Risk Markets And Politics

Wednesday, August 23, 2006

Nymex: "Evolution is Inevitable"

Nymex seatholders have for some time been contemplating the value of their trading rights versus the equity value in the eventually public exchange. On September 4th, Nymex will begin offering physically settled electronic energy futures. Although it was known to be in the works, this announcement is significant and cues the end-game of futures floor trading in the US. Nymex first launched regular-hour electronic contracts in 2002, but the addition was a half-hearted gesture given the exchange's commitment to floor trading at the time. Volume on the electronic side languished until last year, when competition from the ICE motivated Nymex to back the contracts more fully. Recently, full-size electronic contracts were launched as part of April's agreement with the CME. But even though the electronic side is seeing better volume, it is missing something important: physical settlement, which can only be found on Nymex's floor. Some speculators do prefer cash settlement, but hedgers and even banks, who are among the largest exchange customers in terms of open interest, demand physical settlement. Next month they will be able to get it electronically, and transparently.

Michael Sankowski's comments on bootstrapping markets reminded me of my experience with the Nymex electronic contracts from 2002 to 2003. Essentially what we had on the oil side were 10-20 market-makers and arbitrageurs — and virtually no-one else. Active markets need a diverse set of traders with different motivations and time-frames. You can't build a market with market-makers and arbs only, even if they are well capitalized. You also need to attract long-term (fundamental) traders, short-term (technical) traders, and of course hedgers, ideally on both sides of the market. (Participants that derive entertainment from their trading can help too.) In the case of Nymex, it wasn't that they didn't "know better". They knew their business well and didn't get behind the electronic contracts until competition made it a necessity.

Leo Melamed, who pioneered financial futures, once said, "[a market] is more than a bright idea. It takes planning, calculation, arm-twisting, and tenacity to get a market up and going." Likewise, Mark Fisher advised me before I left the Nymex scene, "Jason, you don't think right because you think everything is about thinking." This was an exaggeration but he was basically right. Then, at least.

The rise of electronic trading at Nymex is a reminder of how long apparent inevitabilities, or great ideas, can take to develop. This pertains both to developments of new markets and developments within markets. CNBC loves to stress the speed and excitement of markets, but perhaps what is more impressive is how slowly - how painfully slowly - things usually play out. Stocks in the late '90s. Housing in recent years. The current account deficit and the dollar. Concerning new markets, take Robert Shiller's housing futures, which were over a dozen years in the making &mdash and three seconds months after launch many want to write them off as a failure.

Saturday, August 12, 2006

Why we don't have tax futures

I was encouraged by the comments when Tyler Cowen linked to my last post on tax futures. There is, unfortunately, an obstacle that wasn't touched on. Tax futures would have a tremendous hedging utility and would therefore likely fall under the jurisdiction of the CFTC. The CFTC must be reauthorized by Congress every five years, and must pass through the Senate and House Agriculture Committees. (Incidentally, the House committee is headed by Rep. Bob Goodlatte.) The CFTC is also currently funded by the anachronistically named Senate Appropriations Subcommittee on "Agriculture, Rural Development, and Related Agencies". (Incidentally, this subcommittee of fifteen includes Sen. Byron Dorgan, who led the charge against the Policy Analysis Market and, ahem, always demonstrates such a kind eye toward market mechanisms.) In recent years, the Senate Banking Committee has begun signaling jurisdiction over the CFTC. This could point to an eventual merging of the CFTC and SEC under the Banking Committee. The combined agency would be in a more politically secure position, which would make tax futures incrementally more acceptable.

For now, I suspect - well, know - that the CFTC will not approve contracts tied to acts of Congress. The question then becomes: In which countries would tax futures be most feasible from a political and regulatory standpoint?

Tax futures came back to mind upon learning of Cato Director Jim Harper's WashingtonWatch, which estimates the "cost" or "savings" to households of various bills passing through Congress. While still in an unrefined state that ignores specific tax incidences and basically just gives one an idea of the total revenue or spending attached to bills, this resource seems perfect for use with tax futures. The hedging utility of tax futures would give dispersed interests recourse against government spending and implied future tax burdens. If contracts were attached to specific bills, then concentrated interests could also hedge against losing a subsidy or other special treatment, for instance. This might decrease the demand for congressional favors and ease the unwinding of wasteful spending legacies.

