Risk Markets And Politics

Friday, March 31, 2006

Developments concerning the symbiosis of politics and markets

The first story is a few weeks old, but bears mentioning and gives one a chance to visit the excellent Statistical Modeling, Causal Inference, and Social Science blog, where Aleks Jakulin commented on Harold Ickes' plans to create a database of (potential) Democratic voters, replete with details that will allow for targeted messages to marginal voters, a practice in which the GOP had taken the lead. There is some controversy among Democrats about the project, as Ickes, an adviser to Sen. Hillary Clinton, is forming a private company (backed by George Soros) to develop the database. This is perceived to be a snub of Dean's DNC by the Clinton team.

On another level, some have raised privacy concerns as the database will catalog rather sensitive details such as magazine subscriptions, gun ownership, and church attendance. Jakulin, however, points-out that technological efforts by the public to monitor the government are also expanding. The data-mining is symmetrical. Do see the list of such projects he compiled, as well as his work in 2004 analyzing similarities among Senators' voting patterns. This is fascinating stuff and possibly an important "Grundrisse", so to speak.

Next, anyone with an interest in legislation-linked markets will take notice of the controversy over Congressional "insider trading". Currently, it remains legal and technically ethical for members of Congress to trade stocks based on nonpublic information related to pending legislation or appropriations. A study, Abnormal Returns from the Common Stock Investments of the U.S. Senate, by Alan J. Ziobrowski and others found that between 1993 and 1998, Senators outperformed the market by 12% per year on average, whereas corporate insiders beat the market by only 6% annually. Based on his analysis, Ziobrowski has concluded that, "there is cheating going on, at a 99% level of confidence."

The SEC, which receives funding from Congress, has been reluctant to address this issue, but there is a new bill that is seeking to end such trading, as well as requiring firms that specialize in political intelligence gathering to register with the House and Senate, as lobbying firms now do. The title of H.R. 5015 is "To prohibit securities trading based on nonpublic information relating to Congress, and to require additional reporting by Members and employees of Congress of securities transaction, and for other purposes", but apparently the text also carefully includes "commodities futures". Would legislation-linked derivatives be considered "commodities futures"? Given their substantial hedging utility, let's assume so, although it's by no means cut-and-dry. Owing to partisan incidentals, there is some doubt whether or not the bill will even be passed, as Stephen Bainbridge disapprovingly observes. If it is passed, it would seem less likely that the CFTC would approve such contracts, as they are also funded by Congress. If not, legislators might be better disposed towards legislation-linked markets.

Finally, pointing even further down the road, AEI-Brookings has released a new e-book on information markets and their potential impact on public policy. Some of this collection was already available on their policy markets site, but there are some papers that you might have missed. Markets should be useful for collecting political information or hedging legislative outcomes, but thinkers such as John Ledyard, Paul Tetlock, Robert Hahn, Michael Abramowicz, and of course, Robin Hanson anticipate a time when market outcomes might influence public policy more directly.

Thursday, March 23, 2006

The Housing Futures Are Coming

Mark your calendar. On April 26th, futures on the newly-dubbed S&P Case Shiller Home Price Indexes will begin trading on the CME. It's not everyday that a $20-odd trillion asset class opens itself to exchange-traded contracts. This development was the subject of Tuesday's event in New York where the index's namesakes and others spoke and later fielded questions in a roundtable discussion moderated by economist and commentator Dennis Gartman.

We all know the arguments in favor of this market, and the latest contract details will soon be posted by the CME, so let's skip directly to the concerns voiced by attendees.

First and foremost, inquiring minds wished to know who the buyers would be. Hedging sellers abound from individuals to homebuilders to mortgage issuers and federal agencies to local governments. The natural buyers would be prospective home-buyers, trying to ensure that they aren't priced-out of the market, but the relative wealth of that group is - naturally - very small. This is by no means a fatal problem, but it is an obstacle to the market realizing volume and liquidity.

Ideally, the abundance of non-information traders (hedging sellers) would attract speculative buyers. Speculators, however, may be unwilling to stand against the massive weight of hedging, especially with such an infrequent spot price. Fortunately, it was announced that updates on the quarterly index would be released monthly on the last Tuesday of each month. It was suggested that the existing housing-related data releases such as sales, permits, starts, and completions would help to fill in the data void. Karl Case added that traders would no doubt gather their own information and that the futures would come to reveal this. Whether or not enough information can be gathered to overcome the influence on price of hedging, especially at the national level, is an open question. Robert Shiller noted that the term structure of the futures would likely settle into backwardation.

Lack of transparency and the "black-box" nature of the index was another big concern. Happily again, CSW announced that they would soon be publishing the full details of the methodology. Thus two of the major infelicities mentioned here in November were rather squarely addressed.

While most of the concerns dealt with the viability of the futures market itself, there was also the worry that the contract would increase the volatility of the underlying real estate, otherwise a relatively calm asset class. Robert Shiller brushed this off, saying that housing was already "like the stock market", a danger a questioner had posed. Dr. Shiller also noted the possibility of home prices being quoted in terms of futures prices. That is, rather than a fixed amount, the asking price might be advertised as some multiple of the appropriate regional index. That separate, earlier remark probably did little to sooth the worries of whoever asked the volatility question.

