Risk Markets And Politics

Demographics and Returns

2009-04-19T21:48:00.000-04:00

The intensification of the pension crisis provides a reason to re-examine the long-term effects of demographic shifts on underlying asset returns. Increased longevity has strained retirement system funding and this trend is unlikely to abate. At the same time, most asset prices have collapsed, but as the current bust becomes less acute, what can we say about long-term prospective returns?

With longevity rising and fertility leveling-off, unless retirement ages rise commensurately, the ratio of non-workers to workers will go up. This will tend to create more demand for fixed-income assets, driving down yields. Something has to give, and retirement ages are headed higher.

What about equity returns? There is a sense in which the stock market is fundamentally a pyramid scheme. New participants are important, and equities will tend to rise along with population and participation. While the population of developed countries has been stable in the recent past, globalization has picked up the slack in this regard. There is little doubt that globalization is responsible for much of the non-illusory gains of the past twenty years. Now, even if we assume that this trend will continue, will the rate of change slow? Are we past the inflection point of global development? That would not be particularly supportive of equities. Of course it's not just a matter of bodies in the system, but what minds produce and consume.

On the consumption side, there are some disturbing demographic arguments out there, but one of the more initially plausible ones does not appear to hold up to closer examination. The "age wave" theory promoted by H.S. Dent is based on the observation that personal consumption peaks around the time that one is 48 years old. Dent graphs the US stock market alongside immigration-adjusted birth statistics lagged by 48 years. The peaks and declines seem to correspond, suggesting that equity returns are driven by this demographic consumption effect, and that the best days are behind us for some time.

There are a few problems with this argument, one being that such a model does not actually seem to correspond to aggregate consumption. For one thing, US population has drifted upwards in the last 20 years, swamping the consumption-by-age effect. But what if overall population levels-off? Higher retirement ages could again help, as the peak consumption age would presumably also rise.

More importantly though, there are two distortions in the data as Dent presents it. He bases his consumption-by-age curve on the annual BLS Consumer Expenditure survey. One issue is that the survey is based on households, not individual consumers, with the breakdown by age cohort referring to the "reference person" of each household or "consumer unit". This means that if a household has children, the consumption of the reference person as a function of their age will be overstated. If the goal is to model future consumption rates based on consumption-by-age, the model should isolate the latter and not try to predict future fertility rates. When child consumption is mixed with that of the reference person, consumption-by-age is conflated with past fertility rates. Now, when you adjust the BLS data for the average number of children in each household (assuming that children consume some small percentage of what adults consume), the peak consumption age rises to the mid 50s from the late 40s. Not to imply that relative fertility-by-age is constant, but that peak is drifting higher, pushing the conclusion in the same direction.

Furthermore, you will notice on the first graph above that the y-axis has no scale, giving the impression that the consumption of 65 year-olds is roughly that of 25-year olds. When you actually look at the BLS data, adjusted or not, this is simply untrue. The 65-74 cohort consumes less per capita than the 25-34 cohort, but the fall-off is nowhere near as dramatic as Dent presents it. While the granularity of the data does not allow us to compares 65- and 25-year-olds directly, their consumption certainly is not equal. If anything, consumption does not decline back to the 25-year-old level until around 75. When you put all of this together, along with UN projections of US population, aggregate US consumption as a function of demographics only will continue to rise despite a greater percentage of Americans being past their peak spending age. One is much more confident then in dismissing the second graph as an accident of history.

All of this just begins to address some questions that are very pertinent to prospective returns.

The gold trade isn't too crowded yet

2009-02-01T13:03:00.029-05:00

The long gold trade isn't yet crowded because, although the pundits on CNBC have been capitulating over the past couple of months, it still seems like every other commentator has at least one of the following ideas, answered here.

1) Gold is not a true commodity. It's largely useless.

This is true, but of course the question is rather what is the use of paper money, increasing in supply, and paying no interest? Large changes in gold prices have little to do with what value it has as a commodity. It's more useful to think of gold as a (negative carry) currency. But you can't buy milk with it at the corner store? You can't do that with yen outside of Japan either, and privately issued gold-backed notes are feasible. It is easier to turn a store of value into a medium of exchange than the reverse.

2) Gold is just a safe-haven that you only buy if you think the world is going to end. With all that happened in 2008, if gold didn't go up then, when is it going to go up?

Gold had a positive return in 2008, and the drawdown of 30% was pretty muted for a "commodity." Given all of the de-leveraging, you could instead interpret this as impressive relative strength.

More importantly though, the generic "safe-haven" argument is suspect. Gold is not particularly correlated with measures of market risk like credit spreads and implied volatilities. If gold were a generic safe-haven, it wouldn't have a near-zero correlation with the VIX for example. Gold is a monetary safe-haven, and the generic safe-haven concept is largely a straw-man meant to conjure-up crazy gold bugs living in cabins stocked with guns. There are disasters that might be sufficient to take the generic safe-haven idea more seriously, but they aren't necessary for gold to go up.

3) We are experiencing deflation. Gold only goes up during inflation.

