Original author: michaellwy
Original translation: TechFlow
The potential of prediction markets has been widely recognized, but some key issues remain unresolved. This article will reveal the challenges currently facing prediction markets by analyzing recent disputes, especially the difficulties in dispute resolution. For developers, this is a huge opportunity: prediction markets are still in the early stages of development, and whoever can solve these core problems is likely to lead the next wave of innovation.
introduction
Prediction markets are a tool that uses financial incentives to gather information. By allowing traders to bet their own judgments with funds, prediction markets can drive prices closer to the probability that reflects collective wisdom. When this mechanism works properly, prediction markets often produce more accurate predictions than traditional methods.
The advantages of prediction markets were fully demonstrated in the predictions for the 2024 U.S. presidential election. Among them, the Polymarket platform proved to be more reliable than traditional polls, ultimately successfully predicting Trump's victory.
With Polymarket's credibility continuously increasing, mainstream media has also begun to accept it as a data source. Media outlets that have long been skeptical of crypto projects, such as Bloomberg, not only cite its odds in their reports but also show its predictive data in search engine Perplexity results. Traditional media is increasingly referencing its predictive results.
Ethereum founder Vitalik has also shown support for prediction markets, stating: 'Prediction markets and community annotations are becoming two major social cognition technologies of the 2020s.'
However, despite the tremendous potential demonstrated by prediction markets, their decentralized 'truth verification' mechanisms still face many challenges. Recently, the controversial market on Polymarket regarding 'Will the U.S. government shut down?' exposed critical flaws in system design, providing important insights for decentralized dispute resolution.
This article will analyze this controversy in detail, exploring design flaws in prediction markets' dispute resolution mechanisms and proposing improvements.
How does Polymarket operate?
Polymarket operates similarly to traditional exchanges, but users do not trade assets; they trade probabilities. For example, in the market 'Will Bitcoin reach $100,000 in 2024?', traders can buy or sell positions between 0% and 100% through the system.
Assuming you believe Bitcoin will reach $100,000 in 2024 and purchase $100 worth of 'Yes' tokens at $0.47 each. If your prediction is correct, you will receive $212 (calculated as $100/$0.47), which is the reciprocal of your purchase price. This dynamic trading mechanism allows market participants to adjust their positions at any time based on the latest information, providing real-time collective predictive insights.
Polymarket's trading mechanism is based on a Conditional Token Framework. Here is a specific case:
Assuming the total funds in the Bitcoin prediction market are $1,000:
Alice believes Bitcoin will reach $100,000 and purchases $200 worth of 'Yes' tokens at $0.20 each;
Bob believes it will not reach that amount and purchases $800 worth of 'No' tokens at $0.80 each;
The system matches these two orders, as they total $1,000 (i.e., 100%);
The system receives 1,000 USDC and creates 1,000 pairs of 'Yes/No' tokens:
Alice receives 1,000 'Yes' tokens (each at $0.20);
Bob receives 1,000 'No' tokens (each at $0.80).
By the end of 2024, the winner can exchange each token for $1:
If Bitcoin reaches $100,000, Alice's $200 will turn into $1,000 (5x return), while Bob's tokens will lose value;
If it does not reach that amount, the situation reverses, with Bob profiting and Alice's tokens going to zero.
On the Polymarket platform, all trades are automatically completed through the Polygon network, and the market's outcome is determined by social consensus. If there is a dispute over the market result, the UMA protocol (a system based on optimistic oracles) will intervene to help verify and ultimately adjudicate the market result.
The operational mechanism of the UMA protocol is as follows:
When there is a dispute over market results, any user can trigger voting;
UMA token holders will vote on the outcome;
Voting weight is proportional to the number of UMA tokens held;
The winners of the vote will receive rewards, while the losers will be penalized.
The original image is from michaellwy, compiled by Deep Tide TechFlow.
A detailed explanation of this mechanism can be found in the official video from UMA. Additionally, reports from ASXN and Shoal Research provide a more comprehensive analysis of how UMA works.
