Risk Markets And Politics

Sunday, April 19, 2009

Demographics and Returns

The intensification of the pension crisis provides a reason to re-examine the long-term effects of demographic shifts on underlying asset returns. Increased longevity has strained retirement system funding and this trend is unlikely to abate. At the same time, most asset prices have collapsed, but as the current bust becomes less acute, what can we say about long-term prospective returns?

With longevity rising and fertility leveling-off, unless retirement ages rise commensurately, the ratio of non-workers to workers will go up. This will tend to create more demand for fixed-income assets, driving down yields. Something has to give, and retirement ages are headed higher.

What about equity returns? There is a sense in which the stock market is fundamentally a pyramid scheme. New participants are important, and equities will tend to rise along with population and participation. While the population of developed countries has been stable in the recent past, globalization has picked up the slack in this regard. There is little doubt that globalization is responsible for much of the non-illusory gains of the past twenty years. Now, even if we assume that this trend will continue, will the rate of change slow? Are we past the inflection point of global development? That would not be particularly supportive of equities. Of course it's not just a matter of bodies in the system, but what minds produce and consume.

On the consumption side, there are some disturbing demographic arguments out there, but one of the more initially plausible ones does not appear to hold up to closer examination. The "age wave" theory promoted by H.S. Dent is based on the observation that personal consumption peaks around the time that one is 48 years old. Dent graphs the US stock market alongside immigration-adjusted birth statistics lagged by 48 years. The peaks and declines seem to correspond, suggesting that equity returns are driven by this demographic consumption effect, and that the best days are behind us for some time.




There are a few problems with this argument, one being that such a model does not actually seem to correspond to aggregate consumption. For one thing, US population has drifted upwards in the last 20 years, swamping the consumption-by-age effect. But what if overall population levels-off? Higher retirement ages could again help, as the peak consumption age would presumably also rise.

More importantly though, there are two distortions in the data as Dent presents it. He bases his consumption-by-age curve on the annual BLS Consumer Expenditure survey. One issue is that the survey is based on households, not individual consumers, with the breakdown by age cohort referring to the "reference person" of each household or "consumer unit". This means that if a household has children, the consumption of the reference person as a function of their age will be overstated. If the goal is to model future consumption rates based on consumption-by-age, the model should isolate the latter and not try to predict future fertility rates. When child consumption is mixed with that of the reference person, consumption-by-age is conflated with past fertility rates. Now, when you adjust the BLS data for the average number of children in each household (assuming that children consume some small percentage of what adults consume), the peak consumption age rises to the mid 50s from the late 40s. Not to imply that relative fertility-by-age is constant, but that peak is drifting higher, pushing the conclusion in the same direction.

Furthermore, you will notice on the first graph above that the y-axis has no scale, giving the impression that the consumption of 65 year-olds is roughly that of 25-year olds. When you actually look at the BLS data, adjusted or not, this is simply untrue. The 65-74 cohort consumes less per capita than the 25-34 cohort, but the fall-off is nowhere near as dramatic as Dent presents it. While the granularity of the data does not allow us to compares 65- and 25-year-olds directly, their consumption certainly is not equal. If anything, consumption does not decline back to the 25-year-old level until around 75. When you put all of this together, along with UN projections of US population, aggregate US consumption as a function of demographics only will continue to rise despite a greater percentage of Americans being past their peak spending age. One is much more confident then in dismissing the second graph as an accident of history.

All of this just begins to address some questions that are very pertinent to prospective returns.

Sunday, February 01, 2009

The gold trade isn't too crowded yet

The long gold trade isn't yet crowded because, although the pundits on CNBC have been capitulating over the past couple of months, it still seems like every other commentator has at least one of the following ideas, answered here.

1) Gold is not a true commodity. It's largely useless.

This is true, but of course the question is rather what is the use of paper money, increasing in supply, and paying no interest? Large changes in gold prices have little to do with what value it has as a commodity. It's more useful to think of gold as a (negative carry) currency. But you can't buy milk with it at the corner store? You can't do that with yen outside of Japan either, and privately issued gold-backed notes are feasible. It is easier to turn a store of value into a medium of exchange than the reverse.

