The Trust Crisis of Prediction Markets: When the "Truth Engine" Starts to Lie, How to Build a More Reliable Prediction System?

Author: michaellwy

Compiled by: Shenchao TechFlow

The potential of prediction markets has been widely recognized, but some key issues remain unresolved. This article will reveal the challenges currently faced by prediction markets by analyzing recent controversial events, particularly the dilemmas in dispute resolution. For developers, this presents a huge opportunity: prediction markets are still in their early stages of development, and whoever can solve these core issues may lead the next wave of innovation.

Introduction

Prediction markets are tools that aggregate information using financial incentive mechanisms. By allowing traders to bet their judgments with money, prediction markets can drive prices to gradually reflect the probabilities that embody collective wisdom. When this mechanism operates normally, prediction markets often yield 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, successfully predicting Trump's victory.

As Polymarket continues to gain credibility, mainstream media has begun to accept it as a data source. Media outlets that have long been skeptical of crypto projects, such as Bloomberg, not only cited its odds in their reports but also included its prediction data in search engine results like Perplexity, with traditional media increasingly referencing its predictions.

Ethereum founder Vitalik has also expressed support for prediction markets, stating that he believes: "Prediction markets and community annotations are becoming two important social cognition technologies of the 2020s."

However, despite the enormous potential of prediction markets, their decentralized "truth verification" mechanism still faces many challenges. Recently, the controversial market on Polymarket regarding "Will the U.S. government shut down?" exposed critical flaws in the system's design, providing important insights for decentralized dispute resolution.

This article will analyze this controversy in detail, exploring the design flaws in prediction markets' dispute resolution mechanisms and proposing improvements.

How Does Polymarket Work?

Polymarket operates similarly to traditional exchanges, but users are not trading assets; they are trading 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.

Suppose you believe Bitcoin will reach $100,000 in 2024 and purchase $100 worth of "yes" tokens at $0.47. If the 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 based on the latest information, providing real-time collective predictive insights.

Polymarket's trading mechanism is based on the Conditional Token Framework. Here is a specific case:

• Assume the total funds in the Bitcoin prediction market are $1,000:

• Alice believes Bitcoin will reach $100,000 and buys $200 worth of "yes" tokens at $0.20;

• Bob believes it will not reach that price and buys $800 worth of "no" tokens at $0.80;

• The system matches these two orders since 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 (at $0.20 each);

• Bob receives 1,000 "no" tokens (at $0.80 each).

• By the end of 2024, the winner can redeem 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 price, the situation reverses, and Bob profits while Alice's tokens become worthless.

On the Polymarket platform, all transactions 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 outcome, the UMA protocol (a system based on optimistic oracles) intervenes to help verify and ultimately adjudicate the market result.

The operation mechanism of the UMA protocol is as follows:

• When there is a dispute over the market outcome, any user can trigger a vote;

• Holders of UMA tokens will vote on the outcome;

• Voting weight is proportional to the number of UMA tokens held;

• The winner of the vote will receive a reward, while the loser will face penalties.

Original image from michaellwy, compiled by Shenchao TechFlow

A detailed explanation of this mechanism can be found in UMA's official video. 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, and their success in the 2024 U.S. election has further enhanced their credibility.

However, what happens when the prediction market system encounters problems? The recent market controversy surrounding whether the U.S. government would shut down revealed some key flaws in the current design of prediction markets.

Polymarket created a market predicting 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 "U.S. Relief Act"), successfully avoiding a government shutdown, and major media outlets confirming unanimously across political lines that there was no interruption of federal government operations, the market still showed a 99% probability of a shutdown as the trading deadline approached, ultimately adjudicating the result as "yes."

The controversy over this result primarily stems from Polymarket's modification of the rules during the market's operation. Specifically, the platform added a new "rule clarification" after a significant amount of trading had occurred, introducing a previously non-existent cutoff date—midnight on December 20, 2024. This change directly led to a disconnect between the market result and the actual situation.

What should have been a simple binary prediction market evolved into a debate about manipulation and design flaws in prediction markets due to the ad hoc adjustment of rules.

Timeline of Events

• December 20, 6 PM (EST): The probability of the "yes" option (i.e., predicting the government would shut down) was 20%, having dropped from 70% to this level. This change occurred as traders generally expected the Senate to 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 to sign.

