed from office. And, you know, according to the reporting, the soldier made more than four hundred thousand dollars on Polymarket. And this sort of insider trading abuse seems not to be the exception.

Unfortunately, the Financial Times reported this past week, which was great timing for our podcast today. They did a study of more than four hundred thousand Polymarket bets over five years, and they found that half of what are considered to be, quote unquote, long shot bets on Polymarket specifically related to military action were successful. I mean, that’s an incredible number.

So these were long shot bets defined as odds with 35 percent or less of winning. And by definition, those bets should pay out less than 35 percent of the time. But what happens is when you look at those long shot bets on elections or other events, the military events won 52 percent of the time versus what you would expect would be 35.

So a big differential between the two and frankly, very suspicious. What it suggests is that people placing these bets might have access to inside information, either because they’re inside the military or close to it somehow. And the lesson seems to be that the outcomes are being determined by a small group of decision makers who could be structurally susceptible to insider trading.

So the military actions are just one example, but it’s pretty stark. Now, of course, Polymarket says that any time it identifies users trading on classified information, it contacts the Department of Justice. And it’s also worth noting that while Polymarket’s U.S. operations and Kalshi require a lot of personal information from customers, you have to put in your birthday, your Social Security number, your address. I mean, they have all your details. The offshore accounts at Polymarket are still pretty anonymous. And if people want to use those from the U.S., there are workarounds like getting a V.P.N. that let them do that.

MALLABY:
And to add on, I’ll mention something else that came up in the news just in the past week or so. And this is about how she finding and suspending three American political candidates for betting on their own election races. This, again, was a story in The New York Times.

So, you know, the bets were quite small, admittedly. But the story does illustrate that there can be a third type of abuse with prediction markets. So it’s not about reading the thermometer.

It’s not about inside information. It’s about betting in order to boost your own political profile and maybe even your odds of winning the election. Basically, you know, the temptation is here that candidates bet on their own success in order to create the illusion that they have real momentum.

PATTERSON:
And as I mentioned earlier, Congress has noticed this Thursday, just last week. The Senate unanimously voted to ban themselves and their staff from trading on prediction markets. I don’t think the House has done that yet, but I’ll double check that.

There’s also a bill being considered now called the Public Integrity and Financial Prediction Markets Act. Can’t believe I got that out that easily. And it would prohibit federal officials and congressional staff from trading contracts where they might have information.

And there’s yet another bill called the Death Bets Act, which would explicitly prohibit contracts tied to war and death. I mean, you can imagine, you know, does someone think a certain leader will be removed from office? What you don’t want to see is that actually creates some perverse incentive to assassinate someone.

So it’s going to be telling to see how quickly Congress passes any or all of these bills. So that’s the landscape we’re operating in. And I think we have the perfect person today to help us understand more how we got here and where all of this is headed.

And that’s Christy Goldsmith Romero. She was the CFTC Commissioner and had been in regulatory senior, senior roles across four administrations. And she’s been a public servant for 23 years.

Christy, first of all, thank you so much for your public service. And welcome to the spillover today. We’re so happy to have you.

ROMERO:
Thank you. It’s so great to be here. Thanks for the invitation.

And I’ll tell you, Rebecca, everything’s a commodity except for onions, movie tickets, and now stable coins. There we go. So you have a couple of more.

It’s not only onions. Excellent. Thank you.

Not only onions.

MALLABY:
I’m just having a hard time connecting those three things, you know, onions, movie tickets, and stable coins. What do they have in common?

ROMERO:
Lobbying.

MALLABY:
Okay. All right. So Christy, as I understand it, prediction markets were virtually illegal in the U.S. for the broad public until maybe a year and a half ago. And as I understand it again, that changed with this court decision in October 2024, the Federal Appeals Court. And that opened the door for election betting and started the ball rolling and everything we’re seeing now kind of came from that. You were at the CFTC when this was all playing out.

What was the feeling inside the CFTC when this change was unleashed by the court? And how do you feel about how the developments have come down the pike since then?

ROMERO:
Yeah. I mean, I think the loss in the courts on the election contracts was hard, but not unexpected. So to give you a sense, the Commodity Exchange Act gave the CFTC the ability to prohibit event contracts that are on certain categories.