2) Gold is just a safe-haven that you only buy if you think the world is going to end. With all that happened in 2008, if gold didn't go up then, when is it going to go up?

Gold had a positive return in 2008, and the drawdown of 30% was pretty muted for a "commodity." Given all of the de-leveraging, you could instead interpret this as impressive relative strength.

More importantly though, the generic "safe-haven" argument is suspect. Gold is not particularly correlated with measures of market risk like credit spreads and implied volatilities. If gold were a generic safe-haven, it wouldn't have a near-zero correlation with the VIX for example. Gold is a monetary safe-haven, and the generic safe-haven concept is largely a straw-man meant to conjure-up crazy gold bugs living in cabins stocked with guns. There are disasters that might be sufficient to take the generic safe-haven idea more seriously, but they aren't necessary for gold to go up.

3) We are experiencing deflation. Gold only goes up during inflation.

Well, first, what sort of inflation do we expect some months out? Second, gold has historically gone up during periods of deflation, and notably in those periods corresponding with multi-year boom/bust credit cycles (where the busts tend to be labeled "depressions"). The fact that gold declined during one period of disinflation of the 1980s colors many trader's view on this. When the predominant concern is inflation, gold will tend to fall with inflation expectations, but in deflation money appreciates relative to stuff, and gold, again, is closer to money than stuff. I'm not going to push this specific point too hard though because I don't think we have enough useful data on it. Most of the data we have is from the 1800s, where of course we were on the gold standard, so the comparison isn't quite fair for that and other reasons. Here is an interesting paper on the historical behavior of gold under deflation. Judge for yourself. Note though that the recent low inflation number in Europe allows the ECB to cut rates in order to fulfill their single mandate of promoting price stability. Two weeks after the HICP was released, gold broke out against the euro. Five days later it broke out against the dollar. Only the yen was left standing against gold and now in the past couple of days it's also succumbing in relative terms. What would happen if the JCB intervenes to weaken their currency?

The options on the December 2009 gold futures roughly give a 20% chance of those futures expiring above $1500/oz, and a 10% chance of them finishing above $2000/oz. If anything, the options might be a crowded trade, and an outright long is more appealing to me here. My main question is what price level will provoke some undermining public policy response, or credible threat thereof?

Anecdotally, Treasury is offering gold at over $1200/oz.

Saturday, October 18, 2008

Intrade offers an explanation of strange trading

Intrade has made a statement on the unusual trading that many have noted and alleged to be manipulative. The statement suggests that the price action is mostly attributable to a single firm, a hedger "using our markets in good faith and in the ordinary course of their business."

The first company that comes to mind is Centrist Messenger. Centrist is an interesting firm that re-sells political ad time and refunds sales to customers whose candidate loses. Centrist has stated publicly that it uses Intrade to hedge this exposure.* If Centrist had something to do with the unusual trading, it suggests that they sold more Obama than McCain ads, creating exposure to a GOP victory, resulting in McCain buys and Obama sales on Intrade. Why such a firm would be such urgent price-takers isn't fully explained.

Whether or not it was Centrist isn't important, but as these markets mature we should expect them to attract more hedging activity, and this might introduce persistent price distortions. Indeed it makes sense for people in the top tax bracket to be long Obama apart from considerations of his chances of victory. This is another uncomfortable subject that I've warned about in the past. When these markets become deeper and more widely available, the odds of the high-tax candidates might begin to show an upwards bias, a risk premium. Interestingly, Musto and Yilmaz predict that such markets will eventually lead to increased promises of redistribution by candidates. Talk about unintended consequences.

Intrade is doing the right thing here though, dealing with tough issues realistically and with as much transparency as possible. They provide valuable information, for free, even in places where they are not necessarily welcome. The depth of this information helps us to evaluate Intrade prices and have more confidence in them. Here is an example below, based on Obama's market over the past two weeks. Some have noted that the purported attacks occurred in hours where the market was unusually thin. This chart measures such price manipulability. The red line represents the ease of a downwards attack. It is the 100 x the amount of margin required to sweep the top fifteen bids divided by the difference between the highest bid and the fifteenth highest bid. (That is, how much the probability of an Obama victory can be moved by risking $100. Commissions are not taken into account but would of course would be vital.) The green line is the ease of an upwards attack. This is a very preliminary study and I will leave it to others to voice initial impressions. The fact that we can gauge to what extent traders are exercising market power is in itself important however.