Well, first, what sort of inflation do we expect some months out? Second, gold has historically gone up during periods of deflation, and notably in those periods corresponding with multi-year boom/bust credit cycles (where the busts tend to be labeled "depressions"). The fact that gold declined during one period of disinflation of the 1980s colors many trader's view on this. When the predominant concern is inflation, gold will tend to fall with inflation expectations, but in deflation money appreciates relative to stuff, and gold, again, is closer to money than stuff. I'm not going to push this specific point too hard though because I don't think we have enough useful data on it. Most of the data we have is from the 1800s, where of course we were on the gold standard, so the comparison isn't quite fair for that and other reasons. Here is an interesting paper on the historical behavior of gold under deflation. Judge for yourself. Note though that the recent low inflation number in Europe allows the ECB to cut rates in order to fulfill their single mandate of promoting price stability. Two weeks after the HICP was released, gold broke out against the euro. Five days later it broke out against the dollar. Only the yen was left standing against gold and now in the past couple of days it's also succumbing in relative terms. What would happen if the JCB intervenes to weaken their currency?

The options on the December 2009 gold futures roughly give a 20% chance of those futures expiring above $1500/oz, and a 10% chance of them finishing above $2000/oz. If anything, the options might be a crowded trade, and an outright long is more appealing to me here. My main question is what price level will provoke some undermining public policy response, or credible threat thereof?

Anecdotally, Treasury is offering gold at over $1200/oz.

Intrade offers an explanation of strange trading

2008-10-18T12:55:00.004-04:00

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.

The gamble of downplaying manipulation

2008-10-15T23:02:00.001-04:00

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.

Disneyland burned down

2008-10-13T21:06:00.003-04:00

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.

Regulated US election markets might not be so hard

2008-08-03T11:23:00.002-04:00

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.

My response to the CFTC on event contracts

2008-07-05T12:05:00.007-04:00

Here is my response to the CFTC's "Concept Release on the Appropriate Regulatory Treatment of Event Contracts." I appreciate this opportunity to help in working towards regulated prediction markets in the US, and I thank the Commissioners for it.

Given the political implications of the rise in commodity prices, this is not the best environment in which to begin regulating markets like election contracts, but the consensus that seems to be building on the relevant questions is rather auspicious. Hedgestreet and I have presented similar legal and regulatory frameworks to allow for at least the types of election contracts we are familiar with through sites like Intrade. Given Hedgestreet's vigorous and incisive comments, I regret not having argued more for the desirability of non-intermediated exchanges.

In their focus, however, Hedgestreet steered clear of the gaming pre-emption questions and did not present a comprehensive and general framework for event markets. In that respect, their broaching of the CFTC's plenary option authority opens more questions than it answers, but several interesting and important markets could perhaps be traded without answering all such questions.

I encourage Hedgestreet to begin working with the NFA to develop the infrastructure necessary for the types of trading prohibitions that we each described in our comments. I encourage the CFTC to act decisively in light of the self-evident and massive value of certain event markets — even with the current political pressures, which are mainly relevant to event markets on a superficial level. Perhaps if the CFTC deems that an exercise of emergency powers is necessary at some point, that would be an appropriate day to also make a decision on event contracts public.

We are at a specific point where a little bit of additional regulation might cause an explosion in legal prediction markets, and possibly soon. As a libertarian, I generally dislike regulation, and of course it’s true, pretty much by definition, that over-regulation is bad, but I don't believe that to be the most effective message for this comment process and the unique opportunity it presents.

June 30th, 2008

Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st St. N.W.
Washington DC 20581
Attention: Office of the Secretariat

Re: Concept Release on the Appropriate Regulatory Treatment of Event Contracts

JURISDICTION AND EVENT MARKETS IN GENERAL

Given the explicit statutory definitions of “excluded” and “exempt” commodities, it is reasonable to conclude that the U.S. Commodity Futures Trading Commission (“CFTC”) has jurisdiction over all exchange-traded event markets. That is, if an "occurrence, extent of occurrence or contingency" does not meet the additional "beyond the control" and "economic consequence" criteria, then contracts on such events should be considered exempt commodities. While currently all exempt commodities are associated with a deliverable other than cash, the open-ended definition of “exempt commodity” considered alongside the definitions of “commodity” and “excluded commodity” in 7 U.S.C. § 1a imply that contracts on events that are not beyond the control of participants or do not involve an outcome of economic consequence are exempt commodities.

This conclusion presents enforcement issues that the CFTC may wish to avoid, such as being obligated to pursue actions against exchanges offering contracts based on the outcome of sporting events. Unfortunately, without further statutory clarification, this conclusion seems like the most defensible one, based on the letter, if not the intent, of the law.

That said, until statutory clarification is attained, given the purposes and history of the Commodity Exchange Act (“CEA”), it would be appropriate for the CFTC to only assert jurisdiction over those event contracts satisfying "economic consequence" criteria, which would include the price discovery aspect of the former economic purpose test. An interpretation to this effect by the CFTC would not be inconsistent with the text of the CEA, and would best serve to minimize the burden on interstate commerce. This policy decision would effectively reconstitute the pre-Commodity Futures Modernization Act economic purpose test for event contracts in a way that avoids unwanted enforcement issues. Such a decision would be unlikely to meet significant resistance until such time that further statutory certainty is forthcoming.

