Risk Managing Prediction Markets
Financial professionals are always on the hunt to quantify binary events. To this point, prediction markets, which give a tradeable (albeit thinly liquid) estimation for the likelihood of a binary event resolving in one way or another, are used as calibration tools for models or as sense checks for assumptions.
The issue then becomes: how does one crystallize this probability into a trade? Essentially, when a trade is put on in traditional markets surrounding an event catalyst, the trader assumes the basis risk between event and observed outcome. There have been plenty of examples of events playing out in one way and the market having an unexpected response to this new information. As an example, the market reaction after a hot CPI print count be either risk-on or risk-off given market backdrop. However, a business exposed to inflation only cares about the number. This makes a corporate hedging in outcome space (the market’s reaction to the number) trickier and less applicable to its business function than hedging in event space (the number itself).
The core concept of Galaxy's entry into this market is to be a principal counterparty that is capable of managing these complicated risks so that eligible, institutional, end users are free to make business decisions or speculate on the actual event itself, rather than being concerned with the market outcome. Importantly, while event contracts may reduce certain forms of basis risk, they do not eliminate risk entirely, and participants may continue to face other market, liquidity, operational, or idiosyncratic risks.
In addition, due to our fluency with volatility products, we have additional risk management frameworks that we can deploy in order to create and then manage these hedges.
The cleanest TradFi equivalent for what we are doing is an exotic derivatives desk. Counterparties transact in exotics products to have a very specific exposure to an asset. It is the desk's job to come up with an appropriate hedge to manage these risks, and understand the risks left unhedged. This construct is almost identical in prediction markets.
There is an interesting externality that results from our participation in prediction markets. Because we face eligible, institutional counterparties in prediction markets while hedging risk across traditional financial and crypto markets, we help transmit information between these ecosystems. As prediction market prices adjust to new information, that information can increasingly be reflected in broader financial markets through our hedging activity. Over time, this creates stronger linkages between prediction markets, crypto, and traditional finance, which may help align pricing and improve market efficiency across all three.
Key Takeaways:
Prediction markets provide probabilities, but turning those probabilities into investable trades introduces basis risk.
Galaxy acts as a principal counterparty, allowing eligible, institutional counterparties to gain exposure to event outcomes while Galaxy manages the resulting market risk.
By hedging prediction market exposure in crypto and traditional markets, Galaxy can help connect pricing and information across all three ecosystems.
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