Controversy over the U.S. government shutdown case
Prediction markets have demonstrated strong capabilities in predicting event outcomes, with their success in the 2024 U.S. elections further enhancing their credibility.
However, what happens when the prediction market system encounters problems? The recent market controversy around whether the U.S. government will shut down has revealed some key flaws in current prediction market design.
Polymarket created a market to predict whether the U.S. government would shut down between August 30 and December 31, 2024. Initially, the design of this market seemed quite simple. However, despite President Biden signing a funding bill (H.R. 10545 - the U.S. Relief Act) that successfully avoided a government shutdown, and major media outlets confirming unanimously that there was no interruption of federal government operations regardless of political stance, the market still showed a 99% likelihood of a shutdown as the trading deadline approached, ultimately adjudicating the result as 'Yes.'
The controversy over this outcome primarily stems from Polymarket's modification of rules during the market's operation. Specifically, the platform added a new 'rule clarification' after a significant number of trades had already occurred, introducing a deadline that did not originally exist—midnight on December 20, 2024. This change directly led to a disconnection between market outcomes and real circumstances.
What should have been a simple binary prediction market has evolved into a debate about prediction market manipulation and design flaws due to temporary adjustments in the rules.
Event timeline
December 20, 6 PM (EST): The probability of the 'Yes' option (i.e., predicting a government shutdown) was 20%, having dropped from 70% to this level. This change occurred because traders widely anticipated the Senate would pass the H.R. 10545 bill to avoid a shutdown.
Polymarket's official tweet: The probability of a government shutdown has dropped to just 20%. The funding bill is about to pass.
Later that day: Polymarket added a banner to the market user interface stating that if Biden failed to sign the bill before midnight, the market would interpret it as 'Yes.' Subsequently, the probability of the 'Yes' option skyrocketed to 98% as traders bet on the Senate's inability to pass the bill in time for Biden's signature.
- If President Biden fails to sign the funding bill before midnight, this market will interpret it as 'Yes.'
Market comment area reaction: The comment area erupted into fierce debate. Holders of the 'No' option were confused by the sudden surge in probability and pointed out that all news sources reported that the Senate was about to pass the bill to avoid a government shutdown.
December 21, 00:38: The Senate successfully passed the funding bill.
December 21 morning: Biden officially signed the bill into law, with major media outlets unanimously reporting that the government shutdown had been successfully avoided.
CNN reported:
The Senate is close to passing the funding bill, and the OMB will not shut down the federal government.
According to reports from the White House, the Office of Management and Budget (OMB) will not shut down the federal government because the Senate is close to passing the funding bill.
The White House stated in a release: 'Due to the confidence that the bill will soon pass and that the president will sign it on Saturday, the OMB has halted preparations for a shutdown.'
'Since the obligation for federal funding is generated and tracked daily, agencies will not shut down and can continue to operate normally.'
Why did the market interpret it as 'Yes,' when in reality there was no government shutdown?
Despite the government not actually shutting down, the market ultimately interpreted it as 'Yes.' To understand this outcome, we need to carefully analyze the market's original rules.
Content in the image:
If the U.S. government shuts down between August 30 and December 31, 2024, at 11:59 PM (Eastern Time), this market's outcome will be determined as 'Yes.' Otherwise, it will be determined as 'No.'
If the acting president fails to sign the relevant funding extension bill before the applicable deadline, even without a clear announcement of a government shutdown, the market's outcome will still be adjudicated as 'Yes.'
Regardless of any form of shutdown, this market will be adjudicated as 'Yes.' For example, if only some U.S. government departments are supported by an extended funding bill while others fail to secure funding, this market will still adjudicate as 'Yes.'
The primary basis for this market's determinations will be official information from the U.S. government, but credible media reports may also be referenced when necessary.
Source
Market rules analysis:
Point 1 – This is relatively simple, observing whether a government shutdown occurs within a specified period (noting that the end date of this period is December 31, 2024).
Point 2 – This is at the heart of the controversy. Proponents of 'Yes' believe that according to market rules, the president must sign the relevant bill before the applicable deadline. They argue that midnight on December 20 is the applicable deadline and since it was not signed before then, the market outcome should be adjudicated as 'Yes' (we will discuss this further later).