Skepticism inevitably surrounds new markets. Dennis Gartman recalled the eyebrows initially raised, for instance, at Nymex's crude oil futures. Again, residential real estate in the US tallies in at approximately $20 trillion dollars. One basis point (one percent of one percent) of 20 trillion is 2 billion, so volume may be impressive despite the worries. In terms of popularization, there was a good deal of talk concerning indirect trading of the futures, and it was suggested that most individuals would actually come into contact with the futures through OTC instruments packaged by institutions or through index-linked mortgages. An AMEX ETF tied to the index is also in the works.

Tuesday, March 14, 2006

Some Benefits of Legislation-Linked Derivatives

Though tiny and not significant in a technical sense, one of the more exciting data sets to become public of late is Randall "Duke" Cunningham's "bribe menu". Cunningham, a former member of Congress where he "served" as a member of a defense appropriations subcommittee from 1998 to 2005, redirected more than $150 million in defense contracts to a single company in exchange for over $1 million in cash and other gifts. The data set in question is a list of price quotes for favors, depicted to the right and detailed below:

Defense ContractPrice
$16 Million$140,000 + Luxury Yacht ("BT" = "Boat")
$16-$20 MillionAdd $50,000 for each $1 million above $16 million
$20 Million +Add $25,000 for each $1 million above $20 million

This is a fascinating look into the market for congressional favors. Alex Tabarrok was disturbed by how low the prices were, noting that they implied competition among congressional suppliers. The curve of this particular price scale along with the inclusion of a non-cash gift could mean that supply was only limited by money-laundering capacity. From the standpoint of the favor buyers, risking the illegal transaction provided phenomenal returns.

Returns are presumably much lower for legal campaign contributions of the sort one finds on Opensecrets.org. The outcome of legal contribution is uncertain and indirect, and some of it is probably downright futile. The lack of association between contributions and specific pieces of legislation (or contract awards) suggests that the process may be inefficient for the contributors. In many cases, prediction markets should be a more reliable and precise way for (special) interests to manage the risks of such outcomes. Promoting the creation of positive, pro-agenda legislation might still involve contributions, but when bills surface that are unfavorable to a certain group, legislation-linked derivatives will be more efficient than the current nebulous system. Actually, insofar as the current system is "efficient" for special interests, it approaches straightforward favor-buying; legislation-linked derivatives should reduce the demand for congressional favors. Sure, they could lead to a new market in congressional inside information, but this outcome would be less likely to distort the content of decisions made on the Hill.

Such markets would furthermore enjoy the advantage of natural counterparties. Perhaps competing special interests with opposite hedging needs could trade with one another, thereby partially disintermediating the government in their private affairs. More generally, any time a tax or subsidy is in play, the natural counterparties are the directly affected interest group on one side and every other taxpayer on the other side. Whenever a tax-break or subsidy is awarded to a special interest, this in itself implies an additional tax burden on every other taxpayer. The existence of markets to hedge such events from either side would, among other benefits, frame the operation of the government in a way that would encourage greater fiscal discipline.

Wednesday, March 08, 2006

Following the Money (and the Online Gambling Lobby)

Chris Masse, who graciously named RM&P "Blog of The Year" for 2005, has asked me what transpired at the "Event Markets & The Futures World" FIA luncheon which took place in New York last month. While much less touted than the "Summit", this short meeting was perhaps more significant and more telling of the future of prediction markets in the United States.

My first answer to Chris was that I had already written about the luncheon. I had noted over on Agoraphilia that Richard Shilts, Director of Market Oversight at the CFTC, said that the agency was considering the extent of its authority over non-hedging, price-discovery markets (i.e. "information markets", although no-one used that term on that day, and I only heard "prediction markets" once). Later on, a slightly contentious discussion addressed the difference between gambling and hedging markets. The essential ideas of those exchanges were toyed with in "Schedule One".

Representatives of companies enjoying less-than-cheery relationships with the CFTC may have been a bit uncomfortable that afternoon. Indeed, the event did little to relieve the fear that America's confused (and somewhat puritanical) attitude towards gambling has forsaken the quickly growing $11 billion online betting industry to the rest of the world, particularly to the rest of the Anglosphere. However, one was able to walk away with some doubt for the meme that has surfaced here and there that America's neglect of online betting will cause the country to fall behind in a new, important area of financial innovation. If nothing else, the list of US-based attendees, which was packed with top-shelf investment bankers, regulators, lawyers, derivatives industry groups and established exchanges was encouraging in that respect. While they are doubtlessly keen on innovation, online gambling is still a rather small business to that crowd.

In any case, legal online gambling in the United States is unlikely until there is a lobby behind it, but who will take that risk? The current legal gambling industries in the US, which include commercial and tribal casinos, state lotteries and sports betting operations, are not necessarily strictly opposed to online gambling as they are often accused of, but they are unlikely to lobby for it either. On the other side, since non-US companies already enjoy the business of American bettors, they are probably not going to argue for legalization that would bring them new competition from established local brands, even if the market were to grow in total size.

The fact that the stocks of overseas gambling companies are available to US interests also saps the potential life behind an online gambling lobby. Why bother when you can already share in the ownership of this industry?

Ultimately, either in terms of participation or investment, it may take an attempted crackdown to galvanize support for online gambling in the US. Markets that provide risk-sharing or some other demonstrable utility beyond entertainment should be less controversial, but as we know, these categories aren't completely distinct.