* Technically another firm does the trading. Centrist is incorporated in the US, and the trading firm is incorporated in St. Kitts. Through this arrangement, Centrist cleverly avoids violating UIGEA.

Wednesday, October 15, 2008

The gamble of downplaying manipulation

Whether it is GOP bias, manipulation, or simply confident well-funded traders, there is some agreement that the Intrade presidential markets have been affected by "non-informational" trading. To be clear, this is not a condemnation of Intrade. The exchange's liquidity and trader diversity are hamstrung by archaic laws in the U.S., the continuation of which will frustrate a fair assessment of market accuracy. The point is that arguing for legal and regulatory change while downplaying the viability of manipulation and other market pathologies is counterproductive.

That prediction markets may be manipulated with some persistence should be no surprise to anyone who has followed the subject in the past couple of years. Here is a sampling of some of the warnings:

The HRC attack, part 2
The Giuliani manipulator buyer is back.
Manipulation can affect prices.
Is there manipulation in the Hillary Clinton Intrade market?
Is there manipulation in the Hillary Clinton Intrade market? Redux
Measured Enthusiasm For Prediction Markets

We now even find some academic papers that admit that manipulative trading may be profitable given certain assumptions. It is up to readers to decide which papers contain the most "stylized" assumptions.

No-one argues whether, in the long run, in general, manipulation is a losing proposition that subsidizes other traders — but is it really prudent to deploy that message, in comments to CFTC for example?

First, if Obama wins the election, based on the other available markets and poll projections, it would seem that an error had been introduced into the largest and most widely-cited of prediction markets. When comparing market and poll accuracy over time we are usually talking about only a few percentage points difference, so this error isn't trivial. Furthermore this is a market that takes place only once every four years, so long-run arguments ring a little false. There's no reason why something similar couldn't happen in 2012. At least, one is optimistic that the regulatory situation will improve and Intrade's traders will be more numerous and less capital-constrained at that time, which should make manipulation more difficult on average. Those who downplay the dangers of manipulation risk such goals by sacrificing their general credibility. It's a negative skew proposition.

Second, some markets can irreversibly affect the outcome they predict. This happens infrequently and requires some fundamental basis, but specific cases can spectacularly undermine a general argument. This is the old bit about trying to cross a river that's three feet deep on average. An example we've seen recently: when a business is predicated on maintaining a deposit base or borrowing short-term at certain rates, manipulation might be irreversible if it targets confidence or attacks the business's funding costs. In essence, the manipulator forces the (possibly quite liquid) market to "settle" as the firm approaches insolvency, and prices do not snap back. Breaking a currency peg has a similar dynamic. Now, there is currently no real analog to these situations in prediction markets as such, but either these markets will continue to be relatively small and not widely-followed, or ....

Kenneth Arrow and Intrade CEO John Delaney are making the right arguments here: transparency in the form of more public markets, along with less concentrated risk, would have helped avoid this crisis. But don't try to sweep uncomfortable subjects under the rug. That won't end well.

Monday, October 13, 2008

Disneyland burned down

Satyajit Das, in his 2006 book:

Dealers on exchanges charge clients a fixed commission to trade; the cartel of dealers means that clients have no choice other than to deal through them. The dealers are fierce advocates of competition except where it affects them.

In the OTC markets, dealers are more creative — they ensure that the clients do not know the true price of what is traded. The lack of transparency lies at the heart of derivatives profitability. You deny the client access to up-to-date prices, use complicated structures that are hard for them to price, and sometimes just rely on their self-delusion.

In the late 1990s, I was visiting Mumbai. The stock exchange was debating a move to electronic trading, but there was resistance. They invited a Nobel-Prize-winning US financial economist to speak at the conference, seeking to win over brokers to electronic trading. The economist spoke eloquently and movingly of 'greater trading efficiency', 'lower transaction costs' and 'greater pricing transparency'. The audience was almost in tears — of laughter.

