Throughout our series on the convergence of AI and blockchain technology, we have explored how the merging can enhance specific aspects of the DeFi space. These entries have primarily focused on the benefits, challenges, and security improvements that AI can have on DeFi's overall infrastructure.

If we look closer at some of the niches that exist within DeFi, we can understand just how tangible these improvements can be. Predicitictive markets and advanced derivatives are two such niches where we can already see the impact of AI on the DeFi space.

For this entry, we will give a quick overview of predictive markets and DeFi derivatives before exploring how AI might improve these two areas and what challenges and regulations they each still must overcome, even with the support of AI.

Speculating on Macro Events

Predictive markets are nothing new to the world outside of DeFi. Long before blockchain technology burst on to the scene, humans were looking for any means possible to speculate on unknown future events. Everything from politics and sports outcomes to more specific futures markets in areas like gross movie ticket sales and specific company quarterly announcements. Prediction markets are futures markets that speculate on issues beyond the mere price of an asset. 

Predictive markets are impressive because the speculation of future events can often be a more accurate indication of the event’s outcome than other traditional legacy means. This was certainly the case if we look at the polling results of the last few U.S. presidential elections versus the predictive markets that speculated on the same events. Going into election day in 2024, most pollsters had former VP Kamala Harris winning by large margins compared to the predictive markets that told the opposite story. Predictive markets better capture public sentiment in elections for a number of reasons, including investors having a financial stake in predicting the correct result, an unwillingness to admit to a stranger who you are voting for, and outdated polling techniques that fail to capture an accurate representation of the public. 

Unsurprisingly, these predictive markets are incredibly restrictive in most regions due to the concern of them impacting the result of the market they are predicting. This is especially true when it comes to the speculation on political results. The fear is that investors could impact or manipulate a race by overspeculating on a candidate and driving sentiment one way or the other. Yet, there are a few centralized predictive markets that exist. The Iowa Electronic Markets was launched at the University of Iowa in 1988 and allows students to invest real money in various contracts, including political markets.

Where Does DeFi Come into Predictive Markets?

One of the earliest industries to adopt crypto transactions was the online betting and gambling industry. Organizations like Bovada, Betway, and Supabet began integrating the online crypto payment rails as an alternative method to the legacy fiat card and third party payment options. It was unsurprising then to see blockchain projects leverage these markets to gain a foothold in the space before developing their own entirely crypto predictions market. 

‍Gnosis launched its prediction market offerings in 2015. This set the stage for the larger blockchain prediction markets to emerge. In 2020, Polymarket was launched on the Polygon blockchain. It has since grown to become the most dominant predictions market around the globe with the ability to place wagers on everything from the frequency of Elon Musk Tweets to  how many inches of snow New York City will see in January, as well as already accumulating over a billion dollars worth of predictions on this year’s Superbowl.

Blockchain technology has enabled global decentralized access to prediction markets. While this may appear to primarily benefit the individual investor, we have seen through the centralized prediction markets that predictive markets are often a better indicator of future events than legacy alternatives. They also offer global access to liquidity in smaller prediction markets. For example, Polymarket offers options for the upcoming Belarussian and Ecuadorian presidential elections, which may be difficult to obtain through traditional means.

AI could further enhance these offerings by using next-generation smart contracts, and chatbot interfaces like the ones we saw in our piece on NLP in crypto. Chatbots that enable anyone the ability to create their own prediction markets in real time that are fully enforceable and abide by global restrictions through the use of smart contracts. AI could also improve the current state of predictive markets through the ideas outlined in our AI-driven risk assessment piece. AI anomaly detection could also help prevent malicious actors from investing in predictive markets with the intention of impacting the result through early detection. 

Decentralized Derivatives and Futures Trading 

Similar to predictive markets, derivative trading is not a new financial instrument that blockchain technology enables. Derivatives have always been considered to be one of the three main types of investing tools, along with debt and equity. Derivatives simply refer to contracts that earn their value from the performance of the underlying asset they are representing, such as a commodity or index fund. There are a number of reasons why someone may want to engage in derivatives, including hedging their bet as insurance against volatile price movements, broader risk management, or mere speculation on the future price movement of the derivative.

Within DeFi, derivatives are often leveraged via smart contracts to derive value from the future value of a cryptocurrency. This often takes the shape of overcollateralized loan agreements and staking options where a user locks up their crypto to lock in current prices in times of heightened volatility. In our Deep Dive into the Future of Finance article, we briefly explored how stop loss trading works and how AI trading bots can improve the algorithmic trading models, as well as integrating NLP and advanced security measures to prevent malicious actors from manipulating the market.

AI may also be able to reignite the development of algorithmic stablecoins. Few in the space will have forgotten the fallout from the collapse of the Terra ecosystem when its algorithmic stablecoin Luna depegged and collapsed to zero in a matter of days. AI may be able to overcome the shortcomings of that specific project through better collateralization modeling and risk detection from potential malicious actors. Similarly, AI can be leveraged for more efficient collateralization in loans and advanced derivatives across DeFi.

As with most areas in this series, AI shows immense disruptive potential in prediction markets and advanced derivatives trading by creating more efficient and expansive offerings. 

Yet, as with the other areas we have explored, these advances are not without challenges and risks. Even if AI can dampen the risk of algorithmic stablecoins and derivatives, if that risk is not absolutely zero, it has the potential for a similar collapse to the Terra ecosystem in 2022 that wiped out $60 Billion of market capital in a matter of days. Similarly, predictive markets show immense room for growth by merging blockchain and AI technologies, but the highly restrictive regulated markets in which they operate still pose a challenge. For all its merits, Polymarket is not available in the U.S., which remains one of the world's largest and most ravenous untapped betting markets. 

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Both of these niches are sure to expand in the upcoming years. AI can help accelerate this trend and adoption, but how quickly and how tightly regulated they become is anyone's guess.