Risk Markets And Politics

Monday, February 27, 2006


A philosophical interlude — Apropos of prohibition, Libertarians might want to address the economic obstacles to drug legalization. David Friedman once wrote that preventing someone from taking drugs is coercion, but preventing them from shooting you isn't. Unfortunately, the state of risk-sharing in healthcare is so inefficient that using recreational drugs or doing anything unhealthy effectively does impose on others' property in the form of higher insurance costs.

In order for health insurance coverage to be priced more specifically, genetic and other tests would have to be made available to insurance providers. There is an understandable concern that such information is "private", but since it is relevant to an insurance contract, there is no real justification for withholding it. Any reference to this kind of privacy is actually a Rawlsian appeal to social justice; one's bad luck or the price of one's bad habits should be shared with others. (Keep in mind, this point is basically a challenge to Libertarians.) Regarding some of the bad "luck", as disease-prone genes become more expensive, there will be greater demand for genetic intervention, thus the scare quotes around luck.

Recall that the distinction between "cure" and "enhancement" has long been a litmus test for the legitimacy of drug use. The double-negative (i.e. eliminating an illness) has been sanctioned while pursuing changes beyond the norms of performance and mood is usually frowned upon — but already legal drugs in the United States have been advertised in ways that blur the line between cures and enhancements, e.g. Viagra and its ilk. This is occurring unreflectively and points to a difficult philosophical problem on the horizon. Specifically, where is the line drawn between the elimination of hereditary diseases through gene therapy and the engineering of more positive traits? Especially when one is the "side-effect" of the other?

In relation to sports, performance-enhancing drugs are roundly disapproved, but life is not a zero-sum game. Excellence is not a negative externality. Should the same logic hold in genetics?

"Freedom" is "power" expressed as a double negative. Some of the most important philosophical problems of this century will relate to the identity and difference of these two concepts, whose similarity happens to be especially apparent in Mandarin Chinese.

Friday, February 24, 2006

Schedule One

The addictive potential of gambling has often been likened to drug abuse. How far does this analogy extend with respect to the future of prediction market regulation in the United States?

Risk-sharing or hedging is usually contrasted with gambling and is an important, if not the most important, legitimizing factor in the eyes of "commodity" market regulators. The quintessential hedging market is one where traders have equal and opposite risks. In addition to the pristine aspect of legitimacy, exchanges hosting these markets have the wind at their backs, benefiting from active trade. In the past, successful futures markets have tended to deal with "intermediate commodities", where producers and consumers of some commodity trade with one another. In the example below, all of the risk is nullified. Each participant has a pre-existing risk tied to an event that might occur. They can take positions that alter this risk with respect to the event. Before and after trade, total risk is somewhat crudely expressed as the sum of the absolute risks, but this schema captures the sorts of conceptual distinctions one encounters. (The sum of market risk is of course always zero.)

Risk BeforeMarket PositionRisk After
Trader A($1)$1$0
Trader B$1($1)$0

Now consider the following "schedule" of idealized two-participant markets:

Market 5:
Risk BeforeMarket PositionRisk After
Trader A($1)$1$0
Trader B$0($1)($1)

This is the storybook "hedgers" and "speculators" scenario. The hedger transfers risk to the speculator, who is essentially gambling, though skill may be a bigger factor than luck in his fortune.

Market 4:
Risk BeforeMarket PositionRisk After
Trader A($1)$2$1
Trader B$1($2)($1)

Here, both traders are nominally hedging, but at the margin are actually gambling by over-hedging. The previous two examples cast doubt on whether total risk should be used to distinguish "hedging markets" from "gambling markets". The total risk may not rise despite that fact that all participants are gambling, and to require total risk to fall may be too strict a criterion to allow any markets to operate.

Market 3:
Risk BeforeMarket PositionRisk After
Trader A($1)$3$2
Trader B$1($3)($2)

Here there is over-hedging to the point where total risk increases. Many would consider this to be a de-facto gambling market despite the fact that some hedging occurred.

Market 2:
Risk BeforeMarket PositionRisk After
Trader A($1)($1)($2)
Trader B$1$1$2

Still more blatant gambling: traders are "levering" up their pre-existing risk.