Wednesday, August 09, 2006

On "Digital Maoism"

It's difficult to boil-down Jaron Lanier's essay on the limits of online "collectives", but these are the most salient points:

  • Collectives are stagnant and threaten to smother the voice of genius by enshrining consensus. Genius and creativity will naturally not correspond to average opinions.
  • Collectives are too volatile and chaotic, and need to be filtered by individuals
  • It is misleading for collectives to masquerade as objective when they might well contain some personal bias.
  • The collective fails in matters of subjective taste.
Notice the tension among these assertions, especially between the first two. This essay has received plenty of criticism already. Here are some paraphrased examples:

  • Lanier is attacking strawmen and taking phrases like the "Wisdom of Crowds" too seriously without considering how they are really used.
  • Voluntary collective efforts should not be identified with coercive forms of "collectivism". The word "collectivism" in the essay is generally spread too thin over too many distinct endeavors and technologies.
  • Projects like Wikipedia are not actually anonymous collectives, but are largely the undertaking of known, independent individuals operating within some degree of hierarchy and editorial control.
  • All minds are ultimately "hive minds" insofar as they are connections of neurons.
There's no need to rehash all of the criticism here, so let's focus on what specific relevance the essay might have for prediction markets. It's not clear that any of Lanier's concerns particularly confront these examples of crowd "wisdom". Prediction markets always resolve on something objective and have a strong meritocratic element. Even if subjectivity underlies a market, as with predicting box-office receipts or album sales, those traders with "good" taste who recognize quality work by underappreciated and underpriced artists will be rewarded far more in the long run than those who merely bet with the consensus. No-one is advocating using any sort of collective effort to legislate the aesthetic and reverse the long-tail trend in entertainment and culture. It's also unclear how "collectives" would hinder the emergence of a Dylan or Hendrix or Ellington as Lanier suggests. For all the talk of Googlization, older forms of media where those stars rose were much more centralized.

The title of "Digital Maoism" was a very strange choice and one guesses that it was chosen to emphasize the suspect point that collaborative, anonymous endeavors might present themselves as objective while containing significant biases and personal imprints. Lanier of course prefers that collective efforts be guided by individuals, so long as this takes place in the open. Apart from concerns about quality and innovation, he also fears instability:
One service performed by representative democracy is low-pass filtering. Imagine the jittery shifts that would take place if a wiki were put in charge of writing laws. It's a terrifying thing to consider. [...] The calming effect of orderly democracy achieves more than just the smoothing out of peripatetic struggles for consensus. It also reduces the potential for the collective to suddenly jump into an over-excited state when too many rapid changes to answers coincide in such a way that they don't cancel each other out.

First, this passage gives an idea of the measured world-view of the piece, which sneers at both socialism and anarcho-capitalism. (The latter would develop its own mechanisms of regulation and stability much like wikis have.) Second, the phrase "answers coincide in such a way that they don't cancel each other out" should pique the interest of prediction market advocates, as this is a textbook problem-case for such markets. Fortunately, these scenarios should be relatively easy to identify. Logically, one can ask questions like "Are all relevant interests/departments represented?" or "Is there a predominance of hedgers?" Empirically, if one has market data over a long enough period covering a set of sufficiently similar questions, one might be able to weight opinions based on similarities in past biases.

There is one further idea to parry: that there is really nothing emergent in an aggregation of opinions. This is best summed-up in one of the comments on Edge, by Yale Law Professor Yochai Benkler:
This leaves the much narrower set of moves that are potentially the legitimate object of Lanier's critique: efforts that try to depersonalize the "wisdom of crowds," unmooring it from the individuals who participate; try to create ever-higher-level aggregation and centralization in order to "capture" that "wisdom;" or imagine it as emergent in the Net, abstracted from human minds. I'm not actually sure there is anyone who genuinely holds this hyperbolic a version of this view. I will, in any event, let others defend it if they do hold such a view.

James Surowiecki, earlier:
I would question the implicit assumption in Tyler's post that the "knowledge" these markets are trying to tap is something that one employee (or a very few employees) have and that most employees are completely without. No one person knows what a company's sales are going to be in forthcoming quarters, or whether a given product is likely to be a hit or not, or whether a software project will be done in time. The information that's relevant to answering any of these questions well is not concentrated in the hands of one person or a few people. Instead, it's distributed among lots of people, each of whom likely has a small bit of knowledge that's germane.

This seems to just be another terminological straw-man; Surowiecki is talking about specific objective knowledge here, not "wisdom" in the broad sense. Prediction markets might be good at providing objective answers in many situations, but as Jaron Lanier aptly points-out, asking the right questions can be more important.