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Reader Nicholas Edmunds copied me on this open letter he's sending out to various academics in the Prediction Markets world. For background on the issues he raises, see my posting here of my latest SmartMoney.com column. Dear Friend of Prediction Markets,

Given your interest in Prediction Markets I trust that this market integrity problem at Tradesports.com merits your attention. Tradesports expired its North Korean test missile contract at 0 last week in the face of logic, the facts of the case, and its own contract rules. The case is very dense and I will offer a brief summary to clarify the facts and dispel the fallacy that Tradesports was bound by its contract rules to expire at 0. More information can be found at Chris Masse's web site and in this article by economist Donald Luskin.

Tradesports offered a contract concerning the possibility of North Korean missile launches by July 31. The contract was to expire at 100 if at least one missile was launched beyond North Korea's air space, or at 0 if there was no launch, or if all launches were confined to North Korea's air space. You may notice that this dichotomy leaves out the possibility that missiles were launched but could not be confirmed to have landed within or beyond North Korea's airspace; more on that below.

The contract rules stipulated that the confirmation source would be the Department of Defense. Tradesports management later stated that confirmation from the White House would also be accepted. There is no reasonable doubt that North Korea launched at least one missile into international waters, and that the US Government has confirmed this fact.

On July 4 North Korea launched seven missiles and the DOD published two press releases confirming that the missiles fell in the Sea of Japan. Tradesports was skeptical about these statements and asserted that they were not specific enough to confirm that any missile had yet left North Korea's airspace. (The press releases can be found here and here.)

National Security Advisor Stephen Hadley and Press Secretary Tony Snow held a press briefing from the White House on July 4 as news of the launches broke. Mr. Hadley commented on each launch, saying of some of the missiles ""these went out about 275 miles." Mr. Snow said the missiles fell "short of Japan" and mentioned one or more missiles falling in the "[Economic] Exclusion Zone" (by definition an area outside any country's territorial waters). The DOD, asked about these quotations via its Public Inquiry site responded, "We will let the White House comments speak for us." (The White House briefing can be found here.)

UN Ambassador John Bolton, speaking before the Security Council on July 15, said that the NK missiles fell "into the waters surrounding its neighbors, notably Japan." (Bolton's statement can be found here.) North Korea's territorial waters do not surround its neighbors; they surround North Korea.

Tradesports management professed uncertainty about these statements too, first claiming that Mr. Hadley's "these went out about 275 miles" statement was somehow too vague and later suggesting, even more incredibly, that what Mr. Hadley might have meant was that the missiles had flown along the coastline for 275 miles before suddenly veering into the sea. This is 2+2=5 logic, and based on information in the official record it is both geographically and mathematically impossible. About Mr. Bolton's comments Tradesports said that they failed to confirm a landing area.

The contract rules cite the DOD as the confirmation source, but they do not preclude Tradesports from using other official information sources to understand the DOD and White House comments. For example, Tradesports used the CIA World Factbook to determine that North Korea's airspace includes the 12 nautical miles of its territorial sea. Tradesports might similarly consult a dictionary, or a map, or other reliable sources not as confirmation, but to interpret the DOD and White House's confirmation. The various official statements and reports regarding the missile launches put the DOD and White House statements in an unambiguous context and render the "possibilities" Tradesports imagines ridiculous.

One last piece of evidence: working alone, I was able to get clear, simple, and conclusive email confirmation that the missiles left NK air space from the top DOD spokesman, Bryan Whitman. Rather than authenticate the email responses I received from Mr. Whitman, Tradesports acts as if they don't exist and to this day has not told me if they ever asked Mr. Whitman about the evidence he gave me. For Tradesports to have expired the contract at 0 with this evidence before it was professional malpractice.

This is not a case of Tradesports being caught in a tough situation but faithfully standing by its contract rules. This is a case of Tradesports dismissing or distorting evidence that should have expired the contract at 100 consistent with its contract rules and ignoring the facet of the rules that should have precluded an expiry at 0 absent confirmation that all seven missiles were confined to NK air space. Apparently Tradesports' evidentiary standard for this aspect of the contract rules was considerably more lax.

The confirmation requirements presumably relied on government officials conveying the clear meaning that one or more missiles left North Korean air space, not in uttering some formula of magic words. That meaning was conveyed in multiple forms and is understood by all, yet the management of Tradeports persists in an inexplicable skepticism about what the DOD, NORTHCOMM, the White House, and others REALLY MEANT by what they said in plain English. Indeed, Tradeports wrote that "the specifics of the North Korean Missile Test Contract have created an undesirable scenario in which the Exchange cannot confirm an event which some of our members believe has occurred." Does Tradesports not believe the event occurred? This level of skepticism would make Descartes blush.

In his article Mr. Luskin writes: "Tradesports' handling of the North Korea missile contracts has been a public relations debacle... Once a securities exchange has experienced a misstep this bad, it can be very difficult to build trust with investors....It's especially unfortunate because Tradesports and its competitors are potentially offering a very valuable service to investors."

Already, the well-regarded SportsBookReview.com has downgraded Tradesports to a dismal C+ rating because of this botched contract.

It is not too late for Tradesports to rectify this situation, starting with an acknowledgement of its error. It must do so if it wants to rebuild trust with its customers and restore its reputation in the industry. To not do so in the face of all evidence and logic would be unethical. Tradesports is a working laboratory to test all your theories about Prediction Markets and their potential value, but not if its business practices destroy its credibility and erode its customer base.

I urge you to contact CEO John Delaney (john.delaney@tradesports.com) and ask him to fix this mess before it does further damage to Tradesports' reputation and business. The concept of a Prediction Market can work, but not without honesty, common sense, and a dedication to truthful results within clear contract rules.

I would be happy to answer any questions or provide further information.

Sincerely,

Nicholas Edmunds
Tradesports member

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