Risk Markets And Politics

Monday, January 29, 2007

Legal "prediction markets", sooner than you think.

This month continues to see consensus build that "prediction markets" ought to be regulated by the Commodity Futures Trading Commission. It is quite possible that the CFTC will approve CME's Credit Event Futures on Wednesday, signaling the legal way ahead for other "event futures" in the US.

Richard Jaycobs made a good point, among several, saying that calls for a PM lobby unrealistically ignore regulation, or treat it as an afterthought. The CFTC of course already has a regulatory framework in place that shields markets from gambling laws. In the case of Hedgestreet, it has also approved non-intermediated small-contract trading. Russell Andersson notes that the CFTC is, "open minded, approachable, thoughtful, and progressive", and that, "Without question, the CFTC is by far the most approachable and reasonable regulatory agency out there."

Whence the unease with CFTC regulation then? Aside from the barrier to entry of the contract market designation process, there is the fear that the agency will not approve potentially controversial contracts such as political markets — even if they unquestionably satisfy an "economic purpose test".

Along the same lines, traders aren't happy with Hedgestreet's current offerings, and this colors their opinion of CFTC regulation. But Hedgestreet's current lack of original longer-term contracts probably says more about the company's internal development than it does about the CFTC. (Not to imply that it says anything negative about their development.)

In any case, if Hedgestreet were to launch 2008 election contracts, much of the unease over CFTC regulation would evaporate. Hopefully the wheels are already in motion, with the relevant parties recursively making sure that no-one will be too "surprised". (And if Hedgestreet doesn't offer these contracts, someone else might. I suspect that one or two "dormant" exchanges are re-tooling for similar retail trading.) Election markets have been the most popular (non-sports) prediction markets to date and their legal operation in the US is the next major benchmark to anticipate. Such markets are also a natural starting point for any dialog with the agency.

Wednesday, January 24, 2007

Aloha, Poker Players Alliance

As more prediction market enthusiasts in the U.S. reconcile themselves with eventual CFTC regulation, the Poker Players Alliance is making a bid to join the ranks of the privileged exemptions to UIGEA. Prediction markets have simply not been profitable enough to support a national lobby for a similar exemption. The CFTC route is cheaper and less controversial, though more restrictive.

Is there is room in the PPA's tent for prediction market interests? Probably not, but it is worth looking into, especially since they are characterizing their request as a "skill game exemption".

If not, while I don't begrudge the PPA their relative progress, I would not be inclined to support their efforts to attain an exemption for the game. According to PPA President Michael Bocherek, "While we are working toward the short-term goal of a poker exemption, the PPA will also be laying the foundation for the eventual U.S. regulation of online poker. This is the only proven public policy for online gaming."

Perhaps they ought to keep to their long-term goals, as in the short-term, poker is a game of chance.

You could say that these opinions are divisive, but I would counter that it's up to the PPA to determine how specific their interests are. The more they act like a privilege-seeking special interest, the more my general libertarian support for all forms of legal gaming is trumped.

Saturday, January 20, 2007

The LindeX Currency Exchange

In the wake of the Neteller arrests this week, alternate currencies are unfortunately a bit less interesting. While the DOJ has not yet moved against gambling in virtual worlds such as Second Life, it is only a matter of time now. When the UIGEA was passed, a person identifying himself as Linden Lab's lawyer offered some reasons why UIGEA should not apply to Second Life, but promised full cooperation with any investigations.

Now that the Neteller founders are being prosecuted on money laundering in conjunction with racketeering laws, the existence of The LindeX Currency Exchange will become increasingly controversial. (By the way, here is a virtual casino property that was auctioned on EBay.)

When I first mentioned ways to gamble with real money in virtual worlds in July, reaction was muted. To this day at Terra Nova, there is almost no discussion on this issue although its authors pride themselves on straddling real and virtual economies. Nonetheless, more people are starting to ask questions.

One moral of this story is that we should eschew legal "hacks". I hope to have something more constructive to say in a couple of days.