It's one thing when opaque markets allow dealers to disguise trading costs. Our traders in Mumbai knew that to be a real source of profits, and one that would merely bleed their clients. More insidiously, opacity allows losses to be mis-represented. Before even considering the shortfalls of the Gaussian, it's obvious that the surest way to deliver a shocking tail move to the market is to just not mark (that is, mis-mark) prices. It's not clear to what extent the meltdown was actually a failure to predict as opposed to the result of skewed incentives and conflicts of interest along the chain beginning with mortgage origination and ending with the shareholders, who may have not even realized that they were in the security warehouse business. The models and the rating agencies gave the "right" answers, but who thought they were the correct ones?

In any case, the market thinks that public exchanges and clearing companies are among the winners. It was only a few months ago that the DOJ questioned the legality of exchanges such as CME operating clearing businesses. There is little doubt that the "Four Seasons" consortium of banks was behind those concerns. We haven't heard from that group for a while now, but perhaps soon. One is tempted to quip that they might be down to only one or two "Seasons", but the banks that make up the consortium stand relatively strong.

Meanwhile, the CME's regulator finds that its prestige has increased relative to the SEC. Why should the CFTC be under periodic Congressional review but not the SEC?

Timely public prices and agent incentives make a crucial difference. I hope that the implementation of TARP and other government programs will not be lacking on these points.

Sunday, August 03, 2008

Regulated US election markets might not be so hard

Based on the arguments Hedgestreet presented in its response to the CFTC on event markets, the exchange has a fairly strong justification to self-certify and begin trading election futures, soon. While most event markets trade as binary options, and the CFTC has flexible discretion over options per 7 U.S.C. § 6c(b), the Commission does not have direct discretion over approving DCM futures that conform to the Commodity Exchange Act, by 7 U.S.C. § 7a-2(c)(3). Therefore, a vote-share or electoral college future is more feasible at this moment than a winner-take-all option, although the latter is more useful as a hedging vehicle.

The major question here is what degree of trading restrictions the CFTC considers appropriate in order to fulfill the CEA's "beyond the control" criterion of excluded commodities. There is little doubt that low position limits alongside candidate death contingencies and prohibitions on trading by candidates, their staffs, members of the electoral college, and their proxies would not satisfy the CEA in this respect. The challenge lies in enforcing such trading prohibitions. I hope that Hedgestreet is in the process of developing a framework to do so. The CFTC could also issue an interpretive letter on this specific point, without addressing the more general, challenging issues related to their jurisdiction over event markets.

If Hedgestreet's trading restrictions are conservative and rigorous, it is improbable that such a self-certification would put Hedgestreet in bad graces with the CFTC. Alternatively, Hedgestreet could submit the futures (or options) for approval under CFTC regulation 40.3. If they do so, the CFTC has 45 days to review the products, at which point they could render a decision or extend the review process. In the meantime, however, Hedgestreet could be in communication with the CFTC and NFA concerning the development of trading restrictions, which again should be the main point of contention here, as there is no doubt that such event markets are associated with an "economic consequence". Note that CME does not even believe that trading prohibitions are necessary, citing the role of the Fed in determining interest rates and the lack of problems there with respect to manipulation. I tend to believe that the Fed and interest rates is a special case, not to mention that it is treated differently in the CEA, and that it is prudent to impose special trading restrictions on political event contracts. Those restrictions, however, can remain flexible and be loosened over time, especially the position limits, as the market grows.

Given the current political climate in which the CFTC operates, the Commission may welcome such an active stance from Hedgestreet and other DCMs on this issue, as it will allow them to take a more passive role in the process. In the case of vote-share, electoral college and tax futures with appropriate trading restrictions, the Commission would simply be complying with the CEA by allowing such contracts. Allowing winner-take-all options would be incrementally more sensitive for the CFTC given their additional discretion in such cases. In any case, I think we have passed beyond the point where there is any material doubt that such markets are bona fide excluded commodities.

Saturday, July 05, 2008

My response to the CFTC on event contracts

Here is my response to the CFTC's "Concept Release on the Appropriate Regulatory Treatment of Event Contracts." I appreciate this opportunity to help in working towards regulated prediction markets in the US, and I thank the Commissioners for it.