Market 1:
Risk BeforeMarket PositionRisk After
Trader A$0($1)($1)
Trader B$0$1$1

Finally, a pure gambling market where there was no pre-existing risk.

A hedge must refer to a specific risk. If Market 1 were tied to the outcome of a recurring coin-flip or card-draw, one could not argue that this non-correlated return stream was in fact a hedge since it could be used to reduce portfolio risk. Could one??

The philosophical differences are slippery. Even Superbowl betting is not a pure gambling market since various sports-related businesses may want to hedge financial risks associated with the outcome of the game. Or, to reiterate a favorite example, Michael Jackson, his producers, gardener and zoo-keeper could have hedged their fortunes by betting in the Tradesports market tied to Jackson's trial, a market sometimes held-up as an example of pure gambling frivolity. In these cases, one might reason that while the markets do allow for some hedging, in practice the vast majority of trade is gambling-related. Ok, but where is that line drawn and by whom?

In theory, the difference between hedging and gambling can be blurred or "deconstructed". More importantly, in practice, effective hedging often depends on gambling and the liquidity provided by speculators. Returning to the drug analogy, the Greek word for drug is pharmakon, which means both "cure" and "poison". The cure always comes with some "side-effect".

By now, some readers might be thinking, "Look, you are really missing the point. I don't care what you call it. To me, the implicit normative distinction between hedging and gambling just isn't there, so it should all be completely legal!" Ok, but it is often useful to reason with opponents on their own terms, forcing them into contradiction. Otherwise, you're vulnerable to "difference of opinion" hand-waiving.

Saturday, February 11, 2006

New York Summit Recap, Part 2

Russell Andersson spoke about Hedgestreet, which was the only CFTC Designated Contract Market among the exchanges officially in attendance at the "Summit". Additionally, Hedgestreet is a Derivatives Clearing Organization, and its contracts are fully collateralized, making them more likely to attract "real money". Andersson noted that some investment strategies and markets might be overcrowded, and that in addition to Hedgestreet's core vision of extending futures trading to retail clients, they are thinking of markets that would build capacity for larger players like hedge funds.

Andersson mentioned many intriguing possibilities, including markets tied to merger & acquisition events, equity earnings, credit rating actions, credit defaults, bankruptcies and IPO announcements. There seems to be demand out there for such contracts despite the fact that they will be correlated to existing instruments. Hedgestreet also has an eye on economic data release derivatives. Lastly, Hedgestreet is working with external market makers in an attempt to make their markets more liquid, but doesn't have plans for automatic market-making.

Emile Servan-Schreiber, CEO of NewsFutures mentioned a series of corporate internal prediction markets, including Eli Lilly markets on health insurance costs, drug benefits, and access to physicians. Emile made a joint presentation with Bob O'Brien of Corning on a prize-based liquid crystal display market. The market aggregates information across the LCD supply chain, from component makers to TV manufacturers to retailers, and it will be interesting to see if its use reduces the volatility of LCD prices. Corning is also running a conditional market on price elasticity, i.e. LCD demand is projected given various price ranges. O'Brien expressed some concern that the markets might be exploited or contaminated by competitors, and said that suspect traders might be weeded-out over time, although specific orders were confidential. In addition to rewarding accuracy, the market's scoring rule takes into account certainty and timeliness. Only the top 3 traders in each "tournament" receive prizes.

Servan-Schreiber was eager to cite his research with David Pennock and others on the predictive accuracy of play money versus real money markets. In short, real money markets were not found to be significantly more accurate. I would add that in some cases, play money markets might actually be more accurate, as they are not subject to structural factors like hedging or interest rates. Of course, then the problems are what will compel participation and information discovery? Emile gave two suggestions on encouraging participation in play money markets. First, participants should value the information; it should be intrinsically relevant to them. Second, the interaction with other traders is important, especially the recognition that comes from successful trading. The second piece of advice might be somewhat problematic from a predictive standpoint, as traders motivated by reputational pay-offs will tend to be risk-loving, and this sort of behavior is among the litany of explanations for the favorite-longshot bias. The same can be said about discontinuous prize-based payoffs.

