Risk Markets And Politics

Monday, May 26, 2008

CFTC regulation and election contracts

Insofar as event markets are within the CFTC's jurisdiction, they would likely be approved as "excluded commodities". Here is the relevant part of the definition within the Commodity Exchange Act:

(iv) an occurrence, extent of an occurrence, or contingency (other than a change in the price, rate, value, or level of a commodity not described in clause (i))
that is—
(I) beyond the control of the parties to the relevant contract, agreement, or transaction; and
(II) associated with a financial, commercial, or economic consequence.

With the putative terrorism and assassination markets, by their nature, it is impossible to reliably identify who might manipulate an outcome. It could be argued then that such contracts do not involve commodities and lie outside the jurisdiction of the CFTC.* The counterargument is that such markets are actually "exempt commodities", defined broadly in the CEA as "all non-agricultural, non-excluded commodities". This is something for the CFTC to clarify: are event markets "excluded commodities", "exempt commodities", or might they fall into either category depending on their specifics? Examples of exempt commodities are energy products, metals and quasi-currencies like energy, bandwidth and carbon credits. In practice then, if not by law, exempt commodities have involved something deliverable in units other than cash, although specific contracts might also be cash-settled.

It is a good bet then that the CFTC would classify event markets as excluded commodities. Additionally, invoking the "beyond the control" clause would be a very antiseptic way for the agency to repudiate markets based on terrorist events and the like, although they would risk losing the ability to punish similar markets that do not meet all criteria. Putting that issue aside for a moment and considering only the CFTC's approval process, this treatment would bring up two problems with markets that the agency might want to regulate. Each of these problems has a solution.

First, wouldn't election and policy markets also be disqualified by the clause? After all, a candidate could throw an election for profit, or perhaps more likely, engage in some sort of "point shaving". Remember, these are not securities and thus not subject to insider-trading laws. The CEA, however, includes a section 13(f) prohibiting members of exchanges from trading on material nonpublic information obtained through their exchange duties. It is feasible to create similar trading restrictions at the regulatory level, by disallowing candidates, their staffs and proxies from trading.

Such trading prohibitions would reasonably ensure that no trader would be in control of the outcome of the contract. The CFTC could levy a special trading fee (much less than 1% notional) on such contracts to offset the relative work they might entail. The framework for such an arrangement could possibly be clarified on the CFTC's next reauthorization. In a sense, it was unfortunate that their request for comments on event markets came so late in their recent reauthorization process. From another perspective, they ostensibly have until 2013 to exercise innovative, progressive policy.

Now, what if someone not barred from trading possesses damning information, photos, etc, on a candidate? By deciding whether or not to release that information, are they then "in control" of the contract's outcome? It's doubtful. Even though they might influence the contract's outcome, they are not "in control" of it. The situation is similar to whether or not a trader, who might be aware of a new oil find or simply has a large account, is in control of that non-"excluded" commodity price. In general, the rules should be designed to elicit as much information as possible, falling short of allowing traders to decide a 0 or 100 settlement.

The second issue is the implicit assassination option in candidates' contract prices.** This issue could be easily dealt with, as Intrade does with their updated rules. Clearly this would be necessary with CFTC-regulated contracts, or else an unknown might be in control of their outcomes. The CFTC rule might work as follows. Upon a death, all contracts would be immediately cash-settled at their last price before the event. As soon as possible, an updated set of contracts would then begin trading so that no trader is able to profit or lose from the jump in prices. This process would be similar to traders simply rolling into a new contract maturity. It would be disruptive, but nothing to complain about compared to the tragedy of the situation. Small modifications to the rule could address scenarios where a candidate is incapacitated for some time during which their candidacy is uncertain.

A more challenging scenario is the possibility of a manipulation preceding the event such that the forced settlement locks-in profits, presumably just as market power is exhausted. Regulations could provide for an investigation of such situations, and the relevant transactions and profits shouldn't be too hard to find with that level of scrutiny.

This framework addresses several of the questions posed in the CFTC's concept release. That document and comments elsewhere seem to indicate a reluctance to expand jurisdiction to the point where sports markets and gaming might be included. Officials now and then harken back to the pre-CFMA economic purpose test, but that test could be effectively reconstituted for event markets with a policy decision such that those markets will only be approved as excluded commodities, subject to their specific "economic consequence" clause. In itself, that policy would not impinge on the agency's ability to prosecute unauthorized exchanges in similar markets (and hopefully they will treat Intrade with some degree of amnesty given the ambiguous and arbitrary law of this country). While this policy would leave the door open even for regulated sports-based hedging markets, the CFTC could leave the prosecution of online sports and gaming exchanges to the DOJ and state authorities for now. The burden of the duty to prosecute illegally operating exchanges might be smaller than feared, and, again, the agency could levy a special fee on such regulated markets to offset demands on its resources.

These opinions perhaps pose more questions than they answer. The Commodity Exchange Act is broad enough to encompass jurisdiction over event markets. The CFTC seems unsettled that the language is too broad, but there are ways for them to calibrate their jurisdiction at the policy level.


* A market in research science claims would follow the same logic in terms of jurisdiction. Even without a no-action letter or public interest exemption, the chances seem very good that such an exchange could operate without interference if they stayed with small claims, did not advertise and did not accept trades from States where the predominant factor test does not apply.

** Let me condemn Hillary Clinton's recent remarks as sinister and irresponsible.

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