• If President Biden does not sign the funding bill before midnight, the market will interpret it as "yes."

• Reactions in the market comments section: The comments section erupted into heated debate. Holders of the "no" option were confused by the sudden spike in probability and pointed out that all news sources reported 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, and major media outlets unanimously reported that the government shutdown had been successfully avoided.

CNN reported:

The Senate is close to passing the funding bill, OMB will not shut down the federal government.

According to the White House, the Office of Management and Budget (OMB) will not shut down the federal government as the Senate is close to passing the funding bill.

The White House stated, "Due to Congress's imminent passage of the relevant funding bill and the President's signing of the bill on Saturday, the OMB has halted shutdown preparations."

"Since federal funding obligations accrue and are tracked daily, agencies will not shut down and can continue to operate normally."

Why did the market interpret it as "yes" when the government did not actually shut down?

Despite the government not actually shutting down, the market ultimately interpreted it as "yes." To understand this outcome, we need to carefully analyze the original rules of the market.

Content in the image:

If the U.S. government shuts down between August 30 and December 31, 2024, at 11:59 PM (Eastern Time), the result of this market will be determined as "yes." Otherwise, the result will be determined as "no."

If the acting President fails to sign the relevant funding bill before the applicable cutoff date, even if there is no explicit announcement of a government shutdown, the result of this market will still be determined as "yes."

Any form of shutdown will lead this market to be determined as "yes." For example, if only some U.S. government departments receive support from the extended funding bill while others fail to secure funding, this market will still be determined as "yes."

The primary basis for this market's determination will be official information from the U.S. government, but credible media reports may also be referenced when necessary.

Source

Analysis of Market Rules:

1. Point 1 -- This point is relatively simple: observe whether a government shutdown occurs within the specified time frame (note that the end date of the time frame is December 31, 2024).

2. Point 2 -- This is the core of the controversy. Holders of "yes" believe that according to market rules, the President must sign the relevant bill before the applicable cutoff date. They argue that midnight on December 20 is the applicable cutoff date, and since the signing was not completed before this time, the market result should be determined as "yes" (we will discuss this further later).

3. Point 3 -- This involves the situation of partial government shutdowns, but it is not closely related to the current issue, so we will not delve into it here.

4. Point 4 -- This explains that the primary basis for determining the market result will be official information released by the U.S. government, and credible media reports may also be referenced.

Views of the "Yes" Camp:

• Polymarket added a banner clearly stating that midnight on December 20 is the cutoff date.

• The platform released "additional background information" on December 21, further supporting this rule.

Additional Background

According to the rules, "If the acting President fails to sign the relevant funding bill before the applicable cutoff time (12:00 AM Eastern Time on December 20), even if there is no explicit announcement of a government shutdown, this market will interpret it as 'yes.'"

Since President Biden failed to sign the funding bill before midnight on December 20, this market should be interpreted as "yes."

• Because Biden failed 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 if a government shutdown did not actually occur.

Views of the "No" Camp:

1. Timing Issues:

2. The original scope of the market rules is from August 2024 to December 31. The "yes" camp emphasizes that the midnight cutoff on December 20 was not explicitly written into the rules, only mentioning "applicable cutoff date."

3. Federal government funding operates on a daily basis, so the actual cutoff date should be 11:59 PM on December 21.

4. The banner stating "midnight cutoff date" was still visible on December 21, which contradicts logic since the interpretation standard had expired.

5. Actual Situation:

6. The White House's senior deputy press secretary confirmed: "Due to confidence in the bill's imminent passage, the OMB has halted shutdown preparations."

7. According to conventional logic, missing the cutoff should lead to a shutdown. But since no shutdown occurred, it indicates that no critical cutoff was missed.

Finally, a separate Polymarket question about "Will the House and Senate pass the funding bill by midnight?" was correctly adjudicated as "no." The key point here is that missing a procedural cutoff does not equate to a government shutdown, conflating process with outcome. This is also why there are two separate pages, as the spirit of the markets is different.

