Risk Markets And Politics

Tuesday, August 23, 2005

Hay-Maker (PAM, Two Years Later)

The Defense Advanced Research Project Agency's "Policy Analysis Market" was abandoned in late July 2003 under legislative pressure fueled by worries that it would encourage terrorist attacks, assassinations and coup d'etats. Of course, the project had merit and such event-linked futures were a secondary function. PAM's primary function was to price indices of economic and demographic prosperity in the Middle East, to which specific events of violent unrest would most probably be correlated.

Regarding the event-linked futures, the basic argument was that potential terrorists and their proxies who entered such markets would then be able to profit from terrorism. Or, more subtly, they could stay out of such markets and the market price would come to reflect only U.S. & allied intelligence. If tensions were high, potential terrorists could also "abstain" and sell short the futures since they would essentially be "insiders." To me, this was the basic problem with the event-linked futures component of PAM; the insiders and their proxies were inherently lawless. This will not be a critical problem with legislation-linked futures, where the "insiders" are legislators.

Nonetheless, I will make a couple points in defense of the PAM event-linked markets:

1) There were already plenty of highly liquid markets that would allow one to profit from terrorism by taking short or option positions in stocks, bonds, commodities such as gold and oil, or the exchange rate of the target country.
2) While it would involve overhead, it would be possible to do a background check on anyone betting on a negative event, at least as part of the settlement process. Perhaps they would have to demonstrate a legitimate hedging need? This would also dissolve the vague "moral" concerns directed at such markets, since they would then essentially be insurance markets. Viable futures markets tend to be insurance markets in the first place. The presence of hedgers, those who are compelled to enter the market as a side-effect of some other business or activity, greatly increases the ease with which a new futures market forms. NYMEX's as-yet failed crude oil and natural gas electronic markets bear witness to this, as hedgers are directed exclusively to the antiquated and opaque pit markets.

With pitchforks in hand, Senators Byron Dorgan and Ron Wyden of Oregon led the charge against PAM in July 2003. Their misleading haymaking succeeded in getting the project pulled. One could speculate that legislation-linked futures markets will face even more energetic opposition on The Hill, but ultimately there are some key differences:

1) LLFMs would be operated privately and would not receive government funding.
2) As was mentioned, there is no insider problem here. Or rather, insofar as there may be an insider problem, it is not intrinsic to LLFMs per-se, but to the legislators themselves. Legislators couldn't argue that they would be unable to police themselves. Could they?
3) LLFMs could be restricted to fiscal legislation so an insurance purpose could always be demonstrated. The first important LLFMs would probably only deal with fiscal legislation in any case.

Remember that this is will all happen under the larger umbrella of peer-to-peer insurance, which will allow ways to hedge more common risks such as home and energy prices.

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