Risk Markets And Politics

Saturday, November 05, 2005

Know When to Hold 'Em...

Mark Cuban is holding his cards closer to the vest nowadays, at least as far as his sports-betting hedge fund business is concerned. The fund was announced nearly a year ago and there's been almost no word since. One wonders to what extent the opportunities he was targeting such as inter-book arbitrage still exist. The uncertainty principle at work in trading is more intense than most other disciplines, and paranoia is likewise more advisable. Giving the gambling world a one year head-start may be too much to overcome. I also note Cuban's recent "What's an investor?" missive, which backs away from speculation, his definition of which implicitly includes sports gambling. It wouldn't surprise me if Cuban ultimately folds on the entire idea. To me, once the obvious hurdles are overcome, a legislation-linked futures exchange seems like a much better business anyway. Although both businesses seem a little shocking at first glance, regulators will recognize that legislation-linked futures provide a wholly legitimate form of "peer-to-peer" insurance.

Recently I've been focused on techniques of structuring markets that maximize liquidity. The primary strategy is choosing a market that will compel the participation of hedgers (insurance-seekers). This will tend to create an order imbalance, which will attract yield-seeking speculators, with the goal of bootstrapping the size of the market (and liquidity) up to its expected target, which can be guessed at by considering the total hedgers' risk and an estimation of their risk-appetites and internal liquidities.

Notice how different this approach is from a lot of the discussion on prediction markets. I stress the field and the formal aspects of the market, where others like to talk about the content of the market and debate whether the price is "correct", all the while assuming a certain interpretation of what the price should mean. Consider Greenspan's comment from Thursday: "The markets have become far more complex, and the simple relationships that the yield curve's slope indicated no longer worked." He is referring to an imbalance in the market's field that is invalidating the usual interpretation of price/yield. In the case of legislation-linked futures markets, the imbalances are more simple by orders of magnitude — and vastly easier to evaporate, largely because yield-seeking behavior resolves the imbalances in those cases!

Of course we all look forward to the day when prediction markets are used to save lives. I think this development will be coextensive with their graduation from the milieu of gambling/entertainment to something more like insurance. Most markets can somehow be framed as insurance markets, but I don't suppose Michael Jackson actually bet on his conviction, nor his gardener, zoo-keeper, etc! When trading becomes an end in itself, as a form of entertainment driven by the thrill of risk-seeking, that is gambling. Gambling is risk-seeking. Apropos of the internal/external market discussion, this explains the tendency of teams to trade richly in local betting markets, if that in fact still happens. Otherwise, you would expect more selling pressure as fans would tend to "hedge" against the subjective value of their favorite team's fortunes, rather than "levering-up."

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