The core tension here lies not only in the interpretation of the issue but also in whether prediction markets should prioritize the technical interpretation of rules over the real-world outcomes they are supposed to predict. When the market adjudicates a government shutdown that objectively never occurred as "yes," the mechanism for seeking truth has malfunctioned.

Similar Controversies Are Not Uncommon

One might think this is just an isolated incident due to poorly written rules. However, similar controversies are not rare. A watchdog site named Polymarketfraud (forgive the provocative name) records many cases where market adjudications contradict reality.

The Venezuelan presidential election winner market is particularly interesting. Currently, the 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 in his article. Here is a brief summary.

1. The market rules explicitly state: "The primary basis for resolving disputes is official information from Venezuela, but credible media reports may also be referenced."

2. Official election results show Maduro winning:

3. First announcement: 51.20000% to 42.20000%

• Second announcement: 51.9500% to 43.1800% (this precision to multiple decimal places, especially with multiple zeros, raises doubts about its authenticity and may indicate data manipulation).

1. However, according to polling station data, the opposition's vote share showed they were leading by over 20%.

2. UMA token holders (who have final adjudicative authority in dispute resolution) were strongly lobbied to ignore Venezuela's official information sources and instead accept credible media consensus reports about election fraud.

3. Ultimately, UMA holders voted to overturn the primary basis for resolution stated in Polymarket's rules, adjudicating Gonzalez as the winner—despite Maduro remaining in power.

This contradictory decision-making exposes the problem. In the U.S. government shutdown case, UMA voters strictly adhered to a technical rule (the later added clause about the midnight cutoff), ignoring the media's unanimous reporting that "no government shutdown occurred." However, in the Venezuelan election case, they took the completely opposite approach, overturning the primary information source and supporting media consensus reports about election fraud.

Fraudulent Markets

(Source)

This list is still expanding, and work is ongoing to research other markets. It can be reasonably speculated that in all the aforementioned markets, countless (new) users have lost significant amounts of money, while some top users have made considerable profits at their expense. Although there is currently no conclusive evidence, there are reasons to suspect that these accounts may have coordinated behavior in the UMA voting process and/or Polymarket clarifications.

Additionally, it can be further pointed out that the rules regarding "Will there be a U.S. government shutdown?" are suspected of being deliberately misleading and do not clearly state which cutoff dates are valid for market resolutions. However, all signs indicate that this market should resolve as "yes," for example, if a government shutdown did indeed occur before 2025.

Polymarket should consider refunding users affected by these fraudulent markets and/or adopting a 50/50 resolution where applicable. If no action is taken, this controversial market trend will continue, leading to profits for a few large users while many new users suffer losses. This may be a matter that the U.S. Commodity Futures Trading Commission (CFTC) and/or the Federal Bureau of Investigation (FBI) should investigate promptly.

Another case involves the Israel-Hezbollah ceasefire market. Despite reliable reports that military operations were still ongoing, the market still adjudicated the result as "yes." A YouTube video titled Game Prediction Markets: Lessons Worth $40 Million details this event.

Additionally, Lou Kerner proposed an interesting theory in his article, exploring potential issues with the U.S. election market. Although he calls it a "conspiracy theory," his analysis suggests that Polymarket's presidential election market may be structurally biased in favor of Trump.

The scenario he envisions is as follows: If Trump loses, he might refuse to concede defeat, claiming voter fraud and contesting the election results, just as he did in 2020. Therefore, even if Kamala Harris actually wins the election, the market may not adjudicate the result in her favor.

This situation creates a "win for me if Trump wins, but I don't lose if he contests" scenario for Trump's supporters. If Trump wins, bettors will profit directly; if he loses but contests the result, the market resolution may be delayed or changed due to UMA token holders' votes.

Emerging Issues

First is the issue of rule manipulation. When the platform can add clarifications at will, the role of the oracle becomes meaningless. In the government shutdown case, the posting of the new banner caused market odds to soar to "yes," changing the originally effective cutoff date from December 31 to December 20, 2024.

This also raises other questions about resolution standards. When rules conflict, which rule should prevail? Although the primary resolution standard clearly specifies news sources and credible reports and sets the cutoff date as December 31, the market ultimately made its 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 both trade and vote, this creates a strong conflict of interest between large traders and oracle voters.