So war and assassination, as you mentioned, Rebecca, terrorism, violation of state laws and gaming. But it didn’t say elections. And then the CFTC afterwards in 2011 put in a rule that banned election contracts on those categories.

So we knew it wasn’t a clear category that was enunciated by Congress. And it wasn’t the clearest call. But we made the decision anyway to really sort of say, well, we’re going to look at elections as coming under the category of gaming and state law.

What that loss did was it ends up chilling the CFTC on its interpretation of gaming. So it does chill the CFTC. And then you add in the change in the administration and you have sort of the deregulatory nature where prediction markets have now expanded to almost everything.

I think I’ll add in two additional things. The first that I’ve been thinking about lately, the first is sort of where we get our information from. And it really has changed from traditional sources.

I think as a society, the wisdom of crowds is coming in more and more. And, you know, we don’t see people getting their information from polling, right, or from traditional media as much. So you have this wisdom of crowds, and there’s a lot of value to this information, particularly, as Sebastian said, that it’s continuously updating.

So it’s very, very timely. And then you think about this massive source of information during a time of AI. So you have like these institutional investors investing in these markets, and you have contracts with media companies.

And then you have the Federal Reserve report that recently came out and said, essentially, that the information coming out on Kalshi in terms of forecasting and data on macroeconomic conditions is as good as the traditional benchmarks. So I think I recognize the value of this information. And the second thing is, particularly on sports, this question about where’s the line between investing and gambling.

And Sebastian, you mentioned this. And I think prediction markets have expanded in a way that that line is blurred. You know, we were really looking at trying to keep it to kind of the hedging and the commodity markets and the economic forecasting that is typical for investing.

And now I really love Justin Bieber’s swag album. I’m not sure that that is really sort of a hedging use of these markets. Fair.

PATTERSON:
But I’m glad you like Bieber. So I want to talk a little bit more about the CFTC’s role in in kind of making sure the rules of the road are fair and the guardrails are in place. I know the CFTC doesn’t pick winners and losers.

That’s not their job. Their job is just to make sure that everyone can participate in the markets fairly. But the growth of these markets has come at the same time that we’ve seen a lot of cuts to staff at across the government, but including at the CFTC.

I mean, I don’t know if this is accurate, but the reporting I’ve read suggests the CFTC staff is the smallest it’s been now in about 15 years. You gave an address when you left the commission at Brookings and you talked about this need to balance regulations and growth of markets and also creating a framework so you can continue to have financial stability. I don’t think you were talking about prediction markets, just those you were talking more generally.

But, you know, I’d be curious to get your perspective today since you’ve left. How are you feeling about those issues and how are you feeling about the fact that regulations can swing so much one administration to the next?

ROMERO:
Yeah, I think that’s very destabilizing. So that’s the worry that that I brought. And and it was both to say when Democrats are in power, there is no reason to overregulate to the extent that you heard what could be valid growth.

And then when Republicans take over to have a completely deregulatory nature where there’s not potential guardrails, like against this insider trading and manipulation and things like that. So I still have those concerns. I think I certainly can see what has happened with prediction markets and this expansion in a way of of allowing sort of everything to come in, as opposed to trying to draw that line as to what would be the appropriate use of derivatives markets versus versus gambling.

I think the cuts in staff are really tough because there’s so many contracts that have to come before them. I would say, though, that my biggest concern right now is the loss of independent bipartisan regulators. You know, we had a full five of us.

And when we were looking at those election contracts, we all engaged and it was a very fulsome discussion and we convinced each other of things and we moved forward. I think that’s very healthy and very much leads to kind of balanced regulation. The CFTC commission is one person now.

I’m not sure if it’ll ever be by bipartisan again under this administration, at least. And you lose that fulsome nature of the discussion. And I think at the end of the day, the decisions will not be as durable.

So there is this potential spillover of the Supreme Court stepping in, right, and making this decision on federal preemption, whether the CFTC has it or not versus the states. And I think that is that that decision about sports and letting all of that come in is one of those that would benefit from having an independent bipartisan commission.

MALLABY:
So, Christy, there you’re talking about, you know, the debate over whether sports should be allowed to be part of all this. But just focusing on the more, you know, obviously beneficial ones where you’ve got, you know, prediction markets on political outcomes or maybe to do with financial instruments. What opportunities do you see there?

