Sports Betting Industry
Proponents of the sports betting industry argue that the industry is good for sport and good for consumers. A number of different business models have been developed for the industry, including the traditional bookmaker-bettor relationship and the bettor-bettor relationship at Betfair (Wray & Kelly, 2005). The latter company’s model of peer-to-peer betting and high levels of transparency is especially interesting to the case of consumer welfare. In sports betting, the traditional underground bookie model put the consumer at a disadvantage, owing largely due to information asymmetry. Today’s betting houses maintain this information advantage, but the question at hand is whether this advantage is significant, or if consumer welfare has truly improved as a result of the advent of betting exchanges within the industry.
There can be little doubt that sports betting is a growth industry, and much of this growth is fueled by the Internet, which brings gambling to a wider audience. An industry that was in 2004 worth just over $5 billion is going to be worth an estimated $35 billion by 2012 (Smith, n.d.). The betting exchange industry represents a new innovation in sports betting. The traditional model uses the bookmaker as the intermediary between bettors. The bookmaker collects bets from all sides, and offers odds that reflect in part the results of statistical modeling and in part the different bets that have been taken. The bookmaker then earns its income by taking a spread on the bets, not dissimilar to the way a currency exchanger counter earns its money on the buy-sell spreads that it charges (Ibid).
The betting exchange functions differently in that the odds are provided by the individual bettors. One bettor must find the odds that he or she likes with another bettor and place the bet. The company’s role is more of a clearinghouse. The exchange takes a commission on the bet, but the odds are not set by the exchange. In addition, the exchange functions akin to a stock exchange in that there is a high degree of transparency and fluidity to the transaction (Ibid). Because the exchange does not have an economic stake in maintaining information asymmetry, it can offer greater transparency with respect to the bets cast on a particular event. This additional information should, in theory, empower bettors and allow them to make better bets (Ibid). That the information is publicly available effectively pits the knowledge and savvy of the two bettors against one another in the same way that investors experience when participating in the stock market, buying at a time when another investor thinks it better to sell.
There is some controversy with respect to the legality of betting exchanges. They are subject to prohibition and strict regulation (Smith & Vaughan, 2008). This opposition often comes from the entrenched interests in the bookmaking industry. Bookmakers have argued that betting exchanges do not provide better odds, nor do they provide consumers with better consumer welfare because market efficiency is lower (Smith, Paton & Williams, 2006).
Consumer welfare stems from the removal of barriers to that welfare. In the case of sports betting and the comparison between traditional bookmakers and betting exchanges, the theoretical improvements in consumer welfare stem from the removal of information asymmetry and improved efficiency with respect to price movements. This increased liquidity should be expected to drive prices (odds) towards a more natural market equilibrium, thereby creating a more efficient market. A more efficient market should be correlated with greater consumer welfare.
With respect to the efficiency of the odds, Smith, Paton and Williams (2008) found in a study published in the Journal of Economic Behavior and Organisation that betting exchanges resulted in better predicative capabilities with respect to odds for any given event. The study illustrates the power of a liquid, transparent market. The authors assert that traditional bookmakers offer superior odds to betting exchanges because of their experience and skill in the art. However, the authors’ study showed that this was not the case, that in fact betting exchange odds were a better predictor of outcomes. Part of this discrepancy may relate to the fact that bookmakers’ odds incorporate the bookmakers’ spread, whereas betting exchange odds do not. The assumption here is that even if he bookmakers are superior to the market at setting odds, they are unwilling to deliver those accurate odds because to do so would reduce their ability to profit. Bookmakers, if they did in fact possess superior odds-making abilities negate those abilities with their profit margins. That this has been shown to bring their odds to a point where they underperform betting exchanges indicates perhaps that bookmakers will need to take smaller spreads in order to improve their odds performance going forward.
The same authors in a 2006 paper note some of the potential reasons for the superior performance of betting exchanges. One such reason is the elimination of the favourite-longshot bias, a chief characteristic of the bookmaking industry. Whereas bookmakers use this bias in order to drive higher margin bets, the liquidity and transparency of betting exchanges eliminates much of the longshot bias. The result of this, the authors find, is that bettors enjoy efficiency gains that lower the total transaction costs associated with their bets.
These authors also note that compared with traditional betting media (bookmakers), betting exchanges provide better market efficiency. Exchangers were found to outperform both with respect to strong-form and weak-form market efficiency. While bookmakers have traditionally argued against betting exchanges, defending their spreads as the result of risk preferences, Smith et al. (2006) found that contrary to these claims the information efficiency of betting exchanges results in more efficient markets, not less efficient.
