Risk Markets And Politics

Saturday, October 18, 2008

Intrade offers an explanation of strange trading

Intrade has made a statement on the unusual trading that many have noted and alleged to be manipulative. The statement suggests that the price action is mostly attributable to a single firm, a hedger "using our markets in good faith and in the ordinary course of their business."

The first company that comes to mind is Centrist Messenger. Centrist is an interesting firm that re-sells political ad time and refunds sales to customers whose candidate loses. Centrist has stated publicly that it uses Intrade to hedge this exposure.* If Centrist had something to do with the unusual trading, it suggests that they sold more Obama than McCain ads, creating exposure to a GOP victory, resulting in McCain buys and Obama sales on Intrade. Why such a firm would be such urgent price-takers isn't fully explained.

Whether or not it was Centrist isn't important, but as these markets mature we should expect them to attract more hedging activity, and this might introduce persistent price distortions. Indeed it makes sense for people in the top tax bracket to be long Obama apart from considerations of his chances of victory. This is another uncomfortable subject that I've warned about in the past. When these markets become deeper and more widely available, the odds of the high-tax candidates might begin to show an upwards bias, a risk premium. Interestingly, Musto and Yilmaz predict that such markets will eventually lead to increased promises of redistribution by candidates. Talk about unintended consequences.

Intrade is doing the right thing here though, dealing with tough issues realistically and with as much transparency as possible. They provide valuable information, for free, even in places where they are not necessarily welcome. The depth of this information helps us to evaluate Intrade prices and have more confidence in them. Here is an example below, based on Obama's market over the past two weeks. Some have noted that the purported attacks occurred in hours where the market was unusually thin. This chart measures such price manipulability. The red line represents the ease of a downwards attack. It is the 100 x the amount of margin required to sweep the top fifteen bids divided by the difference between the highest bid and the fifteenth highest bid. (That is, how much the probability of an Obama victory can be moved by risking $100. Commissions are not taken into account but would of course would be vital.) The green line is the ease of an upwards attack. This is a very preliminary study and I will leave it to others to voice initial impressions. The fact that we can gauge to what extent traders are exercising market power is in itself important however.

* Technically another firm does the trading. Centrist is incorporated in the US, and the trading firm is incorporated in St. Kitts. Through this arrangement, Centrist cleverly avoids violating UIGEA.

Wednesday, October 15, 2008

The gamble of downplaying manipulation

Whether it is GOP bias, manipulation, or simply confident well-funded traders, there is some agreement that the Intrade presidential markets have been affected by "non-informational" trading. To be clear, this is not a condemnation of Intrade. The exchange's liquidity and trader diversity are hamstrung by archaic laws in the U.S., the continuation of which will frustrate a fair assessment of market accuracy. The point is that arguing for legal and regulatory change while downplaying the viability of manipulation and other market pathologies is counterproductive.

That prediction markets may be manipulated with some persistence should be no surprise to anyone who has followed the subject in the past couple of years. Here is a sampling of some of the warnings:

The HRC attack, part 2
The Giuliani manipulator buyer is back.
Manipulation can affect prices.
Is there manipulation in the Hillary Clinton Intrade market?
Is there manipulation in the Hillary Clinton Intrade market? Redux
Measured Enthusiasm For Prediction Markets

We now even find some academic papers that admit that manipulative trading may be profitable given certain assumptions. It is up to readers to decide which papers contain the most "stylized" assumptions.

No-one argues whether, in the long run, in general, manipulation is a losing proposition that subsidizes other traders — but is it really prudent to deploy that message, in comments to CFTC for example?

First, if Obama wins the election, based on the other available markets and poll projections, it would seem that an error had been introduced into the largest and most widely-cited of prediction markets. When comparing market and poll accuracy over time we are usually talking about only a few percentage points difference, so this error isn't trivial. Furthermore this is a market that takes place only once every four years, so long-run arguments ring a little false. There's no reason why something similar couldn't happen in 2012. At least, one is optimistic that the regulatory situation will improve and Intrade's traders will be more numerous and less capital-constrained at that time, which should make manipulation more difficult on average. Those who downplay the dangers of manipulation risk such goals by sacrificing their general credibility. It's a negative skew proposition.

Second, some markets can irreversibly affect the outcome they predict. This happens infrequently and requires some fundamental basis, but specific cases can spectacularly undermine a general argument. This is the old bit about trying to cross a river that's three feet deep on average. An example we've seen recently: when a business is predicated on maintaining a deposit base or borrowing short-term at certain rates, manipulation might be irreversible if it targets confidence or attacks the business's funding costs. In essence, the manipulator forces the (possibly quite liquid) market to "settle" as the firm approaches insolvency, and prices do not snap back. Breaking a currency peg has a similar dynamic. Now, there is currently no real analog to these situations in prediction markets as such, but either these markets will continue to be relatively small and not widely-followed, or ....

Kenneth Arrow and Intrade CEO John Delaney are making the right arguments here: transparency in the form of more public markets, along with less concentrated risk, would have helped avoid this crisis. But don't try to sweep uncomfortable subjects under the rug. That won't end well.

Monday, October 13, 2008

Disneyland burned down

Satyajit Das, in his 2006 book:

Dealers on exchanges charge clients a fixed commission to trade; the cartel of dealers means that clients have no choice other than to deal through them. The dealers are fierce advocates of competition except where it affects them.

In the OTC markets, dealers are more creative — they ensure that the clients do not know the true price of what is traded. The lack of transparency lies at the heart of derivatives profitability. You deny the client access to up-to-date prices, use complicated structures that are hard for them to price, and sometimes just rely on their self-delusion.

In the late 1990s, I was visiting Mumbai. The stock exchange was debating a move to electronic trading, but there was resistance. They invited a Nobel-Prize-winning US financial economist to speak at the conference, seeking to win over brokers to electronic trading. The economist spoke eloquently and movingly of 'greater trading efficiency', 'lower transaction costs' and 'greater pricing transparency'. The audience was almost in tears — of laughter.

It's one thing when opaque markets allow dealers to disguise trading costs. Our traders in Mumbai knew that to be a real source of profits, and one that would merely bleed their clients. More insidiously, opacity allows losses to be mis-represented. Before even considering the shortfalls of the Gaussian, it's obvious that the surest way to deliver a shocking tail move to the market is to just not mark (that is, mis-mark) prices. It's not clear to what extent the meltdown was actually a failure to predict as opposed to the result of skewed incentives and conflicts of interest along the chain beginning with mortgage origination and ending with the shareholders, who may have not even realized that they were in the security warehouse business. The models and the rating agencies gave the "right" answers, but who thought they were the correct ones?

In any case, the market thinks that public exchanges and clearing companies are among the winners. It was only a few months ago that the DOJ questioned the legality of exchanges such as CME operating clearing businesses. There is little doubt that the "Four Seasons" consortium of banks was behind those concerns. We haven't heard from that group for a while now, but perhaps soon. One is tempted to quip that they might be down to only one or two "Seasons", but the banks that make up the consortium stand relatively strong.

Meanwhile, the CME's regulator finds that its prestige has increased relative to the SEC. Why should the CFTC be under periodic Congressional review but not the SEC?

Timely public prices and agent incentives make a crucial difference. I hope that the implementation of TARP and other government programs will not be lacking on these points.