(Bloomberg) - Prediction markets are booming. Wagers on everything from the return of Jesus Christ to who will win the World Cup have driven weekly volumes on platforms like Polymarket (POLA.PVT)and Kalshi (KLSH.PVT) into the billions of dollars.
Even as some Wall Street players have taken the first steps into this sort of event betting, many big trading firms, including Citadel Securities, IMC Trading and Hudson River Trading have stayed away so far.
There are numerous reasons why institutional traders have not joined in, including the lack of regulatory clarity and the relatively light volumes compared with the other areas where they operate.
But a new academic paper points to another potential reason: Some of the basic tools that sophisticated traders use to manage risk in other markets aren’t available in event-based bets.
At the most basic level, most market makers offset their risk in one type of trading by hedging with other related assets — for options markets, they can do this in the underlying stock market. That is much less easy when the bet is on a celebrity wedding or an election, according to the paper published by Nick Palumbo, a former product manager at the sports betting site DraftKings Inc.
“Unlike options or futures markets, event contracts do not reference an underlying spot asset that permits mechanical hedging,” Palumbo wrote in his paper.
Representatives for Citadel and IMC confirmed that they are not involved in prediction markets, but declined to offer comment on their reasons. HRT did not respond to a request for comment.
The lack of an underlying asset is not a total deal killer. Proprietary trading firms take a variety of approaches to dealing with the directional risks involved in the assets they buy and sell. Many market makers opt to stay as risk neutral as possible, through hedging. Others, like Jane Street, are more willing to take directional risk to make money.
For Palumbo, trying to compare trading on event bets to market making on financial exchanges is the wrong approach. Instead, he thinks credit underwriting and insurance underwriting may offer better comparisons. Those are situations where the capital provider is risking resources either in exchange for an upfront premium, or for the steady drip of a long-term yield.
“They are underwriting outcome risk,” Palumbo said in an interview. “They’re taking a stance, they’re saying, ‘I need to be right on this to make money.’ Whereas a market maker doesn’t care about price direction, just about being able to collect spread.”
Once a loan or insurance contract has been underwritten, there are ways banks and insurers can pass that liability onto others through credit default swaps, structured risk transfers or reinsurance. It will take some time for those products to develop in the nascent prediction market industry, if it happens.
“Because there’s no spot market to hedge, this concept of ‘delta neutral’ doesn’t exist in sports betting,” said Jason Trost, the founder of sports market maker Hanson Applied Sciences, referring to a concept options market makers use to manage the risk a swing in an asset’s value leads to losses.
Trost said that bookmakers address this by creating a large bid-ask spread between where they are selling to customers on both sides of a bet.
The margins in sports bets are huge,” Trost said, adding that while a spread of 200 basis points, or 2%, is “very common,” they can reach as much as 16% in illiquid markets. “That’s unheard of in a lot of traditional finance.”
For Palantir (PLTR)Technologies, for example, the bid-ask spread on calls expiring in May is roughly 1.6%, while the spread for Palantir stock is roughly 0.02%, according to data compiled by Bloomberg.
The comparison between prediction markets and sports betting is very relevant given that sports games have become the most popular category of trading. The exchanges say they are fundamentally different because they do not take the other side of customer trades, but Palumbo and Trost say market makers can essentially take on the role of the bookie.
One of the first Wall Street firms to get involved in prediction markets, Susquehanna International Group, has a history that could be helpful here. It has long had a unit that specializes in sports betting, based in Dublin. Currently, the firm is hiring more sports traders in the Irish capital and at its headquarters in the Philadelphia suburbs, according to job postings on the company’s website.
By Bernard Goyder
With assistance from Emily Nicolle, Katherine Doherty and Cecile Vannucci.