[Cross-posted from Midas Oracle]

Monday, January 08, 2007

Yootle interest rates and inflation

There is some excitement around Yahoo's planned "Yootles" currency and group decision-making mechanism. Near the end of the above paper, one sees that the initial interest rate for Yootles will be set to 5.375%. This strangely precise level is 1/8th of a percent higher than the current Fed Funds target rate. Yahoo will play central banker to its currency and is keen on controlling inflation.

Perhaps interest rates are not the best way to combat inflation in a new currency like Yootles. In "play" money exchanges, inflation can be caused by traders opening multiple accounts in order to push prices and build profits in their main accounts. (This might be the best strategy where automated market makers set initial prices away from fair value.) Yootles are a little different in that you aren't given any Yootles by virtue of creating an account, but a trader could still credit his main account arbitrarily. The trader doesn't care about the second account, so it is not clear how the high interest rate would discourage borrowing (Yootle issuance). If anything it would encourage Yootle issuance since the trader only cares about the account that is earning interest. Although credits and debits always net to zero, higher interest rates will lead to more Yootles over time. Traders will also be able to specify custom interest rates on transactions and so will be tempted to use high rates on bogus transactions. Similarly, what's to stop someone from abandoning an account that went negative through genuine transactions? Their past counterparties have already been paid and will continue to receive interest so they have no incentive to report users switching to new accounts. All of these scenarios underline the importance of user authentication in controlling inflation.

What are the interest rates on other play money exchanges? HSX currently pays the Fed Funds rate of 5.25% on cash balances. The rationale behind this is unclear since it discourages trading. Possibly HSX feels that the interest rate improves the quality of trades that are made, and inflation is not a concern there. Foresight's market rate has traded roughly between 3% and 0.5%, and since tying-up currency that is less recognized has less opportunity cost, one would generally expect play money market rates to be lower than real money rates. It is also expected that market interest rates for new exchanges will decline over time, as inefficiencies and reliable profit opportunities are competed away.

Regarding money supply, as a currency becomes more widely recognized and therefore useful, a "network effect" will accelerate its acceptance. This network effect will work against potential inflation from the increasing money supply.

Illegitimate transactions might again be the more important issue in practice. If they cannot be stopped, a high interest rate might do little to control inflation, and unexpected monetary operations could confuse traders.

Many will be especially focused on the emergence of a dollar-Yootle exchange rate. Although some qualms have been expressed about this from the perspective of fairness in the decision-making process, Yahoo has not indicated that it will block dollar-for-Yootle transactions. Even identifying such transactions may not be possible, as users might resort to suitably cryptic descriptions ("Craig's List style" indeed!). Exchange rate transactions have some very interesting implications.

HP and corporate prediction markets mechanisms

Leslie Fine's announcement that HP had signed with Pfizer to deploy an "information gathering tool" could mark a turn for corporate prediction market consultants, regardless of nomenclature. Pfizer had enough internal resources to build their own prediction markets, and ran them for about a year. As Leslie tells it, Pfizer encountered some issues that HP had already solved. First, Pfizer wasn't interested in "crowd" knowledge as much as aggregating the opinions of small groups — of experts, one might say. (A scoring rule was helpful to solve the liquidity problem.) Second, time spent following a market is a cost, so Pfizer wasn't thrilled with a standing market, nor the CDA format. Finally, HP's mechanism doesn't automatically relay information back to everyone, which has an appeal to managers and also works against information cascades.

Two of Pfizer's infelicities can arguably be expressed as costs: how to minimize the number of participants and the time they spend on the mechanism?

Keeping the aggregate price private is even more desireable in situations where participants are external to the "patron", who after all has paid for that valuable information.

As Robin Hanson noted, it's not as though prediction markets are strictly opposed to expert opinion. Larger samples are more robust, but the marginal costs and advantages of adding participants must be weighed, and will vary across companies and questions. HP also cluster-samples participants to reduce costs.