But how do you also respond to the risks that we’ve been talking about? You know, the risk of capturing the thermometer, the risk of insider trading? How do you balance those two?

ROMERO:
Yeah, well, first of all, I think I see tremendous opportunity about the information that’s coming out of these markets, right? The longer they’ve operated, the bigger they’ve gotten, the bigger data points that there are, at least on the markets that are trading fairly well, they’re not thinly traded. So I think there’s tremendous information coming out of there.

I think it’s also very interesting that the prediction markets got it right on the presidential election and polling got it wrong. And I think people are paying attention to this. And I think there’s something about how the information is just so timely.

It never gets stale, right? It’s continuously updated. I was just looking.

They’ve got Vance as being having a higher percentage over Rubio for, you know, the Republican nominee. They’ve got 80-20 split for the House with Dems taking over and the Senate, you know, the Republicans hanging on slightly. So I would say that we do see how prediction markets can reflect the wisdom of crowds.

But that’s only as long as those markets have integrity, right? So this has been my big concern all along. And the question is, you know, the concern on elections that we had was just borne out.

And at least Cal, she caught some of those. And my concern all along has been like the CFTC does not have the expertise nor the access to information that it would allow it to ensure that markets have integrity in the election space. They also don’t in sports.

And what they’ve just done is started to take some steps to, you know, work with the sports leagues and other things like that to try to increase the access to information, increase the the integrity kind of controls. But they haven’t done that yet for elections. I think they definitely need to do that.

I think the stakes are much higher on that. So I think there there is a way, you know, elections are here. We’ve heard from the courts on that.

But there is a way for the CFTC and the exchanges to step up and do a lot more and bolster the integrity of these markets.

PATTERSON:
Well, we’ll hope that they do step up. And, Christy, we’re also going to be eager to continue following all your research and the talks you’re giving. I follow you religiously on LinkedIn.

And it’s just been great to get your insights today and in general. So thank you again so much for joining us today on the spillover. And we’ll hope to talk to you soon more about this.

All right. Thank you so much.

MALLABY:
So, Rebecca, it was great to talk to Christy. But I have to admit, you know, my mind has been wandering back to that crazy image of the thermometer at the Charles de Gaulle airport in Paris. How do you think they doctored that thermometer?

PATTERSON:
I’m like going back and forth between a guy with a Bic lighter holding it next to the thermostat or maybe, you know, it is France after all. So maybe it’s like a torch for creme brulee.

MALLABY:
We have some nice cooking to do. And also we would win some polymarket bets.

PATTERSON:
Exactement. Sebastian, let’s pivot to some potential and actual spillovers. I’m going to start with one that I’m hopeful about that I think we have been touching on throughout the episode, and that’s the ability of these markets to improve economic forecasts and maybe even policymaking.

Christy mentioned this Fed report. They did some really interesting research that they released in February, and it looked at whether Kalshi predictions could add value in forecasting key economic data. And they came up with the conclusion that Kalshi for federal funds, interest rate forecasts and consumer price inflation made statistically significant improvements over Fed funds, futures and professional forecasters.

That’s a big deal. And, you know, for some of these markets like consumer price inflation, Kalshi also has the benefit of updating real time. So you’re constantly getting a now cast, so to speak.

So, you know, I don’t think anyone at the Fed or anywhere else is going to switch purely to prediction markets, but I can absolutely see in the future that it becomes part of the Fed’s inflation dashboard, for example, and certainly something that Wall Streeters are going to watch.

MALLABY:
Yeah. And I think what you’re saying about, you know, the usefulness of these financial prediction markets hold also for the political ones, as we were saying earlier, they do perform opinion polls in their accuracy and also, you know, they update in real time. So that’s both those things make them superior.

Some people, I guess, might object that these markets are not really reflecting the wisdom of the crowd because it could be a few very large traders that, you know, kind of whales, they dive in with a massive amount of capital and they can move the market. And there’s some research suggesting that odds on Polymarket and Kalshi may indeed reflect that. So the famous story here is there was a $45 million bet placed by one single French trader on a Trump favorable outcome in the 2024 election.

