Why Susquehanna Is Building a Prediction Markets Business

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2:18Hello and welcome to another episode of the Odd Lots podcast. I'm Jill Weisenthal.

2:23Jeremy Maletz:And I'm Tracy Alloway. So Tracy, we're still rolling out shows from our live show on May 28th in New York City at City Winery. As we discussed in our last episode from this show, it had a sort of future of markets, future of trading theme to the night's conversation. Right. And if you're talking about future of markets and trading, we have to talk prediction markets, right? Yeah, that's right. So in addition to the fact that there is the, quote, AI trade, unquote, the other big thing going on in markets is the sheer explosion of instruments with which people can trade. Right. So it's like you have stocks and bonds and options.

3:02And then the options started getting more exotic, like zero day options, which you love and so forth. But now it's like if you could think of something that would resolve in some way, whether it is snowfall in New York City, Tesla deliveries or how long a halftime show is at the Super Bowl, there probably is a way to bet on it.

3:21Jeremy Maletz:Right. And so one of the big questions is whether or not these markets are going to take off from an institutional perspective, whether or not you're going to see more professional investors get into the business of betting on not just snowfall in New York, but maybe halftime shows and that sort of thing. But that said, we do have some institutional participation in the market already because you have market makers that are starting to come in to try to make these markets more liquid. Yeah, but you really said the key thing here, which is we know there's like a ton of liquidity for like the sports betting, etc.

3:54Like that's not the problem that needs to be solved. It's these other things where in theory, these might be useful instruments for hedging or some sort of economic risk. Maybe not the Taylor Swift one or the halftime show ones, but some of these other ones. But like in theory, some of these contracts could be useful for hedging. And so the question is, yeah, but will anyone use them? And so on this discussion, we really had the pleasure of someone who has had very little media in general and who is right in the heart of trying to essentially solve this chicken and egg problem. Listen to our conversation with Jeremy Mallitz, the head of prediction markets at Susquehanna International Group.

4:33All right. Why don't you tell us just let's start really simply. What does the prediction markets desk at Susquehanna do? So essentially, the main function that we do is market making. So we're the main liquidity provider, one of the main liquidity providers on quite a lot of platforms. And that means we're providing liquidity in everything from sports to economics to politics. But I'd say also a big part of what we do is we were the first institution that got involved in prediction markets in the first place. So we're really trying to have a role of kind of being a shepherd for other institutions as they get involved.

5:11So I'd say it's a two-pronged goal really of providing the liquidity for the ecosystem to help it to grow and then bringing others into the ecosystem, which I think has been one of possibly even the more important role of what we've done to this point in time. Wait, can I ask an even simpler question, which is I kind of feel like Susquehanna is like the sales force of the finance world where I have this like vague idea of what you do, but also not really. What does Susquehanna do? Well, my wife asked me the same thing. It's her birthday, by the way. So happy birthday to her. It's incredible that you're here.

5:49I know. I owe her big time. So we're primarily a market making firm and our bread and butter has always been options. So we make markets in pretty much every option, equity options. But obviously, we trade a lot of instruments across a lot of things. And we have a culture overall that's very much looking for new opportunities and thinking about things and probabilities. And it all starts from Jeff Yoss, our founder. He loves things like prediction markets. So we have a lot of random businesses at Susquehanna all over the place. You wouldn't believe the number of things that we do randomly. And it all comes back to the same culture we have of thinking in Bayesian probabilities and trying to think of everything in terms of break it down into what the odds are.

6:36But the bread and butter remains market making. And we try to use that to kind of make a market or bring a market to any asset class we're looking at. Let's talk about, OK, there's some contract out there. Who is going to win the Texas primary Let's just say, so there's an exchange and there's an instrument and it's either going to end at 100 or zero, et cetera. Why does this market need market makers? Why can't it be entirely peer-to-peer such that if all of us in the room just wanted to trade, we make a price amongst each other on an exchange? Why is a market maker an important part of the infrastructure for this to work?

7:18So if you have a market where you have an insane amount of people that are all trying to trade all the time, you might be able to make it work without a market maker. OK. But what a market maker is really doing is it's helping to bridge the gap between the different people who are trying to trade. So, Joe, you might want to trade now and Tracy might want to trade in an hour. Right. But if there's no if but that doesn't help, that doesn't help you if she's not there now. So we're basically saying, hey, we're going to be there when you want to trade. And then we're going to wait. And when Tracy wants to trade, we'll take the other side of it.

7:50So we're basically a function that matches the buyers to the sellers across time and also across size. So how big does your balance sheet have to be to be like dedicated to this particular business? Like how sizable are you with an entity like CalShe? So, you know, it really depends on the way that you do it. there's a lot of small independent groups or just individual people who are able to be out there and they make markets and their goal is to try to balance it and they have to think a lot about capital. We are very fortunate that capital isn't generally a constraint for us, right? So that's one of the things that it's an advantage for us, but it's also something we can bring to the market.