Citing another paper by David Pennock, Servan-Schreiber mentioned that simple averaging of predictions is not very different from averages weighted by prior trader performance. This is somewhat surprising, and perhaps discouraging for the neural-network-based Owise, which apparently had no representatives at the conference. Now, real money markets to a large extent do weight previous performance, as successful traders can redeploy their winnings.

Additionally, play money markets in corporations might have real money implications. As Bo Cowgill appreciates, this is another obstacle to running internal real money markets as they might in some cases be a reasonable proxy for a company's publicly traded equity.

David Pennock of Yahoo Research Labs reviewed his dynamic pari-mutuel markets, and described ways to maximize liquidity in combinatorial markets with generic bidding languages. Standard pari-mutuel auctions encourage late betting and do not allow for position liquidation. Therefore, it's not possible to "buy low and sell high" as/when information is incorporated into the market. Dynamic pari-mutuel markets overcome these limitations with a price function that reacts to incoming information, and a side auction where participants can hedge away their positions.

Markets that allow for combinatorial bets are problematic because with n events liquidity is potentially spread-out over 2^n outcomes or 2^2^n bets. Of course, the market will likely only need to trade a very small subset of these outcomes. A generic bidding language would allow for bets on any specific logical outcome, e.g. "I win $1 if (A and not B) or C", but then the auctioneer must decide how to match trades, and will likely choose to maximize trade by matching only those orders that leave the house with no risk.

James Surowiecki, author of The Wisdom of Crowds, interprets appeals to the "marginal trader" as a manifestation of reliance on experts and the desire for centralized decision-making. While he believes there are certainly experts in the world who are good at predicting, it is very difficult to know who they are ahead of time for specific questions, and so-called experts are notoriously over-confident in the accuracy of their predictions. (One factor may be that their expert-hood compels them towards further reputational pay-offs.) Surowiecki also described a variation on the jelly-beans-in-the-jar experiment, where after a certain number of rounds the best guessers were grouped together and played more rounds as a group — but these "expert" groups performed no better than groups assembled at random. This case is perhaps an example of retrospective overfitting, whereby some guessers just happened to do well on a previous trials. Surowiecki, like most prediction market enthusiasts, is acutely aware of what kinds of crowds tend to fail and went over the basics of what makes a good predictive group, stressing independence, diversity, and low to negative correlation in biases.

Thomas Malone of MIT argued that advances in communication technology are broadly responsible for the long-term evolution of government and the spread of democracy, and projects similar decentralization in the corporate world. However, communication technology can also abet centralized authority, and it seems that its impact must be assessed on a case-by-case basis. For example, would Charles Schwab have enjoyed so much success if existing brokers could have cheaply deployed retail-targeted trading interfaces via the internet?

Finally, it's been one week since the conference and legal issues might already be heating up in the US. During that week, Intrade's PredictionX market on whether the prediction market industry will suffer a "legality shock" in 2006 has crept from the high single digits into the teens, while the contract for "major political validation" in 2006 has fallen from around 50 to the 30s. Validation is more likely in the UK, although one conference participant claimed that "three letter agencies" in the US were very interested and open-minded about prediction markets.

Some operations seem to be rather illegal, but since the law is vague and archaic, entrepreneurs may feel that the cost of not doing business outweighs the probability and degree of legal punishment.

Monday, February 06, 2006

New York Summit Recap, Part 1

The turn-out was excellent, but there were no big announcements or public tip-offs. This was more of a networking event than an informational seminar. The bankers and venture capitalists far outnumbered the university professors. Other industries with representatives in attendance included pharmaceuticals, autos, energy and accounting. Regulation is a significant concern and there is a sense that controversies over the legality of prediction markets may suddenly escalate, and that "the industry" should be prepared for this — or proactively press for changes in gambling laws. Here are some speaker highlights in no particular order. Watch for Part 2 later this week.

