Risk Markets And Politics

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.


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