Prediction Markets: How They Work and Key Risks

This article is a general overview for educational purposes only and not intended to be legal, tax, or financial advice. Legislation and regulatory guidance surrounding prediction markets is rapidly evolving and is subject to change after the time of publishing. 

What is a prediction market?

A prediction market generally involves contracts connected to the outcome of a future event. Depending on the structure, a contract can provide a defined payment if a specified outcome occurs, while a different outcome can result in a different payment or no payment.

An event contract, sometimes called a prediction contract or forecast contract, can therefore be viewed as an agreement tied to an event rather than ownership of an underlying company or other traditional financial asset. The specific rights and obligations depend on the contract's terms.

Participants can take different positions based on their expectations about the event. Buying and selling activity can influence the market price of a contract.

For a prediction market to function, the underlying event and its possible outcomes generally need to be defined. The contract can also specify:

• The event being measured

• The possible outcomes

• The date or conditions for expiration

• The source used to determine the outcome

• The payment associated with each outcome

• The process used to resolve the contract

Prediction markets are sometimes described as information markets or forecasting markets because prices can aggregate information and expectations from market participants.

How do prediction markets work?

Prediction markets generally revolve around defined events and contracts with predetermined outcomes. The market's structure determines how participants can express different views about those outcomes and how contracts are ultimately settled.

Event contracts and outcomes

An event contract can be structured around a question with a defined outcome. In Canada, the question must relate to a permitted category: an economic release such as a Bank of Canada rate decision or inflation data, an environmental measurement, or certain financial indicators. The contract terms can establish:

• The event being measured

• The possible outcomes

• The contract's expiration or closing conditions

• The source used to determine the outcome

• The applicable settlement terms

Clear definitions can be important because the final outcome needs to be determined according to the contract's rules. An event that appears straightforward in ordinary language can sometimes require more precise definitions when used as the basis for a financial or market contract.

Buyers, sellers, and market prices

Participants can express different expectations through buying and selling activity. When participants hold differing views, transactions can take place at prices agreed upon in the market.

The resulting price can change as new information becomes available, participant expectations shift, or market conditions change. The market price therefore reflects the activity of participants at a particular point in time. It can differ from an individual participant's assessment of the likelihood of an outcome.

How contracts are resolved

Once the relevant event has been determined, the contract can be resolved according to its predefined rules.

The resolution process can depend on an identified data source, official announcement, published statistics such as a Statistics Canada release, or another specified source. The contract terms can determine which information takes precedence if multiple sources report different results.

Resolution criteria can therefore form an important part of an event contract. Ambiguous wording, disputed results, unavailable information, or differences between potential sources can create additional uncertainty.

What types of events can prediction markets cover in Canada?

In Canada, event contracts are limited to three categories based strictly on objectively measurable indicators: economic forecasts, environmental forecasts, and certain financial indicators. Each category carries specific regulatory conditions, and political events, sports, and entertainment outcomes are not permitted.

It is important to note that having an economic, environmental, or financial connection does not automatically make an event contract permissible. To illustrate this distinction:

• Economic Indicators:

  • Permitted: A contract based on the published unemployment rate or central bank interest rate decisions.

  • Prohibited: A contract on whether a specific company or employer will announce employee layoffs.

• Financial Indicators:

  • Permitted: A contract based on the published value of a recognized securities index on a set date.

  • Prohibited: A contract on whether a specific corporation will announce an IPO or acquisition.

• Environmental Indicators:

  • Permitted: A contract based on officially measured atmospheric rainfall or temperature data.

  • Prohibited: A contract on whether a government body will announce a new environmental policy.

Permitted contracts must have a term of 30 days or longer, and leverage and margin are not allowed.

The availability of a particular event contract varies by jurisdiction. An event contract offered in foreign jurisdictions (such as the U.S. or Europe) does not necessarily have the same availability or regulatory treatment for Canadian investors.

The structure can also matter. Two contracts referring to similar subject matter could potentially fall under different regulatory considerations depending on how each contract is created, offered, traded, and settled.

The CSA (opens in a new tab) stated that, in its view, sports and entertainment event contracts should not be regulated under securities and derivatives legislation. CIRO (opens in a new tab) stated that it does not consider it appropriate to facilitate or approve applications by its dealer members to trade these contracts. As a result, these contracts are not available through CIRO-regulated dealers. 

What do prediction market prices mean?

In some prediction market structures, the price of a contract can be interpreted as a market-implied probability of a particular outcome.

Fr example, consider a hypothetical binary event contract that pays $1 if a specified event occurs and $0 if it does not. If the contract trades at $0.60, the price could be described as implying a 60% probability under a structure where the contract price directly corresponds to the probability of receiving the $1 settlement.

Hypothetical trade example

This example is hypothetical, excludes fees and taxes, and is not a recommendation. Actual results will differ. 

• Contract structure: A binary contract with at least a 30-day term to maturity that pays $1.00 if the Bank of Canada cuts interest rates at its next meeting ("YES"), and $0 if it does not ("NO").

• Position: An investor purchases 100 "YES" contracts at a market price of $0.60 each.

• Initial Outlay: 100 contracts × $0.60 = $60.00

• Outcome 1 (Interest rate cut occurs): Each contract settles at $1.00.

