How Futarchy Works
as fast and as simple as possible
Futarchy is pronounced Fu-ta-rke . And it’s the application of prediction markets (fancy name for gambling) to governance.
The premise of futarchy can be understood starting from this question:
“if a CEO told you his company was about to announce that they’re bankrupt, would you short their stock?”
I hope you answered no, because that would be insider trading. But if there was no SEC, you’d probably mortgage all your belongings and short the stock with maximum leverage.
Now imagine if a trusted analyst like Larry Fink tells you that a company is about to skyrocket in valuation. You’d likely long the stock aggressively, but nowhere near as aggressively as your short position from the previous scenario.
What this implies is that your confidence in your information about a situation is directly related to how much you’re willing to stake on the outcome. Keep that in mind as we segue from here to prediction markets.
Prediction Markets
Say a company has to choose between two products: A and B.
And all the decision-makers are convinced that it’s either A or B. Those who think A is the better product think B will ruin the company and vice versa.
The company can choose by vote but they can also use prediction markets. To create a prediction market the company will make two copies of their stock and an equivalent value in USD.
If the company had 100 stocks valued at $1 each, they would create 200 dummy stocks and 200 dummy dollars. They would then split this dummy stock and dummy dollars into two parts:
100 dummy stocks and dollars will be redeemable in the event that product A is launched. We’ll call these A-stocks and A-USD.
100 dummy stocks and dollars will be redeemable in the event that product B is launched. We’ll call these B-stocks and B-USD.
No matter what product is launched, these two stocks together are always worth 100 stocks and 100 USD — the original stock count and valuation of the company.
Now, all shareholders (not necessarily the decision-makers) are free to lock up their real stock and real dollars for dummy stock and dummy dollars. If you lock up 1 real stock, you get 1 A-stock and 1 B-stock. Similarly, if you lock up 10 USD, you get 10 A-USD and 10 B-USD.
Now, the magic happens.
Say you’re an investor who believes it’s product A or nothing.
You should be willing to trade A-USD for A-stock since if product A launches, you expect that stock prices will go up. It also logically follows that you should be willing to sell B-stock for B-USD since you’re certain B launching will send stock prices down.
So you do it. You buy A-stock with your A-USD and sell all your B-stock for B-USD.
So what happens:
Scenario A
If A launches, there are two sub-possibilities:
- A1: A launches and stock prices go up. In this case, you make money.
- A2: A launches and is bad. In this case, you lose money (depending on how cheaply you sold A-Stock)
Scenario B
This also has two sub-possibilities
- B1: B launches and stock prices go up. In this case, you lose money
- B2: B launches and stock prices go down. In this case, you make money.
Here’s a table visually expressing what I just said:
So what’s the point of this?
First, we’ve made a future event tradeable, which is pretty cool.
But more importantly, we established that the amount of money an individual is willing to stake on a the outcome of a situation is directly related to his confidence in his information about said situation.
So it logically follows that this prediction market will collect information that provides a great representation of what people think is best for the company.
Keeping with the same example,
If you, as a CEO, find out after say 10 days that the price of A-stock is significantly more expensive than Stock-B, it signals to you that the market thinks product A is much better for your company.
You’d be running a futarchy if you chose A based on the results of the prediction market, and that’s the basic idea.
Futarchy is the application of prediction markets (fancy name for gambling) to governance.
The potential applications are far beyond companies.
Consider the 2024 US elections. If you ran a Trump/Biden prediction market, i.e., you asked people to “price” the US dollar under both presidents, you could determine which president people think will be better for the economy.
The possibilities are vast—not endless, but vast.
If you understand the idea, the next natural question is: does a Futarchy even make sense?
Why Futarchy makes sense
In our current reality, individuals or committees make decisions. Think presidents or school boards.
However, these individuals/committees often:
- act in selfish interest and/or
- have incomplete information on the subject matter
Futarchy is an antithesis to the second problem that works because it capitalizes on the first.
Imagine a president wants to implement a policy but instead of asking the Senate (which consists of senators who have to protect the interests of themselves and their campaign funders) to vote on it, he throws it to a prediction market.
In this imaginary world, senators are incentivized to vote for better policies because they can make money by doing so.
More importantly, if there’s a super genius who knows exactly what this policy will do, he’s also incentivized to provide this information through the prediction market.
An average Joe who’s not as savvy about the impact of this policy will probably not mortgage his grandma.
So it makes sense that the information gleaned from this prediction market is of the highest quality.
And that’s the point of futarchy.
Futarchy allows decision makers to become privy to expert information.
And yes, there’s a good chance some idiots stake the entirety of their life savings based on a gut feeling or incomplete information.
Futarchy argues that these outliers don’t matter.
Not because they can’t sway the market but because, despite the imperfections of futarchy, it’s superior tocurrent systems of governance.
Futarchy isn’t perfect; it’s just better
Take for example, the valuation of companies. It’s true that there are a few outliers, but the vast majority of companies are priced as they should.
This chart focuses on SaaS companies but it’s a similar story everywhere else.
Markets aren’t perfect but they have proven themselves to be more accurate than other sources of information.
I think the inventor of Futarchy says it best:
The key issue is not absolute accuracy, but accuracy relative to other institutions, on the same topics, given similar resources. We have some data on this. In addition to lab studies, a few studies directly compare real speculative markets with other real info institutions. For example, racetrack market odds improve on the prediction of racetrack experts; orange juice commodity futures improve on government weather forecasts; stocks fingered the guilty firm in the Challenger crash long before the official NASA panel; Oscar markets beat columnist forecasts; gas demand markets beat gas demand experts; betting markets beat Hewlett Packard official printer sale forecasts; and betting markets beat Eli Lily official drug trial forecasts.
So Futarchy doesn’t promise to be perfect, it just claims to be better.
And we could spend hours debating every other potential problem that a futarchy would face.
But the important question is: does that make it worse than representative democracy?
Based on the empirical and scientific data of prediction markets outperforming expert committees, I’d strongly argue NO.
But the truth is, the only way we’ll ever be truly sure about Futarchy is to experiment with it at scale. And for the first time in human history, that’s happening at the MetaDAO.
If you’re not already familiar with it,
The MetaDAO
The MetaDAO is a DAO governed by Futarchy.
It works like any of the examples described above, with a few changes for practicality.
For example, instead of using the final prices of both markets to determine which one has greater support, it uses TWAP — (Time Weighted Average Price).
If it used only the final prices, there would be room for a malicious party to come in at the last second and inflate the value of whatever decision they support. They could make an obscenely large bid that would not be completely filled before the market closes but would still drive up the stock prices.
By using TWAP, it’s harder to manipulate markets.
If you’re interested in participating in the first real futarchy, you can find more on the MetaDAO here.
If you’re interested in learning the exact mechanics of how it works, you’ll find that in the next section.
I hope this article has given you a lucid description of how Futarchy works and how you can participate in it. You might not like it or fully agree with it but it’s easily the most exciting innovation in governance since the ancient Greeks invented democracy.
If you’re interested in learning more about Futarchy and the MetaDAO, I recommend you go through the further reading section.
That’s it.
