Market scoring rules are algorithms designed to produce prices that behave like probabilities and update smoothly as traders buy and sell. They are used to create liquidity and price formation in markets that might otherwise be too thin.
What a Scoring Rule Is
A scoring rule is a mechanism that:
- Maintains a probability estimate.
- Lets traders move that estimate by paying a cost.
- Ensures the system can always quote a price.
The most famous approach in prediction markets is the Logarithmic Market Scoring Rule (LMSR).
The LMSR Intuition
LMSR is popular because it:
- Guarantees continuous liquidity.
- Limits worst-case loss for the market maker to a known budget parameter.
- Produces smooth, probability-like prices.
Conceptually:
- The more you push a probability, the more expensive it gets.
- Small moves are cheap, large moves are expensive.
Why It Matters for Builders
If you build tooling, scoring rules matter because they shape:
- How sensitive prices are to trades.
- How much it costs to move a market.
- The incentives for informed traders versus noise.
Trade-offs
Scoring-rule markets have predictable strengths and weaknesses:
- Great for small markets and early liquidity.
- Can be costly for large trades.
- Require a subsidy or liquidity budget to operate well.
Key Takeaways
- Scoring rules create “always-on” price discovery.
- LMSR is widely referenced because it provides bounded-loss liquidity.
- The tuning parameter determines how jumpy or stable prices feel.