Risk Markets And Politics

Thursday, December 15, 2005

When The Dealing's Done

This morning brought interesting news concerning a potential CME bid for a 10 percent stake in the New York Mercantile Exchange. CME seems hungry to have a piece of every market, and this only reinforces my opinion, seconded by Chris Masse, that the Chicago exchange is positioned to become the leader in prediction markets and alternative derivatives in the United States.

The CME/NYMEX news comes on the heels of Intrade's release announcing their Exempt Board of Trade launch. The announcement stressed weather & economic derivatives, which currently are CME's turf.

The release also mentioned Intrade's intentions to provide markets in "credit risk." Now, bonds and fixed-income derivatives of course already represent credit risk. Is Intrade going to have contracts directly tied to credit ratings? Likewise, on the equity side, how long before someone broaches the possibility of having contracts directly tied to earnings releases? In any case, a proliferation of markets will be limited by liquidity cannibalism.

At first glance, Intrade's release does not seem to address the "eligible contract participant" restriction, which was the subject of most of the speculation over at Agoraphilia. However, I find this John Delaney statement interesting:
We bring not only our proven exchange technology to the table but will also provide a central counterparty [clearing house] to every trade and that should make financial institutions comfortable trading these markets.

Consider this successful 2002 petition from NYMEX to the CFTC, "for Treatment of Floor Brokers and Floor Traders as Eligible Commercial Entities and Eligible Contract Participants Pursuant to Sections 1a(11)(C) and 1a(12)(C) of the Commodity Exchange Act"

This petition came to mind because of this section:
NYMEX asks that its floor brokers and floor traders (collectively referred to hereafter as "floor members"), when they act for their own accounts and are guaranteed by an Exchange clearing member that is registered as a futures commission merchant ("FCM"), be permitted to: (1) Act as an eligible contract participant [...] (my emphasis)

If Intrade/TEN intends to provide a clearing house that will guarantee transactions regardless of traders' assets, perhaps they can make a similar petition? Likewise, as I suggested to Tom Bell, perhaps Intrade can create sufficiently-funded legal entities on-the-fly, as investment banks do with "special-purpose entities". A specific market on the TEN EBOT might then technically have two large counter-parties, and profits and losses could be distributed to actual traders in a pro rata fashion.

Still, I think regulators will balk at these structures if the goal is to allow for entertainment-oriented trading. Regarding these cases, Forbes writer Elizabeth Moyer notes that Intrade, "is exploring ways sports franchise owners, stadium owners and others in professional sports could trade to hedge economic risks to their industry, such as failing to make the playoffs." This is interesting, but where is the line drawn? Almost any market can be framed as serving some conceivable hedging purpose. For instance, would the Michael Jackson contract also fall under this umbrella, since it would have allowed Jackson, his gardener and zoo-keeper a way to hedge his legal fate?


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