Risk Markets And Politics

Sunday, August 03, 2008

Regulated US election markets might not be so hard

Based on the arguments Hedgestreet presented in its response to the CFTC on event markets, the exchange has a fairly strong justification to self-certify and begin trading election futures, soon. While most event markets trade as binary options, and the CFTC has flexible discretion over options per 7 U.S.C. § 6c(b), the Commission does not have direct discretion over approving DCM futures that conform to the Commodity Exchange Act, by 7 U.S.C. § 7a-2(c)(3). Therefore, a vote-share or electoral college future is more feasible at this moment than a winner-take-all option, although the latter is more useful as a hedging vehicle.

The major question here is what degree of trading restrictions the CFTC considers appropriate in order to fulfill the CEA's "beyond the control" criterion of excluded commodities. There is little doubt that low position limits alongside candidate death contingencies and prohibitions on trading by candidates, their staffs, members of the electoral college, and their proxies would not satisfy the CEA in this respect. The challenge lies in enforcing such trading prohibitions. I hope that Hedgestreet is in the process of developing a framework to do so. The CFTC could also issue an interpretive letter on this specific point, without addressing the more general, challenging issues related to their jurisdiction over event markets.

If Hedgestreet's trading restrictions are conservative and rigorous, it is improbable that such a self-certification would put Hedgestreet in bad graces with the CFTC. Alternatively, Hedgestreet could submit the futures (or options) for approval under CFTC regulation 40.3. If they do so, the CFTC has 45 days to review the products, at which point they could render a decision or extend the review process. In the meantime, however, Hedgestreet could be in communication with the CFTC and NFA concerning the development of trading restrictions, which again should be the main point of contention here, as there is no doubt that such event markets are associated with an "economic consequence". Note that CME does not even believe that trading prohibitions are necessary, citing the role of the Fed in determining interest rates and the lack of problems there with respect to manipulation. I tend to believe that the Fed and interest rates is a special case, not to mention that it is treated differently in the CEA, and that it is prudent to impose special trading restrictions on political event contracts. Those restrictions, however, can remain flexible and be loosened over time, especially the position limits, as the market grows.

Given the current political climate in which the CFTC operates, the Commission may welcome such an active stance from Hedgestreet and other DCMs on this issue, as it will allow them to take a more passive role in the process. In the case of vote-share, electoral college and tax futures with appropriate trading restrictions, the Commission would simply be complying with the CEA by allowing such contracts. Allowing winner-take-all options would be incrementally more sensitive for the CFTC given their additional discretion in such cases. In any case, I think we have passed beyond the point where there is any material doubt that such markets are bona fide excluded commodities.


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