And that kind of distorted the whole prediction market. But I guess the question is, you know, to what extent is that a problem? Because, you know, if Trump or a buddy of Trump’s were placing the bet just to manufacture momentum, then yeah, sure, we would worry about it.

But if the big money is acting on good information, then it’s giving everyone else a useful signal about what to expect. And after all, in the 2024 election, Trump did win. The whale was correct.

PATTERSON:
Yeah, no, that’s fair. That’s fair. I think there are some positives from prediction markets, for sure.

I think there’s also some areas where we clearly need to have some caution, you know, and one of the areas we haven’t talked a lot about yet today is state level budgets here in the United States. You know, you have 39 states today, I believe, in the U.S. that have legalized sports betting. And the tax revenue they get so far is pretty modest relative to their overall budgets.

But it’s not de minimis. And it’s something they don’t want to lose, especially right now. You know, you have rising costs and you have a federal government that’s cutting back the funds it’s sending to the state.

So even if it’s small, it’s money they want to keep. I think New York state alone collected an estimated $3.4 billion in sports betting tax revenue since the middle of 2019. So that was primarily just Kalshi.

So it’s not a small amount of money. And states that for now do not have sports betting or related revenue, they’re concerned, too, because they think that prediction markets are going to grab so much market share that even if they were to legalize sports betting, it would be hard to get people to switch over to a different type of betting. And California and Texas are the two big states that fall in that category.

There was a good report in the Tax Foundation from the Tax Foundation that estimated that nationwide sports betting legalization at a 10 percent gross gaming tax revenue rate. That’s a mouthful. But it would generate one point six billion dollars a year in additional state revenue.

So a 10 percent gross tax rate, one point six billion a year in state revenue. California would get about five hundred and seventy million a year. Texas, 326 million a year.

Florida, almost 200 million. So, you know, this is money, again, those states, if they go down that road of legalizing sports betting, they don’t want to give that up at a time when their budgets are already under pressure.

MALLABY:
Right. So there’s a risk to the financial health of the states. But I want to throw in one more, which is, you know, maybe a risk to the financial health of young people who are spending money on prediction markets instead of doing a more conventional, longer term nest egg.

I guess there are two pieces to this. One is the reality that most people who bet in prediction markets are going to lose money. Conveniently, the Wall Street Journal just this week published an analysis of trading on Polymarket, analyzing one point six million accounts since November of 2022.

So that’s a pretty good data sample. And what it found was that two thirds, 67 percent of the profits go to just point one percent, zero point one percent of the accounts. Right.

So two thirds is being hoovered up by this tiny fraction of market participants. And there’s a separate analysis in Bloomberg which kind of pointed to the same kind of conclusion. Basically, the majority of the profits go to a tiny slice of what appears to be automated, high frequency trading systems of the kind that have long dominated traditional financial markets.

So, you know, most regular people are losers. And I think it’s important to wish more of these young bettors. I wish they knew that.

And the fact is that, you know, it would be far better for them in terms of their long term financial health to put money in the stock market when you invest in stocks. In aggregate, there are real returns for investors because companies grow, the economy grows. You know, people can win over time.

And even if your skills are not the absolute best, just by being in the market, you can, you know, derive a lot of gains which are going to be helpful to your retirement. And Charles Schwab’s CEO put it pretty plainly in a recent Barron’s interview, over any 20 year period, equities have never gone down. If you do a balanced portfolio of stocks and bonds, that’s never lost money over 10 years.

That is investing. So, in contrast, these prediction markets are zero sum. Every dollar one person wins is a dollar that somebody else in the market loses.

So, when you put your money in prediction markets, you’re not getting a piece of national growth. You’re not getting a piece of corporate, you know, progress. So, the chances of coming out ahead are much, much lower.

And then there’s the question of what those losses mean over time. And the math here is brutal, you know, if you take two 25 year olds and they invest, you know, $10,000 and one gets an 8% annual return and just holds those, you know, equities. And then the other one gets 5% because they’re losing money in betting markets.

You know, when they retire at 65, the person with the betting losses has about 68% less at that point of retirement. So, that can make the difference, you know, between a comfortable retirement and a really precarious one. So, the point here is that compounding means that small annual differences explode over decades, losing 3% or 4% a year in betting markets, prediction markets because of fees, bad trading, timing mistakes.

