Risk Markets And Politics

Thursday, December 14, 2006

NYMEX to launch Property Damage Risk Futures

The New York Mercantile Exchange today announced that it intends to list Property Damage Risk contracts based on Gallagher Re's planned "Re-Ex Index", which will track losses due to catastrophes, defined as events causing more than $25 million in damages by ISO's Property Claims Services®.

The contracts bear a close resemblance to Hedgestreet's hurricane markets, although NYMEX will allow hedging against other types of catastrophes. Larry Tucker of Gallagher Re notes:
Despite the relatively benign hurricane season this year, demand for property damage cover continues to vastly outstrip supply and the way in which reinsurance contracts are currently negotiated, which has remained virtually unchanged for decades, serves only to frustrate that process. Against this backdrop, the market has seen an increasing presence of the capital markets, particularly hedge funds, within the reinsurance space challenging existing methods by providing cover directly such as collateralised reinsurance contracts and cat bonds.
The business method used in trading and the contracts themselves are patent-pending.

[Cross-posted from Midas Oracle]

Flora of North America (CFTC regulation again)

Flora vs. Iron Fence Tom Bell argues that the CFTC does not have authority over event and prediction markets. At the core of his argument is the definition of commodities subject to CFTC jurisdiction in the CEA: "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." Bell claims that prediction markets offer "present delivery of conditional rights", not "future delivery of unconditional rights". Thus prediction markets are spot markets. However, this critical assertion hinges on whether "delivery" in the CEA definition above refers to delivery of rights. This is not the only possible reading, and I would bet that it is not the most common. Delivery could instead refer to delivery of a thing, or of cash, the amount of which is conditional. Bell also does not cite a relevant part of the CEA's definition of "excluded commodity": "an occurrence, extent of an occurrence, or contingency that is [...] associated with a financial, commercial, or economic consequence". This clearly could apply to an event or prediction market (though a market in science claims might not be considered "beyond the control of the parties to the relevant contract").

In any case, the CFTC has approved a few event markets with little challenge. With the caveat that I have no special legal expertise, I believe that the agency has legal jurisdiction over prediction markets, but does not want to exercise it for the reasons listed last time. Keep in mind that this whole legal and regulatory challenge is only relevant to exchange-traded retail contracts. If someone has a bright idea for a larger-scale commercial, industrial or governmental contract, there are plenty of options available, including an EBOT or OTC transactions. The "safe-harbor" suggestion of Paul Architzel might also entail stifling limitations. When the CFTC granted safe-harbor status to swaps in 1989, it did so under the conditions that the contracts: 1) have individually tailored terms, 2) be used in conjunction with the counterparty'’s line of business, 3) not be settled using exchange-style offset or a clearinghouse, and 4) not be marketed to the general public. Is it possible to negotiate a prediction market safe-harbor that would allow for some level of internet-based retail trading? Maybe, but what would it take? Likely more than a bunch of bloggers and scholars. In order to persuade the CFTC to spend time entertaining such a request, it would help greatly if you have a viable business ready to launch (and one which serves an uncontroversial social function). There is simply too much money at stake on the CFTC's other operations for them to devote resources to help someone disinterestedly sow seeds — even if the agency is completely sympathetic and agreeable in principle.

The no-action possibility seems to be off the table, especially if you want to operate an exchange for profit. On the gambling law front, it is encouraging that state prosecutors have left IEM alone for so long, but this is also probably a function of its non-profit status and lack of advertising.

All of that said, I continue to be optimistic about the possibilities of a real-money prediction exchange operating legally in the United States in the not-too-distant future. Finally, we all owe Tom Bell many thanks for the work he has done on this topic.

[Cross-posted from Midas Oracle]

Wednesday, December 13, 2006

Credit Event Futures and other fauna

Let's reorient ourselves towards the regulatory environment that potentially affects the evolution of prediction markets.

First, is the Chicago Mercantile Exchange's planned Credit Event Future within the jurisdiction of the CFTC? The Chicago Board Options Exchange protests that it is not. CME's initial defense reduces the issue to whether or not the option-like swap "future" is a security. CBOE argues that the product should be considered a security based on the CEA because, although delivery of securities is not involved, the contract's value is based on the "interest therein" or "value thereof" securities. CME's stance is that while a default would also affect the value of securities, their contract's "payout is fixed in advance of listing the contract and does not vary in relation to the price of the security or any referenced entity". Thus, they argue that it is irrelevant whether credit events happen to cause changes in securities prices. The CBOE might then ask what would stop the CME from floating contracts based on earnings releases or dividend announcements, which might serve as a rough proxy for an equity. Again, it is increasingly nonsensical for the CFTC and SEC to remain as separate agencies, especially insofar as jurisdictional friction hampers or blocks innovation in the United States.

More generally, does the CFTC have jurisdiction over event futures? The answer seems to be yes, which might distress some prediction market followers. CBOE does not challenge this point, and references the CFTC's approval of a Catastrophe Single-Event Contract in December 1997. Another example is CME's weather futures, whose value is determined by multiple events accumulated in an index. CME also asserts that the CEA does not prohibit, "options whose value may depend on corporate events or economic events that directly impact companies." Not only does the CEA not prohibit such contracts. It explicitly defines an "excluded commodity", or one that may trade OTC or on an EBOT between eligible contract participants, to include "an occurrence, extent of occurrence, or contingency [...] associated with a financial, commercial, or economic consequence." (Note that the fed funds future is based on a reference rate, not technically a (policy) event, though Hedgestreet's release contracts would probably be considered event options.) Hahn and Tetlock also conclude that regulating "information markets" is within the power of the CFTC, based in part on discussions with the agency's lawyers.

