The cost of a market

A live market price feels free. You open a contract, a number is already there — 62¢, a probability you can read and trade against — and it costs you nothing to look at. But that always-on quote is doing real work, and work is never free. Somewhere, someone is paying to keep that number alive. This piece is about who, and how much, and why the answer turns out to draw the map of which markets get to exist at all.

In The market-maker problem I argued that the always-on price is the product — that the hard part of a prediction market isn't the clever question, it's the robot willing to quote a price into an empty room.¹ This is the sequel to that idea, told as an accountant would tell it. The market maker quotes for free; the market maker also loses money for a living. That loss is the cost of liquidity, and the whole economics of the category is the question of who absorbs it.

Why liquidity costs something

Start with the uncomfortable fact at the center of market-making: an automated market maker that always quotes a price will, on average, lose money to the people it trades against. Not because it's badly designed — because it can't tell who's on the other side. The robot quotes the same firm price to everyone. Some of those traders are noise: they're rebalancing, hedging, or trading for fun, and their orders are uncorrelated with where the price is actually heading. Some are informed: they know something the price hasn't caught up to yet — a poll, a filing, a result — and they only trade when the quote is on the wrong side of the truth.

Against the noise traders the maker does fine: they buy and sell roughly at random around the fair price, and the spread it charges is pure profit. Against the informed it is structurally the patsy. The informed trader buys YES precisely when YES is too cheap and sells when it's too dear; every trade they take is one the maker wishes it hadn't. This is adverse selection, and it's the oldest result in market microstructure: a maker quoting a fixed price loses to better-informed flow and profits from uninformed flow, full stop.²

Write it as a ledger. Suppose a fraction \(\alpha\) of the orders that hit the quote come from informed traders and the rest, \(1-\alpha\), are noise. On a noise trade the maker earns the spread; call that gain \(g\). On an informed trade it gets picked off and loses some amount \(\ell\). Its expected profit per trade is

A market maker that wants to break even has to set its spread wide enough that the first term covers the second — that's the Glosten–Milgrom intuition, and it's why every quote has a spread in the first place. But notice what happens when you don't insist on breaking even. If you're willing to let \(\mathbb{E}[\pi]\) run negative — to keep the spread tight, the quotes generous, the market deep and inviting — then that expected loss is exactly the money you are spending to make the market good. The subsidy and the adverse-selection loss are the same number. Liquidity costs precisely what the informed traders collect from you.

LMSR makes the bill a known number

The beauty of Hanson's Logarithmic Market Scoring Rule — the standard forecasting market maker, derived in Part 6 — is that it turns this open-ended loss into a single number you can read before you switch the thing on.³ For a market with \(n\) outcomes and liquidity parameter \(b\), the most the operator can ever lose, net of everything it takes in, is

That cap holds no matter what the traders do, in what order, with what information — including the worst case where every dollar of informed flow lands against the maker. For a plain YES/NO market \(n = 2\), so the bill tops out at \(b\ln 2 \approx 0.69\,b\). Pick \(b\) and you've picked the maximum you're willing to spend.

The right way to read \(b\ln n\) is as rent. It is what you pay to rent a liquid market into existence — the price of buying the crowd a public probability. And the rent scales with the depth you want: a bigger \(b\) means a deeper book and gentler price impact, which traders love, and a strictly larger subsidy the operator must be ready to fund. There is no free depth. Depth is a number on the curve below, and the curve only goes one way.

So LMSR doesn't make liquidity free — nothing does. It makes the cost legible: a fixed, capped sum the operator agrees to spend, in exchange for a market that exists. Which raises the only question that matters for whether a market gets built at all. Who agrees to spend it?

Who picks up the bill

There are only three places the cost of liquidity can land. Every prediction market you've ever seen is one of these three, or a blend.

The first answer: the exchange or a sponsor eats it. An operator funds the subsidy directly — runs the LMSR market maker, accepts the \(b\ln n\) loss — because it wants the market to exist. Maybe it's a loss-leader to pull in volume and brand; maybe the sponsor genuinely wants the number the market will discover, the way a company stands up an internal market to forecast a launch date, or a research funder underwrites a replication market to price whether a result will hold. The subsidy buys information the sponsor values more than the cost.

The second answer: liquidity providers eat it. This is the on-chain, constant-product route from Part 6. Nobody central underwrites the book; instead the crowd deposits capital into the pool and is paid fees for it. The LPs earn the spread the way the maker did — and they bear the same adverse selection, which in a CPMM shows up as impermanent loss.⁴ In a market that resolves to 0 or $1 that loss isn't impermanent at all; the price marches to a corner and the LP is left holding the losing token. The cost is still being paid — just by a distributed set of capital providers who took the trade because the fees, they hope, out-earn the bleed.