Point 3 – This involves cases where some government departments shut down but is not closely related to the current issue, so it will not be explored in depth here.
Point 4 – The primary basis for determining market results will be official information released by the U.S. government, while consensus from credible media reports may also be referenced.
'Yes' camp's viewpoint:
Polymarket added a banner explicitly stating that midnight on December 20 is the deadline.
The platform released 'Additional Background Information' on December 21 that further supports this rule.
Additional background
According to the rules, 'If the acting president fails to sign the relevant funding extension bill before the applicable deadline (midnight on December 20, Eastern Time), even without a clear announcement of government shutdown, the market will interpret it as 'Yes.'
President Biden failed to sign the funding extension bill before midnight on December 20, so the market should interpret it as 'Yes.'
Due to Biden's failure to sign the bill before midnight, the market should automatically interpret it as 'Yes' according to the rules.
They believe the rules are binding, even though a government shutdown did not actually occur.
'No' camp's viewpoint:
Timing issues:
The original scope of the market rules was from August 2024 to December 31. The 'Yes' camp emphasizes that the midnight deadline on December 20 was not explicitly stated in the rules, only mentioning 'applicable deadlines.'
Federal funding operates on a daily basis, so the actual deadline should be 11:59 PM on December 21.
The banner declaring the 'midnight deadline' remained visible on December 21, which is illogical since the interpretation standard had expired.
Actual situation:
A senior White House deputy press secretary had confirmed: 'Due to confidence that the bill will soon pass, the OMB (Office of Management and Budget) has halted shutdown preparations.'
According to conventional logic, missing the deadline should lead to a shutdown. However, since no shutdown occurred, it indicates that no critical deadline was missed.
Finally, a separate Polymarket question about 'Will the House and Senate pass the funding bill before midnight?' correctly adjudicated as 'No.' The key point here is that missing a procedural deadline does not equate to a government shutdown, conflating the process with the outcome. This is also why there are two separate pages, as the spirit of the markets is different.
The core tension here is not just about interpreting issues but about whether prediction markets should prioritize the interpretation of technical rules over the real-world outcomes they are supposed to predict. When the market adjudicates a government closure that objectively never happened as 'Yes,' the mechanisms seeking truth are malfunctioning.
Similar disputes are not uncommon.
Some might argue that this is just an isolated incident caused by poorly written rules. However, similar disputes are not uncommon. A watchdog site named Polymarketfraud (forgive the provocative name) tracks numerous cases where market adjudications contradict real circumstances.
The Venezuelan presidential election winner market is particularly interesting. The current president of Venezuela is Nicolas Maduro, but the market adjudicated that opposition candidate Edmundo Gonzalez won in the recent election.
Frank Muci delves deeper into this topic in his article. Here is a brief summary.
The market rules clearly state: 'The primary basis for resolving disputes is official information from Venezuela, but if credible media reports reach a consensus, they can also be referenced.'
Official election results show that Maduro won:
First announcement: 51.20000% to 42.20000%
Second announcement: 51.9500% to 43.1800% (This precision to several decimal places, especially with multiple zeros, raises doubts about its authenticity and may indicate data fabrication).
However, based on the data statistics from the polling stations, the opposition's vote rate showed they were leading by more than 20%.
UMA token holders (who have final adjudication power in disputes) were strongly lobbied to ignore official information sources from Venezuela and instead adopt credible media reports about electoral fraud.
In the end, UMA holders voted to overturn the primary resolution basis stated in the Polymarket rules, declaring Gonzalez the winner—despite Maduro continuing to hold power.
The contradictions in this decision-making process expose the problem. In the case of the U.S. government shutdown, UMA voters strictly adhered to a technical rule (regarding a late-added clause about the midnight deadline), ignoring the fact that the media unanimously reported that 'the government shutdown did not occur.' However, in the Venezuelan election incident, they took the completely opposite approach, overturning the primary information source and supporting the media consensus reports about electoral fraud.
