The key is correlations. The market needs to have a relatively low capital way to signal various correlations between the underlying finite state hypotheses. For example, the Foresight Exchange allows for some modest correlation. After all, if claim A rises, that may indicate to you (based perhaps on your knowledge or on past trading behavior you have observed) that the price of claim B should fall. Currently such trading would accomplished by selling both claim A and claim B or more risky, just by selling one of the two claims.

An additional step would be to differentiate on when the claims are settled as well. Ie, if a model states that event A will produce event B at a later time, then a rise in A would indicate that the trader should bid up B (lagged in time by the appropriate amount).

One problem here is that the more details you add, the less likely it is for the market to remain liquid, ie, to have enough traders in it to generate useful information and to support trading for nonspeculative purposes (like hedging).

Dr. Hanson had an ingenious solution in terms of scoring rules for a polling-like system. The idea is that the market has a certain polling value for a large number of hypotheses. You “correct” these hypotheses by submitting a new set of values for the hypotheses. Each such action incurs a cost. If your correction is substantial, then it has a large cost associated with it.

As I understand it, something along these lines was proposed for the “Policy Analysis Market” which was a DARPA project. Unfortunately, the project was discovered by several uninformed (or perhaps malicious) senators who characterized it as a “terror” market which would trade in contracts about whether terrorist attacks would occur. Apparently, the theory was that terrorists would trade directly in this market so as to profit from their advanced knowledge, and it would hence encourage terrorism.

This was the event that lead to the resignation of John Poindexter and the craven knuckling under of the Department of Defense.

This has turned into yet another mini-rant on the myopic politics surrounding prediction markets and gambling in general. Some day, the US (and collectively the world) will need to mature and face the fact that betting whether legal or illegal is widespread and embrace the power of predictive markets.

Further, the current state of these markets are often reported in the media. I think that points out one of the unintended consequences of the online ban. Namely, that it hinders an important source of information for society.