Prediction markets use the “wisdom of the crowd” philosophy to make decisions on future events or outcomes. The events predicted can be extremely diverse, such as - elections, sales of a company, price fluctuations of commodities, etc. In this article, we will talk about DeFi prediction markets. These are prediction markets that use the advent of decentralized finance to drive the prediction systems.
So, first thing’s first….
DeFi stands for decentralized finance. It’s a movement that aims to utilize protocols like smart contracts to create decentralized versions of traditional financial products and instruments. A DeFi can be anything from a digital asset, decentralized applications (DApps), financial smart contracts, and protocols that run on top of public blockchains. Some features of these DeFi applications are as follows:
Prediction markets are collections of people that are speculating on the outcome of an event. To better illustrate how this works, let’s take a slight detour.
At its very core, what is a market? It is a group of people buying and selling things. Pretty straightforward, right? Similarly, a prediction market is a marketplace where you can buy and sell predictions. Or, to put it more accurately, shares in the outcome of an event. The Iowa Electronic Markets (IEM) is the most well-known prediction market in the world.
Speaking of prediction market shares, let’s take a quick look at how it works.
There are two types of shares in a prediction market - “YES”, or long shares and “NO”, or short shares.
The payout given is dependent solely on how much the buyers are willing to buy and how much the sellers are willing to accept.
You can think of prediction markets as event derivatives. The value of these derivatives is directly proportional to the probability of a particular outcome.
To gain a better understanding of how this works, consider the following example.
Imagine a simple dice. Upon a roll, it can show one of 6 results. Suppose the bet is that the dice will display one of three outcomes - 1,2, or 3. So in a prediction market, The weight of “Yes” shares will be equal to the weight of “No” shares. So, if the payout for a correct prediction is one dollar, both the buyers and sellers agree to pay 50 cents each.
However, what if we have a four-sided dice instead of a six-sided one? Now the chance of getting a roll that’s 1,2,3, or 4 suddenly jumps from 50% to 75%. This means buyers will now have to pay 75 cents for Yes and 25 cents for No.
Wisdom of crowds is the idea that large groups of people can collectively make smarter decisions than individuals. This is the core concept behind decentralized finance prediction markets. Wisdom of the crowd was first observed by the great philosopher Aristotle. As per his observations, a potluck dinner, wherein people collectively bring food, results in a much more satisfying meal than a feast produced by just one person. The theory gained further prominence in James Surowiecki’s 2004 book, “The Wisdom of Crowds.”
For this theory to work correctly, the following conditions are necessary:
So, now that we know the theory, let’s look at some practical examples now, shall we? In fact, let’s look at three examples of the wisdom of crowds:
Before we get into the DeFi price predictions markets, let’s understand why we needed them in the first place. What are the problems with centralized prediction markets?
The core component of decentralized finance is the lack of centralized ownership. This gives it several advantages over their centralized counterparts.
The core innovation crucial for the creation of DeFi prediction markets is smart contracts. A smart contract is an automated agreement between two parties. These smart contracts are a bunch of instructions that execute using the IF-THEN-ELSE logic. In other words, instructions can only be executed after the completion of the previous ones. This ensures that two people can enter a binding agreement that’s governed by code, instead of a third-party, like a lawyer.
Predictions Markets are becoming a central part of Decentralized Finance (DeFi)
However, smart contracts themselves aren’t enough to properly execute these prediction markets. Another vital piece of this puzzle is oracles. Decentralized prediction markets like Augur and Gnosis have smart contracts that decide how much the participants get paid if a particular event occurs. However, how do they know that the event has indeed occurred, or not? For this, we require oracles.
An oracle is a third-party service that provides smart contracts. DeFi prediction markets capture knowledge about a particular event via multiple oracles. Think of them as a bridge between the fiat world and the decentralized world. The relationship between the smart contract and oracles works like this:
Alright, now let’s bring everything together and see how smart contracts and oracles work together to create a prediction market.
Augur is a DeFi price prediction market based on Ethereum. Augur traders use ETH to buy and sell shares in the different prediction markets. As per DeFi Pulse, Augur has over $620k in USD.
Augur accommodates for markets of various complexity. The simplest market is a simple YES/NO. These markets give the following results:
Augur has a native ERC20 token called “REP.” While users use ETH to trade (as explained above), they will require REP to create markets. It allows them to:
Augur's actions that positively impact the ecosystem, such as making correct predictions, creating markets, and honestly reporting on off-chain events, are incentivized. This makes sure that the interests of the market actors and the market itself are aligned.
Speaking of creating markets. How exactly do you do it?
Augur has made this a pretty, simple, step-by-step process. Let’s take a look:
Augur is a set of open and public smart contracts that run on top of the Ethereum chain. They are not a prediction market in themselves. Instead, they are just a protocol that users can use to create their own markets. In other words, the users are responsible for the creation and maintenance of these markets.
Augur V2 was released on July 28, 2020. Its main aim is to address several issues like UX, onboarding, market-making, etc. Some of the features that Augur V2 will be bringing in are:
Augur V2 improves overall user-experience by leaps and bounds.
Gnosis is another Ethereum-based, open-source protocol for the DeFi predictions market. The core ideas behind Gnosis is as follows:
Gnosis attempts to achieve its vision via the use of the following platforms:
So, how does Gnosis tie all these together?
For that, we need to look at these three layers.
Gnosis has two tokens in its ecosystem – GNO and OWL. Let’s take a closer look at how these two tokens interact with each other.
So, there you have it. The truly wonderful thing about DeFi is that it allows for more innovative and decentralized versions of legacy financial structures - like prediction markets. Decentralized finance prediction markets can circumnavigate the shortcomings of centralized markets and allow for more participation and higher liquidity. While Augur and Gnosis are definitely the market leaders, there are several other interesting DeFi predictions protocols like Helen and Omen.
We hope that you learned a lot about DeFi price prediction markets from this article. Having said that, do keep in mind that prediction markets are just one aspect of the DeFi-verse. It has a lot more to offer, such as lending, derivatives, decentralized exchanges, etc. There is a reason why DeFi currently has so much hype in the market. It is revolutionary in every sense of the word.
Speaking of which, do you want to learn more about DeFi, besides DeFi prediction markets? If yes, then check out our blockchain courses at Ivan on Tech Academy. We have some of the industry's best experts on the subject, giving you hours of valuable content on DeFi. Come join our academy and open yourself to the world of blockchain and decentralization.
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