While Polymarket and UMA should ideally serve as independent systems that 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 else the banks will turn to competitors. When a system's success relies on pleasing powerful participants, independence is out of the question.

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 interface (UI), complex trading systems, and ample liquidity, if they cannot reliably determine who won the bet, all of this becomes meaningless. Polymarket currently relies on UMA's oracle system to resolve disputes, but this system's operational mechanism may have potential vulnerabilities.

Overview of UMA's Basic Mechanism:

• When there is a dispute over the market outcome, any user can trigger the voting process.

• UMA token holders vote on the outcome according to the rules.

• The size of voting power depends on the number of UMA tokens held by the user.

• The winner of the vote receives a reward, while the loser faces penalties.

In the blog Dirt Roads, Luca Prosperi proposed a concept called "Corruption Value Multiple (CVM)" to measure the potential risks of the market regarding Polymarket's oracle issues. Here is his analysis:

• Currently, the total value of unsettled bets on Polymarket is about $300 million, while UMA's total market cap is only $220 million.

• Controlling half of UMA's tokens requires about $110 million.

• This means that for every $1 spent to control UMA, one could potentially influence bets worth $1.36.

However, the actual risk may be higher due to the following reasons:

• The actual voting rate of UMA tokens is usually only 20%, far below 100%.

• Market rules are often vague, leaving gray areas for dispute adjudication.

• Voters may be influenced by public opinion or stakeholders.

• The funds required to influence market outcomes may be far less than the theoretical calculation of $110 million.

This means that if traders believe they can manipulate the oracle's adjudication to influence the outcome, they may artificially drive market prices far above the true probabilities.

These issues reflect the complexity of prediction market design. Although there is currently no "one-size-fits-all solution," improving dispute resolution mechanisms is undoubtedly one of the most important challenges facing prediction markets. If market adjudications become inconsistent, user trust in the system will gradually erode, ultimately causing the market to deviate from its original goals.

Directions for Improvement: How to Optimize Dispute Resolution Mechanisms?

Fix market rules and prohibit post-hoc modifications. Once a market goes live, 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 sole reference. When disputes arise, the oracle should strictly adjudicate according to these foundational rules, without interference from platform-added content.

Establish rule prioritization and on-chain records. Market rules need a clear hierarchy. For example, when rules conflict, which rules hold greater authority? Primary interpretative standards (such as credible media reports) should be clearly prioritized over secondary mechanisms. This rule hierarchy should be recorded on the blockchain at the time of market creation, forming an immutable chain of evidence to ensure the transparency and authority of the rules.

Reputation-based verification mechanisms. In addition to existing token voting, the market could introduce a reputation-based council system. This system would consist of respected industry experts who participate in adjudicating market outcomes, guaranteed by their professional reputations. This mechanism not only introduces higher professionalism but also increases social accountability in the verification process.

Inter-subject bifurcation mechanism. The inter-subject bifurcation is an innovative mechanism inspired by Eigenlayer, specifically designed to address obvious errors identifiable by human consensus. When significant disputes arise in the market, the community can bifurcate 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 economic penalties as their token value declines, effectively curbing manipulative behavior.

AI agents as independent arbitrators. To avoid potential manipulative behavior by token holders due to economic incentives, we could develop a dedicated AI agent whose sole purpose is to adjudicate market outcomes. Unlike humans who may 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 likelihood of human interference.

Conclusion

It is important to clarify that this article is not specifically aimed at criticizing 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 facing the entire industry.

Why are these issues so important? If we view prediction markets merely as speculative platforms where traders bet on outcomes, then their flaws have relatively limited impact. Indeed, some may incur losses, but ultimately, it is just another betting venue.

However, prediction markets are being positioned at a higher level; they are 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 drawn attention. When the market confidently predicts and verifies a government shutdown that never actually occurred, it reveals how these so-called "truth engines" can create a false reality that contradicts the facts. The issue is not just the economic losses of some traders; the greater danger lies in the fact that these "objective verification systems" we are building may be exploited by those with capital and motives to manipulate public perception.

As the influence of prediction markets grows, their structural weaknesses become a problem that everyone must confront. If we cannot address these fundamental vulnerabilities, we risk turning prediction markets into powerful tools for distorting truth rather than discovering it.