  • Payout: 100 contracts × $1.00 = $100.00

  • Net Profit: $100.00 payout – $60.00 cost = $40.00

• Outcome 2 (Interest rate cut does not occur): Each contract settles at $0.00.

  • Payout: $0.00

  • Net Loss: $60.00 (total loss of amount invested)

This interpretation depends on the contract's design and assumptions. A market price does not guarantee that an event will occur, nor does it necessarily represent an objectively correct probability.

Several factors can influence a prediction market price, including:

• The amount of available liquidity

• The number of participants

• The composition of market participants

• New information

• Participant behaviour

• Market design

• Contract terms

• Settlement rules

A market with limited participation, for example, can produce prices that respond differently to new information than a market with more participants and trading volume.

The relationship between price and probability can also differ when a contract has multiple outcomes, variable settlement amounts, fees, or other features. For that reason, a price should be interpreted in the context of the specific contract rather than treated as a universal probability measure.

Prediction markets vs investing, polling, and betting

Prediction markets can share certain characteristics with other financial and forecasting activities, but the underlying structures can differ.

Prediction markets vs traditional investing

Traditional investing generally involves financial assets such as stocks, bonds, exchange-traded funds, or other securities. The value of these assets can relate to businesses, underlying assets, cash flows, interest rates, or broader financial markets.

A prediction contract, by comparison, can have a value tied to the resolution of a specified event. For example, ownership of a company's shares can provide an economic interest in that company, while an event contract can settle according to whether a defined event occurs. The regulatory treatment can also differ depending on the product and jurisdiction.

Prediction markets vs polls and forecasts

Polls, forecasts, and prediction markets can all be used to collect or express views about future events, but they do so in different ways. A poll generally collects responses from a selected group of people. The results can depend on the sample, methodology, questions, and timing. A forecast can use statistical models, expert judgment, datasets, or combinations of these methods. Different forecasting approaches can therefore produce different results, though not all forecasts prove accurate.

A prediction market aggregates views through market activity. Participants can express expectations through the prices at which contracts are bought and sold.

These differences mean that a prediction market price, a poll result, and a professional forecast can represent different types of information. None necessarily provides a guaranteed outcome.

Prediction markets vs betting

Prediction markets and betting, such as traditional sports betting, can both involve contracts or transactions tied to future events. However, their legal and regulatory classifications can depend on the product structure and jurisdiction.

A particular event contract can be subject to securities, derivatives, gaming, or other legal frameworks depending on the circumstances. As a result, the terms should not automatically be treated as interchangeable across different products or jurisdictions.

Risks and limitations of prediction markets 

Prediction markets can involve several types of risk. The nature and degree of risk can depend on the contract, market structure, jurisdiction, and platform.

Market and pricing risk

Prices can fluctuate sharply and unpredictably in response to news, data releases, polling, rumours, or other developments leading up to event’s resolution.  . The final event outcome can differ from the outcome reflected in the prevailing market price. A market price therefore does not provide certainty about the eventual result.

Liquidity and offset risk

Liquidity refers broadly to the availability of buyers and sellers willing to transact. Event contracts may have less liquidity due to insufficient trading volume or inadequate bid depth in the opposing contract.  This can cause the price of the contract to disconnect from what the market is predicting. As a result, it may be more costly to sell/ exit a position or be unable to sell it at all.

Trading halt risk

The exchange, the clearing house, or a regulator may halt trading when deemed to be in the interest of market participants. A trading halt could prevent you from entering or exiting positions.

Source agency risk

Contract valuation and settlement rely on information provided by third-party source agencies, with exchanges determining the outcome of an Event Contract based on such source data. You are exposed to the risk that a source agency suffers a data security breach, provides inaccurate reports, or fails to release data on schedule, any of which could cause settlement delays or market disruptions.

Event and resolution risk

In Canada, CIRO  permits trading only in event contracts that are based on objectively measurable and reliable indicators. Some event contracts, though not permitted in Canada, may settle based on last traded price when the underlying real-world outcome is ambiguous, disputed, or cannot be objectively confirmed by the contract’s stated expiration.  In such cases, the exchange may settle at the last traded price at its own discretion.

The determination of outcome made by the exchange or clearing house is typically final and binding. Errors in external data reporting or processing may lead to irreversible and unfavourable outcomes.

Regulatory change risk

The market for Event Contracts is subject to evolving regulation. CIRO and the CSA have indicated that further guidance and potential additional restrictions may be forthcoming. Future regulatory action, or changes to CIRO’s terms and conditions or to exchange policies, could materially affect the value, availability, or tradability of event contracts.

Prediction market platform risk

 Product availability and platform permissions can vary between jurisdictions and can change over time. A product accessible online does not necessarily have the same regulatory status for users in every country or province. Prediction market platforms may have terms that can also affect how contracts are offered, traded, and settled.

Risk of loss

Depending on the contract structure, an incorrect outcome can result in some or all of the amount committed being lost. The potential payment and loss characteristics depend on the terms of the particular contract. These risks can exist independently of whether a participant's underlying view about an event later proves correct.

Costs and fees 

Fees, spreads and other costs can reduce returns and increase losses.

Tax considerations

The tax treatment of gains and losses can vary. Consult a tax professional.