Given the political implications of the rise in commodity prices, this is not the best environment in which to begin regulating markets like election contracts, but the consensus that seems to be building on the relevant questions is rather auspicious. Hedgestreet and I have presented similar legal and regulatory frameworks to allow for at least the types of election contracts we are familiar with through sites like Intrade. Given Hedgestreet's vigorous and incisive comments, I regret not having argued more for the desirability of non-intermediated exchanges.

In their focus, however, Hedgestreet steered clear of the gaming pre-emption questions and did not present a comprehensive and general framework for event markets. In that respect, their broaching of the CFTC's plenary option authority opens more questions than it answers, but several interesting and important markets could perhaps be traded without answering all such questions.

I encourage Hedgestreet to begin working with the NFA to develop the infrastructure necessary for the types of trading prohibitions that we each described in our comments. I encourage the CFTC to act decisively in light of the self-evident and massive value of certain event markets — even with the current political pressures, which are mainly relevant to event markets on a superficial level. Perhaps if the CFTC deems that an exercise of emergency powers is necessary at some point, that would be an appropriate day to also make a decision on event contracts public.

We are at a specific point where a little bit of additional regulation might cause an explosion in legal prediction markets, and possibly soon. As a libertarian, I generally dislike regulation, and of course it’s true, pretty much by definition, that over-regulation is bad, but I don't believe that to be the most effective message for this comment process and the unique opportunity it presents.



June 30th, 2008

Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st St. N.W.
Washington DC 20581
Attention: Office of the Secretariat

Re: Concept Release on the Appropriate Regulatory Treatment of Event Contracts

JURISDICTION AND EVENT MARKETS IN GENERAL

Given the explicit statutory definitions of “excluded” and “exempt” commodities, it is reasonable to conclude that the U.S. Commodity Futures Trading Commission (“CFTC”) has jurisdiction over all exchange-traded event markets. That is, if an "occurrence, extent of occurrence or contingency" does not meet the additional "beyond the control" and "economic consequence" criteria, then contracts on such events should be considered exempt commodities. While currently all exempt commodities are associated with a deliverable other than cash, the open-ended definition of “exempt commodity” considered alongside the definitions of “commodity” and “excluded commodity” in 7 U.S.C. § 1a imply that contracts on events that are not beyond the control of participants or do not involve an outcome of economic consequence are exempt commodities.

This conclusion presents enforcement issues that the CFTC may wish to avoid, such as being obligated to pursue actions against exchanges offering contracts based on the outcome of sporting events. Unfortunately, without further statutory clarification, this conclusion seems like the most defensible one, based on the letter, if not the intent, of the law.

That said, until statutory clarification is attained, given the purposes and history of the Commodity Exchange Act (“CEA”), it would be appropriate for the CFTC to only assert jurisdiction over those event contracts satisfying "economic consequence" criteria, which would include the price discovery aspect of the former economic purpose test. An interpretation to this effect by the CFTC would not be inconsistent with the text of the CEA, and would best serve to minimize the burden on interstate commerce. This policy decision would effectively reconstitute the pre-Commodity Futures Modernization Act economic purpose test for event contracts in a way that avoids unwanted enforcement issues. Such a decision would be unlikely to meet significant resistance until such time that further statutory certainty is forthcoming.

The CFTC would be free to classify such contracts as either excluded or exempt commodities depending on their susceptibility to manipulation, before or after special trading prohibitions are in place. Although the anti-manipulation requirements that apply to exempt commodities are directed towards price manipulation, a fortiori they must also apply to outcome manipulation.1

