Risk Markets And Politics

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]


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