From AMM to Order Book: Exploring the Evolution of Prediction Market Pricing Mechanisms

A prediction market is essentially a "future event probability exchange" where users express their judgments about events by buying specific options. Due to the uniqueness of predicting events, its pricing and liquidity mechanisms differ from those of common trading.

Early prediction markets adopted the logarithmic market scoring rule (LMSR) as the AMM mechanism, providing real-time liquidity and pricing for the market. The core of LMSR is a cost function model that calculates prices based on the share holdings of each option, ensuring that prices reflect current market expectations.

The main advantage of LMSR lies in providing unconditional liquidity, solving the cold start problem. However, its static liquidity parameters and non-profit orientation also bring limitations. As the market scale expands, these flaws gradually become apparent.

In order to improve capital efficiency, optimize trading experience, and attract professional liquidity, some platforms have begun to shift towards an order book model. The new model combines off-chain order books with on-chain settlement, balancing decentralized security with centralized trading experience.

In the order book model, price anchoring is achieved through the issuance and arbitrage cycles of shares. The system allows users to mint or redeem a pair of YES/NO shares for 1 dollar, establishing value anchoring. The free trading on the independent order book and the arbitrage mechanism together ensure that the sum of the prices of YES and NO approaches 1 dollar.

The combination of prediction markets and decentralized exchange ( DEX ) holds various possibilities. Prediction markets can provide native risk hedging tools for DEX users, and their price data can serve as a leading indicator for centralized liquidity management of DEX. In addition, linking DEX indicators with predicted events can give rise to new structured financial products.

As the user base continues to expand, prediction markets are evolving into the "risk pricing layer" and "information oracle" of the crypto industry. Their integration with foundational protocols like DEX will be a key factor in driving the DeFi ecosystem towards maturity.