The CFTC is free to determine what qualifies as "economic consequence." As with the economic purpose test, significant hedging and price discovery functions would comprise the principal criteria.2  Regarding the latter, since event derivatives have no corresponding “cash” markets, the origination of prices that may improve economic decisions is all the more desirable in these cases. Furthermore, events that may only directly affect a group of private individuals may also have a strong bearing on commercial decision-making. Note that some general events and measures, as categorized and listed by the CFTC in its Concept Release, do in fact correspond to economic measures.3   Even if these events do not predictably correlate with asset prices, they may have predictable effects on market volatility. For example, from 1980 through present, the annualized weekly volatility of the S&P 500 in weeks in which a presidential or mid-term election took place was 19.97%, vs. 15.34% for all other weeks.4  It is difficult and ultimately undesirable to provide a quantitative recommendation for a bright-line demarcation between those markets that would satisfy an economic consequence criterion and those that would not. However, if a significant statistical test can easily be found that includes the price series of a more familiar asset, and has a logical basis, we can reasonably say that such events are associated with an economic consequence. In many cases the relevant time series may be unavailable, but in those cases the applicability of a proposed event market to other assets may be obvious. For example, consider a market predicting the likelihood of: (1) ethanol-related legislation, and its relationship to corn prices, or (2) offshore drilling legislation, and its relationship to oil prices, or (3) an attack on Iran, and its relationship to oil prices, or (4) future tax rates, and its relationship to municipal bond prices. In such cases, no quantitative test is necessary. In other cases, we may have moderately strong reasons to suspect that a given event or measure has an impact on asset prices, as we do with demographic trends, but those effects may be difficult to measure empirically.

Many potential markets may improve decision-making for a particular business, but have little bearing on the broader economy and asset prices in general. Examples of these markets include those predicting: (1) the revenue of a particular product, published title, film or performance series, (2) the launch or completion date of a particular product or project, and (3) the success of a particular approach applied to certain problem. The CFTC may find that only broad-based events or measures affecting an entire population, industry or significant percentage thereof would satisfy the economic consequence criteria. This would be nothing new, as commodity derivatives were not intended to be specialized insurance contracts. Such narrow questions also present issues from a manipulation and insider-trading perspective. In aggregate, these sorts of questions are quite relevant to the economy and will at times reflect broad trends, but may be more appropriately served by over-the-counter arrangements or riskless information aggregation, despite the obvious advantages of market incentives.

Contracts satisfying economic consequence criteria need not be approved for listing by the CFTC, though it is hoped that guidelines will be made public and remain flexible. At the limit, the CFTC will recognize that even a purely speculative market might serve an economic purpose in reducing portfolio variance.

Additionally:

The CFTC might levy a special fee on regulated event contracts to recoup expenditures related to a trading prohibition facility and other special demands on resources.

It may be required that exchanges pay interest on binary event contract collateral in order to reduce price distortions near extreme prices (100% and 0%). In illiquid markets, such distortions could be used to disguise transfers of money between anonymous participants.

The CFTC should welcome Securities and Exchange Commission opinion on contracts based on events like earnings and dividend announcements, a group of which might begin to replicate a security. Whenever a market is proposed that reflects the cash flow of a particular business or property, this opinion may be relevant.

To the extent that they subsequently conform to the CEA and CFTC policy, amnesty for any past violations should be considered with respect to Intrade and similar exchanges that have operated legally in their domestic jurisdictions.

ELECTION AND POLICY EVENT CONTRACTS

Election and policy event markets are within the jurisdiction of the CFTC based on the letter and spirit of the CEA. These markets represent the largest reasonably predictable yet unhedgeable risk facing businesses and the public. The regulation of such markets follows from the history of enlightened, flexible innovation exemplified by the CFTC. Because of their importance, election and policy event contracts naturally involve special consideration, although only in the course of satisfying the CEA.

Considering election contracts:

Trading prohibitions should be established such that candidates and proxies cannot participate due to their ability to determine the outcome of the contract. In addition to adhering to the "beyond the control" requirement of excluded commodities and general anti-manipulation precepts, the CFTC will want to consider to what extent such prohibitions might be expanded to act as insider trading restrictions similar in form to those of 7 U.S.C. § 13(f) or the proposed H.R. 2341.5  Especially given the all-or-nothing nature of many event contracts, this might be desirable in order to provide for fair and equitable trading.6  

Upon the death of a candidate, the candidate's contracts and those of all competitors must settle on the last known price before the event. A new set of contracts reflecting the new set of candidates could subsequently be offered.7  

Analogous rules could be applied to policy and legislative contracts where appropriate. These rules, either directly administered by the CFTC and related associations, and/or required of exchanges, would firmly address outcome manipulation.