Fraudulent Markets
(Source)
This list is still expanding, with research into other markets ongoing. It can be reasonably speculated that in all the aforementioned markets, countless (new) users have lost substantial amounts of money, while some top users have gained considerable profits on their costs. Although there is currently no conclusive evidence, there are reasons to suspect that these accounts may have engaged in coordinated behavior and/or possessed insider information during the UMA voting process and/or Polymarket clarifications.
Additionally, it can be further pointed out that the rules regarding 'Will the U.S. government shut down?' are suspected of being deliberately misleading and do not clearly specify which deadlines are valid for market resolutions. However, all signs indicate that the market should resolve to 'Yes' (YES) as a government shutdown event did occur before 2025.
Polymarket should consider refunding users affected by these fraudulent markets, and/or adopting a 50/50 solution where applicable. If no action is taken, this controversial market trend will persist, benefiting a small number of large users while causing significant losses for many new users. This may be something that the CFTC (Commodity Futures Trading Commission) and/or the FBI (Federal Bureau of Investigation) should promptly focus on and investigate.
Another case involves the Israel-Hezbollah ceasefire market. Despite credible reports indicating that military actions were still ongoing, the market still adjudicated the outcome as 'Yes.' A YouTube video titled 'Game Prediction Market: Lessons from a $40 Million Event' detailed this incident.
Additionally, Lou Kerner proposed an interesting theory in his article that explores potential issues in the U.S. election market. Although he refers to it as a 'conspiracy theory,' his analysis suggests that Polymarket's presidential election market may have a structural bias in favor of Trump.
The scenario he envisions is as follows: If Trump loses, he might refuse to concede, claiming voter fraud and challenging the election results, just as he did in 2020. Therefore, even if Kamala Harris actually wins the election, the market may not adjudicate the outcome in her favor.
This situation creates a 'win for me if I win, no loss for me if I don't' scenario for Trump's supporters. If Trump wins, bettors will profit directly; if he loses but disputes the results, the market resolution could be delayed or altered due to voting by UMA token holders.
Issues that arose
First, there is the issue of rule manipulation. When the platform can add clarifications at will, the role of the oracle becomes virtually meaningless. In the government shutdown case, the posting of a new banner led to a rapid surge in market odds to 'Yes,' changing the originally effective deadline from December 31 to December 20, 2024.
This also raises other questions regarding the resolution standards. When rules conflict, which rule should take precedence? Although the primary resolution standard clearly states the news sources and credible reports and sets the deadline for December 31, the market ultimately made a resolution based on the later added clarification of midnight on December 20. This inconsistency in rule prioritization severely undermines the market's credibility.
Another structural challenge lies in the relationship between UMA holders and the Polymarket resolution system. Since UMA token holders can participate in both trading and voting, this creates a strong conflict of interest between large traders and oracle voters.
While Polymarket and UMA should function as independent systems to check and balance each other, in reality, UMA is the only oracle provider for Polymarket. This reminds me of a scene in the movie 'The Big Short,' where a ratings agency employee admits they must give a AAA rating, or the bank will shift to a competitor. When the success of a system relies on pleasing powerful participants, independence becomes impossible.
Dispute resolution: The fatal weakness of prediction markets
The core value of prediction markets lies in their ability to accurately adjudicate facts. Even with the most sophisticated user interfaces (UI), complex trading systems, and ample liquidity, if it cannot reliably determine who wins the bet, all of this becomes meaningless. Polymarket currently relies on UMA's oracle system to resolve disputes, but there may be potential vulnerabilities in its operational mechanism.
Overview of the basic mechanism of UMA:
When there is a dispute over market results, any user can trigger the voting procedure.
UMA token holders vote on the outcome according to the rules.
The size of the voting rights depends on the number of UMA tokens held by the user.
Voting winners can receive rewards, while losers will be penalized.
In a blog post on Dirt Roads, Luca Prosperi proposed a concept called 'Corruption Value Multiple (CVM)' to measure the potential risks in Polymarket's oracle issues. Here is his analysis:
Currently, the total value of outstanding bets on Polymarket is approximately $300 million, while UMA's total market capitalization is only $220 million.
