In their paper, A Manipulator Can Aid Prediction Market Accuracy, Robin Hanson and Ryan Oprea use a theoretical model to show that a market can become more accurate when manipulators are present, by increasing the returns to informed trading, which provides incentives for traders to become informed. However, given the number of assumptions made in the model, the authors caution that the “findings may not be robust” and that “since this is not a fully general model, it cannot by itself support strong general claims about the price effects of manipulation.” So far, so good, we are in complete agreement, at least for some markets!
There are quite a few assumptions in the model, including: “risk-neutrality, normally distributed values and signal errors, interior choices of information quantity, no transaction costs of trading, no budget constraints, and a single rational manipulator with quadratic manipulation preferences and a commonly known strength of desire to manipulate.” The authors do examine the potential effects on their conclusions, if some of the assumptions don’t hold true in practice. Let’s look at some of them.
A Manipulative Conspiracy
For example, if there were a conspiracy among most (maybe “many” would be enough?) traders to pursue a common manipulation objective, the supremacy of the informed over the manipulative traders could be upset. This isn’t as far-fetched as it may sound. Large, politically affiliated groups, unions, and industry association groups of members could be inspired to conspire either directly or indirectly (propaganda).
Uninformed by Choice or Constraint
The authors assume that providing an inducement for traders to become better informed, they will actually become better informed.
What if it is not possible for traders to become sufficiently “informed”? This could be the result of the issue being too complex or uncertain, or it could be that the cost of becoming sufficiently informed outweighs the benefits of using that information.
For example, is it even possible for the average bettor to “read up” on climate change research to the extent necessary to determine that the market has been manipulated or that the market reflects too much uninformed, noise trading? I highly doubt it.
It could very well be that some issues (like this one) are so complex and so uncertain as to be unpredictable, until very soon before the market closes. It is only the march of time that whittles away the uncertainty.
The authors state that “when potentially informed traders have deep pockets relative to the volume of noise trading, increases in trading noise do not directly effect price accuracy.” This assumes that traders can be “informed” and have a sufficient volume relative to noise trade volume (including that of manipulators). I would argue that a market (such as a climate change PM) does not meet this condition.
Creating a Prediction out of Nothing
The authors state that “historical, field, and laboratory data, however, have usually failed to find substantial effects of such manipulation on average price accuracy.” Though this may be true, what happens in a market that has no clear average price (i.e. has a flat distribution)? Couldn’t a manipulator create a misleadingly “accurate” market price? The existence of a flat distribution (before manipulation) indicates the market does not have sufficient information to make a prediction. The traders are uninformed. Such a market would be ripe for a manipulation, and the market would not have enough informed traders to know what was happening or to do anything about it.
On balance, I think the authors realize that there is a potential for markets to eliminate the effects of manipulation in some markets, if the necessary conditions and assumptions hold true. In highly complex, uncertain situations, some of the key assumptions are unlikely to be met, calling into question the conclusion of the paper. This is what I was trying to get across in my previous post. Perhaps the single most important condition or assumption in their model is that the informed traders have relatively more trading volume than the noise traders (manipulators). I explained why I didn’t think this would hold true for all markets. In the authors’ paper discussed here, they simply state this condition as a fact. They did warn us, however, that the findings may not be robust or generally applicable to all markets.
One down, three more to go (papers that is).