Risk Markets And Politics

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.


  • I've been thinking so much on this idea Jason, as its has such good potential.

    You raise a good point on the jurisdiction. Additionally, even without jurisdictional oversight, it would be likely that either the CFTC or congress would prohibit trading these contracts by american firms.

    Another question I have relates to the specific product specifications. One problem with many recently designed contracts is that they hedge too perfectly. A perfect hedge for one party means that no other party will want to trade against that party - the informational differences will be too large. Your earlier proposal on the marginal tax rates is good, however, I think most of the people that would really like to hedge would fall into either corporate entities or high net worth individuals.

    For these two groups, treatment of income is as important that acutal tax rates.

    By Blogger Mickslam, at 8:20 PM  

  • Thanks Mike, I expect exciting things from your firm, especially with the new ownership.

    Something like GDP contracts would be a lot easier from a political/regulatory standpoint. Chris Dillow had a post on these today, including a nice quote from Leo Melamed, pioneer of financial futures: "[a market] is more than a bright idea. It takes planning, calculation, arm-twisting, and tenacity to get a market up and going."

    Doubly and triply so with something like tax futures...

    If contracts were tied to pieces of legislation affecting certain industries, those industries might have a significant informational advantage, which could limit trade as you suggest. This is part of the reason why I see these sorts of markets growing-up alongside legislative transparency tools, which might level the playing field a bit.

    By Blogger Jason Ruspini, at 6:51 PM  

  • We are actively looking at introducing all of the bet style contracts like GDP and unemployment. Many of the exchanges are looking at these. We're in the process of design on some of these, and we hope q1-2 2007 we should have something.

    GDP futures, I think, would be best with about 5 to 6 years of future contracts available at all times. This could be used as a business cycle hedge. Most firms perform well in up years, but enough are counter-cylical to make this a useful market, plus if sized correctly, could help take the variablity out of personal pay.

    One problem is the relative stability of GDP. Will it be volatile enough to attract speculators?

    We're going to implement those style of futures that you would consider logical, and I think a few others that are a little more 'experimental'. The marginal cost of creating and launching a new contract for us is very small. We're thinking along the lines of betting style futures, but applied to the financial markets


    I fully agree with Leo. You would think that markets simply appear once they are given space, but this is not the case. For example, the S&P contract took a few years to take off, even with the high utility of the contract.

    One thing Leo doesn't mention is the presence of people, real live people, who think they can make money on this contract. It really only takes a few for a market to be successful.

    I feel there are a few places today where finacial futures could be extremely useful. Tax futures is one. Another that I've personally been kicking around is health care payout futures, and insurance futures in general. Insurance companies right now try to match durations between expected payouts and assets. Health care insurance melds two different businesses, risk managment and providing health care, into one business. Providing a way to seperate those functions might be useful. Life Insurance, Car Insurance. It would give the RMs another tool to match expected liabilities and assets.

    Tax futures would be regulated. I'll ask and find out. But, is there a proxy thats close enough that a contract could be created around it? Hmm..

    By Blogger Mickslam, at 8:00 PM  

  • Thanks again Mike for your great comments and interest..

    "One problem is the relative stability of GDP. Will it be volatile enough to attract speculators?"

    As you begin to suggest, moving to something binary could do the trick. (This is the trend with a firm that might arguably be described as your competitor.) There is a tradeoff however as many traders are only set-up to handle index contracts. And if systematic guys are unable to run meaningful proformas, this shuts-off a lot of money that could potentially be in your market. Likewise, especially with GDP, lack of frequency is a problem.

    "It really only takes a few for a market to be successful."

    I would add that you want a diverse set of traders with different time frames and motivations.

    Insurance futures are very interesting.. they were tried before by CBOT in the early 90s as a way to replace traditional reinsurance markets - both health insurance and catastrophe (reinsurance) futures. I actually wanted to include these in my "Ghosts of Futures Past" post, but frankly couldn't find enough quality analysis of them. The former perhaps died because payout rates simply weren't volatile enough to attract trade. The latter, because the existing reinsurance markets remained more attractive. Both also had basis issues.

    It could however just be a matter of striking on the right contract form and working closely with insurance companies.

    With tax futures, the closest thing might be muni bonds or the MOB spread.

    In terms of regulation, do you think a US exchange launching tax futures for another country would be feasible? This might stand a good chance of getting around CFTC resistance. UK tax futures trading in Chicago, anyone?

    By Blogger Jason Ruspini, at 11:16 AM  

  • Wanted to respond here too. :)

    "I would add that you want a diverse set of traders with different time frames and motivations."

    This is very amusing. I've been trying to educate many people who should know better about this exact idea. My ideas about bootstrapping a market to success involves using the knowledge of how different groups of traders interact with the market. I think there are two very important groups of traders early on, but ignoring any group can be fatal.

    Interesting about the CBOT and thier insurance futures. I didn't know that. I will look into it a little more.

    The GDP issue is pretty tough, as any binary contract implies a strike price of some sort. Backtesting the data even once it exists and then coming up with a reasonable model to then create a strategy around would be extremely difficult. I am trying to think of a way around this problem, so we can design a contract that has the attractiveness both to natural hedgers and interested traders.

    Now about foreign tax futures trading in Chicago - I don't know. I think its pretty possible that the CFTC would be ok with it. It might not. Probably the most difficult issue would be that trading those specific contracts may be prohibited by the govt, no matter the acutal location or jurisdiction of the exchange.

    By Blogger Mickslam, at 10:32 PM  

  • Yes, foreign governments prohibiting their local trade in such a market after it has opened is certainly a danger. Which comes back to my question about what governments might be amenable to such contracts.

    With bootstrapping markets, yes, a group of traders with the same views and motivations doesn't cut it, even if they are very well capitalized. More on this soon...

    By Blogger Jason Ruspini, at 2:33 PM  

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