You know, that’s not a small drag, especially if you’re 25 years old and you have 40 years of potential compounding of your investments ahead of you. And once you miss out on the compounding on your early savings, you just never get that back. And it can make a real difference.

So, you know, I should say here that there is a reason for a little bit of optimism about young people’s financial health because young people in the US are actually saving pretty well. 401k participation among under 35s is higher today than it was 20 years ago. But obviously, betting on prediction markets, if that were to keep growing as fast as it has done recently, that happy story about 401k participation could be threatened.

PATTERSON:
Right. No, exactly. I think it’s a question of how quickly and how widespread do these prediction markets and other types of short term betting, how quickly do they grow?

How widespread do they become, especially for that younger demographic? And how much of that longer term investment does it replace? And it’s too early to know, but it’s definitely a risk, a spillover risk that we should watch.

And I don’t think either of us are saying that people should never gamble. It’s a free market and it’s a it’s a form of pleasure for a lot of people. Fine.

But, you know, there should be appropriate guardrails around it and people should know what they can and cannot afford to lose. You know, I worry that what is happening now in a worst case scenario could sow the seeds for a fiscal and social problem down the road. If there are enough people gambling instead of investing 30, 40 years from now, they don’t have enough retirement savings.

Do we have a big enough cohort of people that have to rely on the government to bail them out and the government might not have the means to do so? And I’m obviously biased here. I chair a financial literacy nonprofit called the Council for Economic Education.

But through that role, I see so much data on this. So I feel pretty confident saying that we need more economic and personal finance literacy for these young people before they get addicted to some of these platforms. And I hope the regulators in Congress continue to play a role creating the right safeguards.

Christy talked about that.

MALLABY:
Okay, so that’s a wrap. But we get to this point where we sort of one up each other with displays of, you know, random curiosity. And mine this week is that apparently one of Russia’s most prestigious universities recently launched a master’s degree in sanctions evasion.

PATTERSON:
That’s awesome.

MALLABY:
I got this from a new foreign affairs essay by our great CFR colleague Edward Fishman. The piece in foreign affairs is all about sanctions and the conditions on which they work and they don’t work and about the way that other countries are learning to, you know, evade American sanctions. But the idea that a Russian university actually teaches a master’s degree in sanction evasion, I mean, I just thought that factoid was spectacular.

PATTERSON:
No, that’s absolutely brilliant. I’m going to be using that later this week. It’s a sign of the times.

I have two quick ones this week. One, you know, we’re doing an episode on predictions and gambling. So I feel like I have to talk about the Kentucky Derby that was just raced this past weekend.

And the winning horse, Golden Tempo, serious long shot, 23 to 1 odds. But the best part about it to me was that the trainer was the first woman to ever win the Derby. So feel good story all around for those horse gamblers.

But my second fun one this week, which is a little more out there is Japanese toilets and AI. There’s a connection, Sebastian. So normally you think about the famous Toto toilets as the fancy Japanese toilets that have all the buttons on them and play music and do all sorts of fun things.

But late last week, Toto’s share price surged 20 percent in basically one day because it said it was going to start making more chip components called electrostatic chucks. They basically help hold wafers in place. So I would just say the AI trade is everywhere all the time, including in Japanese toilets.

MALLABY:
Yeah, I think actually when I was a correspondent in Tokyo for three years with The Economist, my most read article may have been the one where I started by saying, if there were not a Japan Toilet Association, it would be necessary to invent one. And I went on and on about Toto. But I’m glad to see that that story could now be rewritten by other correspondents in Tokyo with the AI angle as well.

PATTERSON:
Or it could be written by AI.

MALLABY:
Okay, so that’s a wrap. Thank you to our listeners for tuning in. We’ll see you next week for another episode of The Spillover.

PATTERSON:
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And please be sure to include The Spillover in the subject line. This episode was produced by Molly McAnany, Gabrielle Sierra, and Jeremy Sherlick. Our video editor is Claire Seaton.

Our audio producer is Markus Zakaria. And research for this episode was provided by Liza Jacob. You can subscribe to The Spillover on Apple Podcasts, Spotify, YouTube, or wherever you listen to podcasts.

This transcript was generated using AI and may contain errors or inaccuracies.