Speaking of Hahn and Tetlock's proposal, what exactly is the relationship of the "economic purpose test" and CFTC jurisdiction? Upon my own reading of the CEA, not so much. That is, the economic purpose test pertains to the agency's approval process, not its jurisdiction. If this interpretation is correct, we have a couple of puzzling statements out there. The first is from Hahn and Tetlock: "The CFTC currently administers a kind of public-interest test similar to the economic purpose test to determine whether futures contracts fall under its jurisdiction and are acceptable." Again, by my reading, the economic purpose has little to do with CFTC jurisdiction -- only approval or rejection of contracts that already fall within its jurisdiction by virtue of their instrument-type. I think that the "public-interest test" above instead refers more to consumer protection. That is, if an illegally operating exchange is within the CFTC's jurisdiction, the degree to which participants are at risk will factor into whether or not the agency decides to pursue enforcement. This, along with potential objections from established US exchanges, helps to explain why the CFTC targeted TEN's financial contracts, and not its more original and smaller markets. But given the definition of "excluded commodity" above, TEN's other contracts probably could have been targeted as well. Which brings us to the next puzzling statement. At the FIA Event Markets Luncheon in February, Richard Shilts said that the CFTC was considering whether it had jurisdiction over futures that provided no hedging utility, but only price discovery. (This is from a note and memory; anyone else who was there, feel free to chime in.) My opinion, before considering Tom Bell's argument, is that the CFTC in fact does have jurisdiction over event futures and options that yield information "with a financial, commercial, or economic consequence", but are reluctant to 1) devote resources towards doing so given the small size of such markets, 2) broach the question of whether sports betting and other seemingly "frivolous" markets might have economic consequences. Also, the CFTC is made up of intelligent and thoughtful people who recognize the potential of prediction markets as well as the "baggage" that their regulation would entail.

What about Tom Bell's argument against CFTC jurisdiction and Paul Architzel's "safe-harbor" proposal? We'll save those for next time. For now, the bottom line is that regulatory events are unfolding that we should make ourselves aware of. Otherwise, opportunities may slip by that will be very hard to recapture.

[Cross-posted from Midas Oracle]

Is the hedging economic purpose test ambiguous?

Apropos of Andrew Gelman's comments on the questionable benefits of betting markets, if insurance can be understood as reducing variance in wealth, consider the effect of diversification at the portfolio level. Uncorrelated assets such as those attached to political events, weather, sports or even poker hands could be used to improve the risk-adjusted returns of more typical portfolios.

Not to say that hedging, insurance and reducing variance in wealth are actually identical concepts. For one thing they are not treated the same in terms of accounting and taxation, but with some refinement this sort of idea could be useful for proponents of financial innovation in the United States.

[Cross-posted from Midas Oracle. JC Kommer later linked to a speech by Leo Melamed, in which he asserted that financial pioneering needs no economic justification. I largely agree, but offer this argument as a matter of pragmatism.]

Economic Derivatives Auction trader motivations

The National Association for Business Economics' experimental auction data for the October payrolls release seems to be unavailable, but let's compare their forecasts to CME's economic derivatives auction for the September release.



The CME numbers had more variance and fatter tails. Specifically:

NABE: Less than 5% in the less-than-0k and greater-than-250k tails.
CME: 10.1% in the less-than-0k and greater-than-250k tails.

NABE: Approximately 75% between 75k and 175k
CME: 47.7% between 75k and 175k

One possible interpretation is that the tails of the CME auction are overbought (by hedgers?). I have not seen the CME data recently, but from what I hear it does not actually show a longshot bias over time. This suggests that the tails were underbought in the NABE auction. We don't have enough NABE data to analyze, but since their participants were fully-funded we might expect them to herd around the consensus number. Justin Wolfers has also suggested that what we see in the NABE auction is overconfidence, which would dissipate in an auction with larger stakes.

In any case, hedging against the payroll release has recently been an absurd exercise. The number reported for September was 51k, but this was later revised to 148k. This revision was reported on the day of the October payrolls release, along with a second revision to the August number, which now stands at 230k. That is, the numbers on which the CME auctions for August and September were settled were low by a total of approximately 200k. Revised numbers were a well-known inevitability to the market's designers and traders, but this had to be exasperating for anyone actually hedging a fixed income position with the October release auction. If this theoretical person had been long fixed-income, he probably would have hedged by buying the upper tail of the payroll outcome: a result likely to embolden the fed and send bonds lower. The October number actually came in on the low side, and our theoretical trader would have happily accepted his hedging loss, but wait a minute... the numbers for the earlier two months were simultaneously revised much higher, causing the largest one-day sell-off in bonds in months.

This begs the question of whether our theoretical hedger exists. A recent article by Howard Simons at TheStreet.Com echoes the earlier opinions of JC Kommer and myself that the economic derivatives markets mainly represent a new avenue of speculation (which is perfectly admirable). Using the risk-based definition of gambling (which I am not endorsing), Simons writes, "The risk, however, is attached to particular markets, not to the number. [...] But in the absence of a tradable instrument created for the sole purpose of assuming that risk -- our definition of gambling above -- the number carried no actual risk itself."

The massive effects of revisions only reinforce the argument against the existence of substantial hedging in economic derivative auctions, but even without hedging utility the auctions still fulfill an information discovery function.

[Cross-posted from Midas Oracle]