Because of their importance and sensitivity, these contracts also require special measures to ensure against price manipulation. However, it is important to note that election and policy markets have typically been traded as binary event options. Such contracts expire at a specific time according to a well-defined objective event and in that way are more resistant to manipulation than futures and perpetuities, the prices of which are unbound in one direction and always open to interpretation based on unobservable factors and developments in related markets. At the same time, the relative detachment of event contracts from the web of more familiar asset prices may make manipulation more difficult to prove.

As would be expected, large trader lists could be maintained and closely followed. A more powerful option is the enforcement of extraordinarily low position limits, which would greatly reduce the potential of price manipulation. At the same time, position limits should respect outstanding risks participants may have and be otherwise unable to hedge, as with traditional hedging and speculative limits. Low position limits also address trader protection concerns if such contracts were to be offered in a non-intermediated fashion. Leverage might likewise be limited. Several tiers of opt-out protection could be available to traders of various capitalization and expertise. Contracts might also be restricted to limit orders in order to curb short-term feedback trading.

Election and policy contracts ought to be restricted to domestic accounts only. This will avoid possible extradition problems where disciplinary action is required. In the case of event contracts that may reflect tax rates, this restriction will also determine that the Department of the Treasury will not lose revenue on a net basis.8  

FLEXIBLE LEGAL IMPLEMENTATION

Instead of, or in addition to, claiming jurisdiction over some event markets, the CFTC has at its disposal a range of public interest exemptions, including some that interpret the 7 U.S.C. § 6(c)3(K)9  qualification clause liberally in order to include participants who might not normally trade in traditional futures and options markets. From my perspective, such exemptions may allow for a more flexible development of event markets in a less heavily-regulated environment. For example, it might allow for a contract in research science claims where trader-researchers capable of determining the outcome are not readily identifiable, or provide for trading in the sorts of narrow, business-specific questions previously mentioned. From the CFTC's perspective, a public interest exemption may be desirable in order to avoid making a firm jurisdictional claim. However, the outcome of this comment process should be a decisive policy statement from the CFTC, not a sequence of ad-hoc actions. It is hoped that any future public interest exemptions would be offered alongside a substantial list of requirements and guidelines that would at least signal jurisdiction over a class of event markets possessing certain characteristics. Legal certainty is perhaps the most important outcome in this process, and it is not desirable for the CFTC to extend exemptions in a manner that leaves its jurisdiction completely ambiguous with respect to the markets so exempted.

This leaves aside the question of who may operate such markets. If exempted exchanges are to operate for profit, a jurisdictional statement from the CFTC is all the more necessary in order to ensure their legal standing. Exemptions directed at non-profits may be superfluous from a perspective of legal certainty, especially if such exchanges only offer trading in States where the predominant factor test holds.

The CEA allows that public interest exemptions may be issued for specified time periods. The CFTC may wish to consider to what extent exemptive or no-action letters with renew-by dates attached might be a useful tool in light of evolving legal conditions and technologies.

Note that theoretically the CFTC could also assert jurisdiction over all event markets and then direct no-action letters to the finite list of sports and gaming exchanges as a facility to repudiate jurisdiction over such markets. Typically, exempting markets formed principally for speculation would be considered against the public interest. However, if the CFTC finds no satisfactory way under the CEA to take jurisdiction over only those event markets that are associated with economic consequences, no-actioning sports and gaming exchanges would be in the public interest on a net basis, and would best promote interstate commerce. Furthermore, in some cases such exchanges operate under their own regulatory bodies and protections. It is also seldom that such exchanges allow for leveraged trading by beginner participants. In general, most gaming takes place via over-the-counter transactions.

THE PUBLIC INTEREST

I have neglected to argue for event markets in terms of the public interests they promote as these facts have been covered by others and have no doubt been obvious to the CFTC for a long time. I will only note some cases that are more subtle:

Information and estimates can be revealed in conditional form, as in the "decision markets" hosted on Intrade.10  One such market pays 100% if a Democrat is elected President in 2008 and the national debt rises in the calendar year preceding October 2011. Since the probability of the former event is also available on Intrade, by P(A | B) = P(A & B) / P(B), we can say that the probability of a Democratic president leading to a rise in the national debt is the decision market price divided by the election market price. This type of market is thus able to predict the result of electoral or legislative decisions, and different decisions can be so compared. With this in mind, consider that while prediction markets are usually described as ways to aggregate information, they are likely also useful in terms of collective problem-solving, even in cases where all information is transparent.