8:28We can provide much, much larger size on things. It's why we're well suited to bootstrap a market and to do institutional type size because we're not constrained by capital in that way. And do you generally try to stay risk neutral? No. I think that is pretty deeply in our culture that obviously all things equal. We would like to be risk neutral, but we're willing to put ourselves out there and wear a position. And in general, on our options trading, we tend to warehouse a lot of risk for the street. Sometimes there's just something where everyone needs to hedge a risk in one direction and someone needs to be on the other side of that.

9:06And that's an important function in prediction markets, especially when you think about use cases such as hedging, where you've got some global risk to the world. Everybody needs to hedge that risk on one side. Someone needs to be on the other side. And we're willing to hold ourselves out there to do that. And there's a lot of pieces that go into being able to do that. Obviously, when you're not neutral on a risk basis, you have to be more confident that you're right. But that's a big part of what our team has striven to build. So this sort of leads into the next question, and it's maybe the multi-billion dollar question of prediction markets, which is, okay, we know that there is a huge amount of the prediction markets business, which is just sports betting under a slightly different form.

9:51But you mentioned hedging, and this gets to the core question, which is, in theory, there are a lot of instruments on these prediction market platforms that could be useful hedging instruments for corporations, say, a market on snowfall in New York City, which might affect an airline or something like that. Maybe they want to hedge that. When I look at the platforms currently, I see a price for like snowfall, but I don't see anywhere near the volume level that say would really justify like an airline could, you know, you see$150 ,000 in volume on whether there'll be between six and eight inches of snow.

10:29That's obviously nowhere near deep enough for a serious economic actor to participate in. So where are we on that in terms of the promise of actually useful instruments for hedging? Right. So when we first got involved in prediction markets, our real role was to bootstrap the liquidity. There were no institutions yet. And it was largely going to be a retail product. We were bootstrapping for large volume retail liquidity. Now our next challenge is we want to bootstrap institutional liquidity. So yes, you might look at a market that doesn't seem like it has enough volume for an institution to hedge tens of millions of dollars of risk.

11:08But that's part of the reason that I'm out here doing a podcast today is we're trying to make sure that people start to understand this is viable and we're putting ourselves out there that we will be willing to put that kind of risk. And we can put out that kind of risk on a contract where far less volume is traded. And that's because what the prediction markets really provide is information. It's a price discovery mechanism. So you have this phenomenal community of super forecasters that exist on a prediction market. And it doesn't take as much volume as you would think to get to a fair price.

11:44And that allows us to say, hey, OK, we've got a reasonably fair price on this prediction market. Maybe it's only traded$100 ,000. But we know that there's been a lot of smart people that have looked at this. We can do our own internal vetting at the same time also. And now we're comfortable going out there and saying, we're confident enough in this price because of the price discovery mechanism that we'll make tens of millions of dollars of risk to a company that needs to hedge its risk of what, you know, some regulation or straight of Hormuz or whatever it is that's happening in the world. So, you know, someone needs to go out and do that.

12:16And I think we're kind of uniquely positioned because of our culture of saying, yes, we are willing to take that risk. And yes, we want prediction markets to grow. What have your conversations been like with institutional players so far? Like, what do they say is their main either constraint or, I guess, reluctance to get on some of these markets? So the first piece is the exact thing that you just brought up, awareness. They look at the markets and they might say, well, I don't see how we could actually hedge some of these things because there's not enough volume and liquidity, to which our response is, we will be the liquidity.

12:47You know, then the other question is, okay, well, we sort of need our compliance to get comfortable with this. This stuff is so new. What's the legal landscape? How do we get this stuff even over our firewall? I think institutions were always going to be the slower moving player relative to retail. And so that's why we really want to sort of hold some of their hands to go through this and figure out a lot of different ways that they can use prediction markets. Some of it might be an institution connects to a prediction market platform, does a block trade on an exchange with us. It could be that a trade goes up off an exchange as a swap, but it's licensing the exchange market data.

13:25And we're trying to create as many different setups as possible so that people can do these trades. And we're going to basically be the facilitator to say, okay, you need a hedge. We're going to figure out how to let that happen. So this is really important. So if I look at a contract and I see a number there, like$150 ,000, it's possible that there was a trade, an off-platform trade of much bigger size that was not printed on that, but that was more by swap form. And is that currently happening? It is possible. I'm not going to go and say that that's a big thing that's happening yet. We're trying to build out the infrastructure to have as many options as possible, because we want institutions to start moving.

14:09And the more they do it, the more they're going to If an institution, again, let's go to the airline hedging snowfall. Would they have a relationship with you? Would they go through a prime broker who then has a relationship with you? Like, what is the actual sort of like chain of phone calls or whatever that happens? So it can be both. But ultimately, when I think of what we're really good at and what we're not really good at, we're not necessarily the best in the sort of know every single airline customer business. So we want to work with a lot of those other intermediaries that could be a broker.

14:40It could be a bank. It could be an insurance company. The people who have those relationships and are in the business of constantly advising, this is what you should do. We understand we want to work with them. And they could have a very important role in helping to be a part of the infrastructure that gets it from the customer with the risk to us being the ones that have the other side of the risk.