It stands to reason that betting exchanges, if sufficiently liquid, would outperform bookmakers. The arguments that bookmakers make if favour of their profession are unrelated to the antecedents of efficient markets. For a market to be considered efficient, it requires a high level of information symmetry, a high level of transparency and a high level of liquidity. Traditional bookmakers have none of these characteristics. The bookmaker controls the information and is not forthcoming about the information that it holds. This means that betting exchanges will have better information symmetry and better transparency. The information symmetry is necessary, in fact, to facilitate liquidity, as bettors need to be attracted to take both sides of the bet. For bookmakers, there is no need to offer odds on both sides of a bet, although with sufficient spread there is profit to be made. However, a bookmaker can take many bets on one side and only a few bets on the other side, and does not disclose if this is the case. This reflects a lack of liquidity — the bookmakers’ market is not based on liquidity anyway; odds can be offered no matter how many interested parties there are for a bet. At betting exchanges, bets are liquid based on interest. The market will set the price at the equilibrium level and thereby will entice all interested parties to make a bet, as they know that the price is the equilibrium price there is no disincentive against betting.
The liquidity issue, however, is not set in stone. While the betting exchange facilitates better liquidity, such liquidity is not guaranteed. Fan interest has to exist, so a minor event will not draw a liquid market. As investors know, an illiquid market is more volatile and more difficult in which to trade, because there is higher risk. If the market is illiquid, this is a disincentive for bettors to enter the market. This is known as Metcalfe’s Law, and represents a drawback for the establishment of liquid betting exchanges (Koning & van Velzen, 2008). Students of stock markets will know, however, that where sufficient interest exists the potential of a liquid market will draw in enough participants to, in time, overcome Metcalfe’s Law. Thus, the stock market of a small African nation may remain forever illiquid because of this Law, stock markets in large open economies will have sufficient liquidity because investors are drawn in. How this works with betting exchanges is that the liquid bets (major football fixtures, for example) will draw in bettors. These bettors, once they are comfortable with the system, will place riskier bets because they believe they have superior information and can improve their odds by venturing into the illiquid events.
Betting exchanges should increase consumer welfare in the sports betting industry. Consumer welfare refers to superior outcomes enjoyed by consumers, including lower transaction cost, more accurate odds and greater ease of placing a transaction. With respect to the first criteria, betting exchanges have been demonstrated to be superior to traditional bookmaking. This is in large part because betting exchanges take a commission on the bet, but bookmakers set their odds in an ad hoc fashion. While the consumer has full knowledge and understanding of the transaction costs associated with betting exchanges, there is not such transparency with respect to the transaction costs associated with the spreads taken by bookmakers.
With respect to the second criteria, it has also been found that betting exchanges deliver more accurate odds than bookmakers. This is to be expected, since betting exchanges are based on open market principles while bookmakers control their markets. The bookmaker’s spread will negate any advantage the bookmaker will have in setting odds vis-a-vis the market. Indeed, the market’s ability to set better odds than bookmakers has to do with removing the traditional information asymmetry that exists in the bookmaking industry.
The only point on which bookmakers may offer superior consumer welfare is with respect to liquidity. The concept applies to bookmakers as well, though, in that spreads are greater for events that receive fewer bets. In addition, the market is likely to remedy the liquidity problem and Metcalf’s Law in the long-run, meaning that over the long-run betting exchanges are expected to deliver superior consumer welfare outcomes compared with bookmakers.
Koning, R. & Van Velzen, B. (2008). Betting exchanges: The future of sports betting? Retrieved May 1, 2011 from http://www.thefreelibrary.com/Betting+exchanges:+the+future+of+sports+betting%3F-a0200185604
Smith, M. (no date). Consumer welfare and policy relating to online gambling. Economics & International Business Subject Group. In possession of the author.
Smith, M.; Paton, D. & Williams, L. (2006). Market efficiency in person-to-person betting. Economica. (2006). In possession of the author.
Smith, M.; Paton, D. & Williams, L. (2008). Do bookmakers possess superior skills to bettors in predicting outcomes? Journal of Economic Behaviour and Organisation. In possession of the author.
Smith, M. & Vaughan, L. (2008). Betting exchanges: A technological revolution in sports betting. Handbook of Sports and Lottery Markets. Elsevier.
Wray, E. & Kelly, T. (2005). Are betting exchanges good for sport? The Guardian. 14 December 2005, in possession of the author.
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