In terms of risk-sharing, eventually the utility of political event markets might begin to address some well-known problems with representative government. Consider the typical special interest problem in which a few relatively well-funded individuals would gain heavily by a particular piece of legislation such as an industry subsidy, and so will lobby heavily for it. Even if the legislation is not in the public interest, the costs will be distributed over so many tax payers that they will not care to argue against it, and most will not even realize what’s happening. When mature legislative and public policy markets are in place: (1) the dispersed interests will have the recourse of hedging against policy they dislike, (2) special interests will also have the option of hedging their legislative fortunes, which might lead to an overall reduction in lobbying, and (3) legislators may find compromises to be easier, since interests would be able to voluntarily "meet each other half way," with price being the arbitrator. This could ease political log-jams, making law-making itself more flexible and efficient. Sensible yet otherwise politically infeasible measures such as unwinding entrenched subsidies could be made viable.

Even if iterations are required, the outcome of this comment process should be a clear statutory interpretation and policy statement from the CFTC regarding event markets. The CFTC should also publish self-certification guidelines for those markets that it determines are within its jurisdiction. Once jurisdiction and/or a public interest exemption framework is determined, it should not be ambiguous whether, for example, a contract based on a presidential election would be approved by the CFTC in principle.

There is good deal of apprehension among those who study prediction markets that regulation will stifle innovation. In truth, exchange requirements may not be as onerous as they are often portrayed, and in most cases are perfectly appropriate. A related, implied fear is that the CFTC may not approve certain contracts such as those on election and legislative events that undeniably possess economic purpose due only to their political sensitivity and considerations of the CFTC’s source of authorization and funding. I hope that this process will assuage such fears. I encourage the CFTC to act decisively and comprehensively in accordance with its purposes.

Sincerely,
Jason Ruspini

Footnotes:

1 For example, a market on infrequent terrorist attacks would not be approved for the simple reason that outcome manipulators could not reliably be identified beforehand.
2 cf. Robert Hahn and Paul Tetlock, “A New Approach for Regulating Information Markets,” AEI-Brookings Joint Center Working Paper (December 2004).
3 Justin Wolfers and Eriz Zitzewitz, “Using Markets to Inform Policy: The Case of the Iraq War,” NBER Working Paper (June 2004).
Justin Wolfers, Erik Snowberg and Eric Zitzewitz. “Partisan Impacts on the Economy: Evidence from Prediction Markets and Close Elections,” NBER Working Paper (March 2006).
Erik Snowberg, Justin Wolfers and Eric Zitzewitz, “Party Influence in Congress and the Economy,” Quarterly Journal of Political Science: Vol. 2: No 3, pp 277-286 (2007).
4 F-test (α = 0.1126). If we instead only consider the Wednesdays following election day compared to all other days over this same period, α = 0.0246.
5 The "Stop Trading on Congressional Knowledge Act".
6 Trading prohibitions on insiders will also avoid a situation in which candidates are able to enjoy a multiplier effect on their campaign funds by shorting themselves. For example, Candidate A has a campaign fund of $2, and candidate B has $1. By hedging, candidate A can maintain a $2 risk while spending $4 on campaigning while candidate B can only spend $2 to maintain a $1 risk.
7 cf. Intrade rules. A more challenging possible scenario involves manipulation preceding the event such that the forced settlement locks-in profits, presumably just as market power is exhausted. See note below on restricting market access to US-based accounts.
8 Such restrictions would however tend to limit the growth of such markets and/or result in risk premia accruing to short tax-rate positions.
9 “Such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections.”
10 For background, see: Robin Hanson, “Decision Markets for Policy Advice,” Promoting the General Welfare: New Perspectives on Government Performance, pp 151-173, Brookings Institution Press (November 2006).