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17:49complete disclosures at public.com slash disclosures. Joe's chosen a pretty like reasonable contract, I would say, um, for his example there, but like, are you committed to making markets in all the contracts available on these platforms? Cause I'm thinking about, you know, like the return of Jesus Christ or will aliens invade? How would you even go about the length of a halftime show? Right. Um, yeah. So we, we don't make everything. Um, and, and honestly, we're not the best to make absolutely everything. Some of the things that you might say that something perhaps in pop culture, we're probably not going to be that good at it relative to others, right?

18:28There are certain things that - Are you trying to build that capacity up? Well, we'll see. But there is a community of a lot of people that can make a lot of these types of markets. And what we want to do is we want to scale our capacity with our technology, our quantitative models, our sort of very trader-driven insights that we have in our capital. That's where we're going to add the most value to an exchange. If something just requires a bunch of people to dig into it, the universe of all the different super forecasters, we're probably not as necessary. So you probably don't need us to know something about when Taylor Swift is going to get married.

19:08But the fact is that the things that have the most economic value tend to be the things that need us the most. And so that's really where we try to play. And I think it's great that the ecosystem has these complementary forces of the community of all of the super forecasters, and then the people like us who both kind of have different skill sets. Do you see right now, so again, people say, yeah, these are just, it's sports betting, et cetera. And then maybe every two years or every four years, there's some election activity. maybe there's some trades that are sort of like look like crypto derivatives etc when you actually look at today's volume of activity do you see a meaningful shift towards what what polite people who wear suits would say like real things is that happening it is yeah and so when you look at the volumes obviously there's a real percentage of the volume more you know more than half the volume certainly is sports.

20:07And there's a reason for that, right? Sports has been a big market in the United States for a long time. And it's happened in kind of a fractured way across a lot of different states. And there's certain states where you can't do it and it's a different regulatory system everywhere. But there was a big market that existed. And then prediction markets basically came around and they provided a better way for sports to trade. So it was natural that there was going to be this massive base from the start. But what we're seeing is it's dragging up all of the other things. So it's brought awareness to prediction markets.

20:38And the more we see that, the more we see everything else growing. And by the way, a lot of that other stuff, the real market, they're growing at a faster rate than sports, just from a lower starting point. And our goal now is really to boost that with the hedging cases, which that's growing too, but it's not a huge part of the market as of now. And we understand it needs to be. From an ecosystem perspective, it's essential that those hedging trades become a much larger part of what the market is. So if you're a market maker for an event contract that's something like the Fed is going to raise rates or hold or lower or whatever, that's pretty similar to something that you might see in traditional markets.

21:22But how different, can you explain it to us from a mechanical perspective, how different the market making process would be for a prediction market contract versus like a traditional option? Right. So honestly, there's not a one size fits all because there's so many different things out there. So if you're thinking about kind of what's the Fed going to do next, there are instruments that capture that reasonably well. And same thing as, you know, what's the price of the S &P 500 going to be at the end of today, for example. There are other instruments out there that capture that reasonably well.

21:58And really, this is just distilling it into a way that might even better capture the idea someone has. There's quirks to the other types of things that you might have that are the proxies. So we can translate what's happening in the traditional financial markets to prediction markets. For other products, is this random one-off event going to happen in the world? Is the Strait of Hormuz going to be open by the end of August? Is Keir Starmer going to be out as prime minister? Yeah. That stuff requires a lot of independent research. But the good news is that there's so much information contained within the prediction market itself.

22:35So one of the core market making principles we have is, you know, it really honestly comes from, you know, kind of a thing we teach with poker of understand what other people know and what other people are doing. We can learn from the markets, seeing where they are. this is what all these other super forecasters know. We can combine that with our internal research and then get to a number. So that's, you know, some things kind of have to be, we draw it up and figure it out like that. Some stuff is we can use the information that's in other markets. And some stuff is we're going to build a brand new model to figure this thing out because that's kind of in our DNA to say like, all right, here's a random thing, but, you know, how are we going to, we're going to have to figure out compute, right?

23:17Let's figure out how to model compute and, you know, we'll build it. So one of the concerns or one of the things that people talk about with prediction markets is the possibility of insider trading. And, you know, like, obviously, like when I think of like a market making firm or some of these firms that do a lot of flow and volume, you just sort of assume there's a lot of noise and it all sort of washes out, right? How does it change you? Like, you have to think like, if there are participants in the market that are like, not just forecasters here, like not just people who are good at predicting things, but deeply informed flow where they maybe just know the answer already.

23:57Are you able to spot that? Are you able to sense that? And does that change how you think about risk management within a given market? Right. So I guess the insider trading is definitely something that comes up and there's certainly been plenty of articles that are written about it. I think there's a couple things to point out there. The first one is that there's actually really two types of prediction markets that it's not always clear to people what the distinction is. But there's the regulated prediction markets such as Calci, such as Rothera Exchange that just launched, such as CME has one and Polymarket has a regulated exchange.