Trade Exchange Network CEO John Delaney expects the prediction market industry to experience 500% year-over-year growth in 2006, but played devil's advocate and examined various risks to this success. What if prediction markets are just a fad? Will the markets be able to improve liquidity? What if there is a major prediction market failure? Will the industry receive mainstream validation and how will this affect regulation? He seemed more concerned about the latter two questions, and proposed an industry association to help navigate these issues. For instance, the association could maintain a historical database of market results that would facilitate a general objective evaluation of prediction markets if there should be a notable specific failure. Bo Cowgill of Google thinks that an industry association could lobby for changes in gambling laws in the United States, but cautioned that it should also get non-corporate interests involved.

Delaney said almost nothing about the Intrade EBOT. When asked about it, he noted that Intrade is still plodding along in its quest to become a CFTC Designated Contract Market. It is unclear whether something is imminently in the works with the EBOT, or if Intrade has moved the venture to the backburner, looking forward to the less limiting DCM status. Delaney did report that Intrade is maintaining an internal prediction market on the date of their CFTC approval, but declined to give any prices. He also announced a "Prediction Market Experiment" and handed out username/password combinations to the audience which will allow them to participate in various play-money markets concerning the future of the industry and the concerns that he had previously outlined. (Some quotes will be included in Part 2.) Delaney also mentioned that rising interest rates are beneficial to Intrade, but acknowledged that higher rates will also distort the probalistic interpretations of their long-dated contracts since the interest isn't passed back to most depositors.

Charles Polk, CEO of Common Knowledge Markets, described the Turkish Avian Flu Outbreak Market, which was subsidized through the Gerson Lehrman Group. This was essentially a real-money market, but it was fully-funded. In other words, the traders competed over a pool of funds to which they did not contribute. Polk described it as an alternate way to compensate consultants (i.e., the traders). This is an interesting example with respect to gambling laws.

Chris Hibbert of CommerceNet is among the most well-versed in the legality of prediction markets and argues that such markets will improve their chances of favorable legislation if they can demonstrate that they are providing socially useful information. To this end, he seems constructive on real-money markets subsidized by information-seeking patrons, as in Charles Polk's case.

On an interesting technical note, while discussing Zocalo, Chris Hibbert described a way for exchanges to alter the liquidity of "N-way claim" markets by posting orders that can trigger the simultaneous buying or selling of the full set of possibilities. For example, consider this $10-per-contract election market whose width is $4 (13 to buy the full distribution minus 9 to sell it). The exchange can lower the Liberal offer to 5, tightening the market width to 3:
Conservative Party24522452
Liberal Party24622452
All Others21222122

The exchange is not exposed to the market because if someone buys their offer at 5, it immediately sells the Conservatives at 4 and the Field at 1, thus selling all possible outcomes for $10, or the full distribution at 100%:
Conservative Party24521452
Liberal Party24512451
All Others21221122

Presumably, all other trades are locked-out of the processing queue while the exchange flattens its exposure in this manner. It is not always possible for the exchange to find such a combination of trades. Even if there is a suitable combination, having it executed may actually increase the market width, as would be the case if the last example were iterated:
Conservative Party14522352
Liberal Party24512462
All Others1122--22

Most importantly, this method always decreases the market depth. In these examples, 1 contract of depth was added while 2 were removed. Unfortunately, it doesn't work in reverse (adding 2 to remove 1) because the 2 added contracts would have to be traded by others simultaneously. Even if market depth is always removed, it might be beneficial for an exchange to make these sorts of trades in order to capture commissions. This would be the case with Tradesports and its policy of charging price-takers commission, but not price-makers.

Marco Ottaviani discussed some subtleties of market and price formation. He stressed the no-trade concept. He described how market participants exaggerate the importance of the information and analysis on which they base their trades - their "secret signals" - and this among several other factors causes the favorite-longshot bias.

Koleman Strumpf summarised his paper Manipulating Political Stock Markets, which detailed the political gambling markets of the late 19th and early 20th centuries in the United States. He does not interpret the 1919 Black Sox scandal as being important in the fall of the original election markets, although he is working on a paper involving that scandal. He finds it curious that political parties are so reluctant to hedge their fortunes by selling themselves short in political markets, especially since it might often be desirable to appear weaker in order to make the opposition complacent and/or galvanize one's own voters.

Again, check back later in the week for Part 2 of the recap, which will include Russell Andersson of Hedgestreet, Emile Servan-Schreiber of NewsFutures, and James Surowiecki.