Controlling half of the UMA tokens would require about $110 million.
This means that every dollar spent to control UMA could potentially influence bets worth $1.36.
However, the actual risks may be higher for the following reasons:
The actual voting rate of UMA tokens is usually only 20%, far below 100%.
Market rules are often ambiguous, leaving gray areas for dispute resolution.
Voters may be influenced by public opinion or stakeholders.
The funds required to influence market outcomes may be far lower than the theoretically calculated $110 million.
This means that if traders believe they can influence the outcome by manipulating the oracle's adjudication, they may artificially drive the market price far beyond the real probability.
These issues reflect the complexity inherent in the design of prediction markets. Although there is currently no 'one-size-fits-all solution,' improving dispute resolution mechanisms is undoubtedly one of the most important challenges faced by prediction markets. If the market's adjudicated results are inconsistent, users' trust in the system will gradually erode, ultimately causing the market to deviate from its original purpose.
Improvement directions: How to optimize dispute resolution mechanisms?
Fixed market rules that prohibit retroactive modifications. Once a market is launched, its rules should be locked and not subject to change. No form of 'supplementary explanation' or 'post-hoc clarification' should be allowed after the market terms are created. The original rules should serve as the only reference point. When disputes arise, the oracle should strictly adjudicate according to these foundational rules, without interference from content added by the platform.
Establishing rule priorities and on-chain records. Market rules need a clear hierarchy of priorities. For example, when conflicts arise between rules, which ones have higher authority? Primary interpretation standards (such as credible media reports) should clearly take precedence over secondary mechanisms. This hierarchy of rules should be recorded on the blockchain at the time of market creation, forming an immutable chain of evidence to ensure transparency and authority.
Reputation-based verification mechanism. In addition to the existing token voting, the market could introduce a reputation-based council system. This system would consist of respected industry experts who would vouch for their own professional reputation to participate in adjudicating market results. This mechanism not only introduces higher professionalism but also increases the sense of social responsibility in the verification process.
Inter-subject fork mechanism. An inter-subject fork is a mechanism inspired by Eigenlayer innovations, specifically designed to address clear errors identifiable by human consensus. When significant disputes arise in the market, the community can split the tokens used for adjudication (whether oracle tokens or protocol tokens) into two versions, each supporting different interpretations of the outcome. Subsequently, the market's selection mechanism will determine which version of the tokens retains value. The side supporting the erroneous interpretation will face a natural economic penalty as their token value declines, effectively curbing manipulation.
AI agents as independent arbitrators. To avoid manipulation that may arise from economic incentives for token holders, we could develop a dedicated AI agent whose sole purpose is to adjudicate market outcomes. Unlike humans who might vote based on their positions, AI agents can be designed to be completely neutral, focusing on fairly analyzing evidence to provide more accurate market adjudications. This approach can significantly enhance the market's credibility and decision-making efficiency while reducing the potential for human interference.
Conclusion
It should be noted that this article is not specifically critiquing Polymarket. However, as the largest (and frankly, the only truly influential) participant in the current cryptocurrency prediction market, it serves as the best case study for understanding the challenges faced by the entire industry.
Why are these issues so important? If we view prediction markets merely as speculative platforms where traders bet on outcomes, then the impact of their flaws is relatively limited. Indeed, some may incur losses, but ultimately, this is just another betting venue.
However, prediction markets are being given a higher profile, being seen as 'truth engines'—objective tools capable of filtering out noise and bias to reveal the true probabilities of future events.
This is precisely why the government shutdown case has attracted attention. When the market confidently predicted and validated a government shutdown event that never actually occurred, it revealed how these so-called 'truth engines' can create a false reality that contradicts the facts. The issue is not just the economic losses for some traders; the greater danger is that these 'objective verification systems' we are building could be exploited by those with capital and motives to manipulate public perception.
As the influence of prediction markets grows, their structural weaknesses become issues that everyone must face. If we cannot resolve these fundamental vulnerabilities, we risk transforming prediction markets into powerful tools for distorting truth rather than discovering it.