Using prediction markets to hedge your cryptocurrency investments
Using prediction markets to hedge your cryptocurrency investments

One of Ethereum’s most hyped projects has finally opened its doors, and it could mean big things for cryptocurrency traders. Augur is a decentralized prediction market built on top of the Ethereum blockchain. If you are not familiar with prediction markets, then you could think of them as a place where people are free to turn literally anything into a tradable commodity. Any question or event could reasonably become something you could wager money on. This month, the hot topic is of course the US Midterm elections. The Augur community is currently wagering over which party will control the house at the end of the year, and it has quickly become one of the largest markets on the platform, with over $990,000 currently at stake and rising.

Of course, prediction markets do not have to be politically motivated. You could create a prediction market for near anything. Sporting events are also popular with these types of platforms, but even wagering about more novel topics like the weather or what crazy things celebrities might do in the coming months is not off limits. While the benefits of having a free market wagering system are obvious, what does it mean for cryptocurrency as a whole?

prediction markets for political events

While many people will not speak highly of prediction markets, because they are essentially ethereum gambling, the truth is that they could actually be useful for other industries. The most obvious use of a prediction market for cryptocurrency traders is to use it as a kind of insurance. In traditional financial markets you have options trading. If you are unsure about the potential performance of your investment then you could either purchase or sell options contracts against your shares as an insurance policy. It’s a more difficult game to play, but for those who are willing to learn the ropes it can be quite lucrative.

Previously, there wasn’t really a way to do this with cryptocurrency. Your only options were to exit a position completely. While investors in other markets would likely diversify into more stable asset classes, cryptocurrency doesn’t really have them. Alternative currencies follow Bitcoin so closely that if something major happens then there really is nowhere to hide. However, many enterprising individuals are actually taking advantage of Augur’s prediction markets to create their own cryptocurrency based insurance policies.

Anyone is allowed to create a market as long as they have some REP tokens, and that person even gets to collect a fee for starting it. A quick look at the Augur marketplace displays a number of different wagers regarding the future price of cryptocurrencies such as Bitcoin or Ethereum. Normally these are posed as a yes or no question, but in some cases there may be multiple options available. Let’s say that you are heavily invested in Ethereum but you are interested in protecting yourself against losses in case the market were to take another downturn.

By purchasing shares in a market titled “Will Ethereum be below $200 at the end of 2018?”, you could shield yourself from some of that volatility. Whether Ethereum goes up in value or down in value you would still come out ahead. However, much like traditional option contracts you don’t actually have to wait for the date in question to cash out of your position. This question is now a tradable asset. As the date of the event grows nearer the activity surrounding this market intensifies. If the price rises well above your purchase price then you are free to cash out immediately and walk away with your winnings.

augur ethereum hedging

This makes Augur a big deal for all cryptocurrencies, because it gives them something that they currently don’t have – an insurance policy. Many users of the platform have also pushed for the project to adopt popular decentralized stablecoin DAI, which would allow for an even better way to manage risk. If you are unfamiliar with the concept of stable currencies, they are a sort of self-managing ecosystem where a stable value is retained for an asset. This is of course in contrast to currencies like Bitcoin or Ethereum where they are permitted to swing wildly.

While cryptocurrency enthusiasts have long cheered currencies which are resistant to inflation, the truth is that things have not gone as swimmingly as everyone had hoped. It may be fun to watch the value of cryptocurrencies jump up and down for investors, but it’s not so fun for people who have completely invested their lives in them. If you were to say, get paid in Bitcoin, then it’s not quite so fun when the money you need to pay for things like rent and electricity is no longer reliable every month. This is of course part of the hesitation of merchants in accepting cryptocurrencies, because small price fluctuations on the day to day can quickly erode small profit margins, potentially leaving them in the red.

What does this all have to do with prediction markets though? Well, we talked earlier about how those markets could be used as insurance. An Ethereum based stable coin like DAI is created when Ethereum is locked up as collateral. So, if you’re creating an insurance policy, it makes more sense to do so in a currency with a more reliable value. This allows everyone to hold a cryptocurrency which they can be assured of the value tomorrow.

stable coins and prediction markets

Of course, the future of DAI is heavily dependent on the price of Ethereum not completely bottoming out, so is DAI truly stable? That remains unclear, but thus far it seems to be the best option that cryptocurrencies have for a stable coin that is truly independent from government backed currencies, and this will be very important for them to succeed in the long run. The truth is that cryptocurrencies are still growing, and it will take a good deal more experimenting before all of the bugs are worked out of the system.

By using DAI, Augur’s system could operate more efficiently, and it would shield users from the day to day movements associated with Ethereum. You don’t even have to exit your Ethereum position to get DAI. In fact, creating DAI is more like taking a loan from yourself, meaning that it’s not a taxable event. When you want your Ethereum back, you can simply repay the loaned DAI. This allows you to use these loans to create hedged positions for your investments or even to just bet against other markets if you want to while keeping your Ethereum. It also protects you from one other thing. If the value of Ethereum goes up, you don’t miss out on that profit. You can repay your loan, and the same Ethereum you locked up in the smart contract will be returned to you, allowing you to sell it and collect your profits and still keep whatever you made on the prediction markets.While Augur is still a little clunky, trading volume has been slowly trickling in, and I’m excited to see what happens with the platform in the future. Is Augur really just a new form of Ethereum casino? Maybe, but I feel the application is worth much more than that.

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