The third answer: the traders eat it, through the spread and the fees. Tighten nothing, subsidize nothing — just quote a wide enough spread and charge enough fees that the noise traders collectively cover what the informed extract. Here the market funds its own liquidity out of the pockets of the people using it. It works, but only where there's enough trading volume for those small per-trade charges to add up to the cost of carrying the informed. That last clause is the whole game.

The sponsor

Exchange · research funder · loss-leader

Funds the subsidy outright to bring the market into being — a loss-leader for volume, or because it wants the price the market will discover.

Cost → a known, capped \(b\ln n\)

The providers

CPMM LPs · permissionless capital

Crowd-funded liquidity, paid in fees. The pool rebalances against them; in a binary that resolves, impermanent loss becomes permanent.

Cost → fees vs. impermanent loss

The traders

Spread · per-trade fees

The market funds itself: noise flow pays the spread that covers the informed. Works only where volume is thick enough to foot the bill.

Cost → wider spread, higher fees

Notice that none of these makes the cost disappear. They relocate it. The sponsor pays it as a budget line, the LPs as a drag on yield, the traders as a worse price — but the adverse-selection loss from earlier is conserved. It is the gas bill of the whole apparatus, and someone's name is always on it.

Cold start, and why most markets stay thin

Now put the two halves together and the economics of the category falls out. A market needs a subsidy to be liquid. A market can fund that subsidy from its own fee volume only if it has enough trading. But trading shows up where there's already liquidity. So a niche market on an obscure question is trapped: too little volume to pay for its own depth, and too little depth to attract the volume that would pay for it. Unless a patron — a sponsor, a hedger, an advertiser, a protocol budget — is willing to cover the subsidy out of pocket, the market stays thin, its spread stays wide, and its price stays a weak signal.

This is the real reason the liquid prediction markets are the ones you can name. Big elections and major sports clear the bar because their fee volume is enormous: millions of noise traders, trading for the thrill, throw off more than enough spread to pay for the informed sharpening the line.⁵ A market on whether a specific bill clears a specific committee next spring does not — there simply isn't the flow to fund the quote, so it never gets deep, and the thin ones stay thin for exactly the reason I laid out in What prediction markets can't do. It's not that the question is uninteresting. It's that no one will pay the liquidity bill on it.

The cost of liquidity draws the map

Here's the deeper point, and it reframes how to think about the whole category. We usually ask which questions deserve a market — which outcomes are interesting, forecastable, important. That's the wrong question. The right one is: for which questions is someone willing to pay to discover the price? Because the price is never free, and the bill has to land on a willing payer. A market exists wherever a hedger needs to offload a risk, an advertiser wants the attention, a casino-style house wants the spread, a research sponsor wants the forecast, or a protocol will subsidize the depth. Where no one will fund the liquidity, there is no market — however good the question.

So the cost of liquidity isn't a footnote to the design; it's the binding constraint on the whole map of what's tradable. The set of markets that exist is exactly the set of prices someone is paying to discover. Change who's willing to pay — a new regulation that lets a hedger on, an exchange that decides a price is worth subsidizing, a sponsor with a budget — and the map redraws. The "free" price you read on a screen is the visible tip of a funding decision made somewhere upstream.

What's genuinely hard

I want to end honestly, because this is the part that's easy to wave away. Subsidizing liquidity at scale is a real, unsolved problem, and it's the reason the category is smaller than the list of things worth forecasting.

The subsidy doesn't shrink with ambition. Every market you want to stand up is a fresh \(b\ln n\) you expect to spend, and across a long tail of thousands of niche questions that line item compounds into something serious. You cannot subsidize the entire space of interesting questions; you can only fund the few whose value clears their cost. So most proposed markets never exist — not because the mechanism can't quote them, but because no one will pay the quote.

Tightening the spread to attract traders widens the subsidy — they're the same dial. Generous, deep, inviting markets are exactly the ones that bleed the most to the informed; cheap-to-run markets are exactly the thin, jumpy ones nobody wants to trade. There's no setting of that dial that gives you a deep market for free, which is the whole reason cold-start is hard rather than merely annoying.

And this is the seam where the work I spend my days lives. The cleanest way to make a subsidy affordable is to make adverse selection cheaper — to shrink the \(\alpha\,\ell\) the informed extract without widening the spread on everyone else. That means seeing who is trading and why: surveillance, position limits, the machinery that lets a market maker survive the people who know more than it does, inside the rules of a real jurisdiction.⁶ The formula for the cost is universal and copyable. Lowering it — so more markets clear the bar and more prices become worth discovering — is the part that takes a company.

So next time a market quotes you a price for free, remember that it isn't. It's the most visible thing in the system and the only part with no bill attached to you — because the bill was paid upstream, by whoever decided that price was worth knowing. Find out who that is, and you understand why the market exists. Find all the prices no one will pay for, and you've found the map of the markets that never will.