The CFTC would be free to classify such contracts as either excluded or exempt commodities depending on their susceptibility to manipulation, before or after special trading prohibitions are in place. Although the anti-manipulation requirements that apply to exempt commodities are directed towards price manipulation, a fortiori they must also apply to outcome manipulation.¹

The CFTC is free to determine what qualifies as "economic consequence." As with the economic purpose test, significant hedging and price discovery functions would comprise the principal criteria.² Regarding the latter, since event derivatives have no corresponding “cash” markets, the origination of prices that may improve economic decisions is all the more desirable in these cases. Furthermore, events that may only directly affect a group of private individuals may also have a strong bearing on commercial decision-making. Note that some general events and measures, as categorized and listed by the CFTC in its Concept Release, do in fact correspond to economic measures.³ Even if these events do not predictably correlate with asset prices, they may have predictable effects on market volatility. For example, from 1980 through present, the annualized weekly volatility of the S&P 500 in weeks in which a presidential or mid-term election took place was 19.97%, vs. 15.34% for all other weeks.⁴ It is difficult and ultimately undesirable to provide a quantitative recommendation for a bright-line demarcation between those markets that would satisfy an economic consequence criterion and those that would not. However, if a significant statistical test can easily be found that includes the price series of a more familiar asset, and has a logical basis, we can reasonably say that such events are associated with an economic consequence. In many cases the relevant time series may be unavailable, but in those cases the applicability of a proposed event market to other assets may be obvious. For example, consider a market predicting the likelihood of: (1) ethanol-related legislation, and its relationship to corn prices, or (2) offshore drilling legislation, and its relationship to oil prices, or (3) an attack on Iran, and its relationship to oil prices, or (4) future tax rates, and its relationship to municipal bond prices. In such cases, no quantitative test is necessary. In other cases, we may have moderately strong reasons to suspect that a given event or measure has an impact on asset prices, as we do with demographic trends, but those effects may be difficult to measure empirically.

Many potential markets may improve decision-making for a particular business, but have little bearing on the broader economy and asset prices in general. Examples of these markets include those predicting: (1) the revenue of a particular product, published title, film or performance series, (2) the launch or completion date of a particular product or project, and (3) the success of a particular approach applied to certain problem. The CFTC may find that only broad-based events or measures affecting an entire population, industry or significant percentage thereof would satisfy the economic consequence criteria. This would be nothing new, as commodity derivatives were not intended to be specialized insurance contracts. Such narrow questions also present issues from a manipulation and insider-trading perspective. In aggregate, these sorts of questions are quite relevant to the economy and will at times reflect broad trends, but may be more appropriately served by over-the-counter arrangements or riskless information aggregation, despite the obvious advantages of market incentives.

Contracts satisfying economic consequence criteria need not be approved for listing by the CFTC, though it is hoped that guidelines will be made public and remain flexible. At the limit, the CFTC will recognize that even a purely speculative market might serve an economic purpose in reducing portfolio variance.

Additionally:

The CFTC might levy a special fee on regulated event contracts to recoup expenditures related to a trading prohibition facility and other special demands on resources.

It may be required that exchanges pay interest on binary event contract collateral in order to reduce price distortions near extreme prices (100% and 0%). In illiquid markets, such distortions could be used to disguise transfers of money between anonymous participants.

The CFTC should welcome Securities and Exchange Commission opinion on contracts based on events like earnings and dividend announcements, a group of which might begin to replicate a security. Whenever a market is proposed that reflects the cash flow of a particular business or property, this opinion may be relevant.

To the extent that they subsequently conform to the CEA and CFTC policy, amnesty for any past violations should be considered with respect to Intrade and similar exchanges that have operated legally in their domestic jurisdictions.

ELECTION AND POLICY EVENT CONTRACTS

Election and policy event markets are within the jurisdiction of the CFTC based on the letter and spirit of the CEA. These markets represent the largest reasonably predictable yet unhedgeable risk facing businesses and the public. The regulation of such markets follows from the history of enlightened, flexible innovation exemplified by the CFTC. Because of their importance, election and policy event contracts naturally involve special consideration, although only in the course of satisfying the CEA.

Considering election contracts:

Trading prohibitions should be established such that candidates and proxies cannot participate due to their ability to determine the outcome of the contract. In addition to adhering to the "beyond the control" requirement of excluded commodities and general anti-manipulation precepts, the CFTC will want to consider to what extent such prohibitions might be expanded to act as insider trading restrictions similar in form to those of 7 U.S.C. § 13(f) or the proposed H.R. 2341.⁵ Especially given the all-or-nothing nature of many event contracts, this might be desirable in order to provide for fair and equitable trading.⁶

Upon the death of a candidate, the candidate's contracts and those of all competitors must settle on the last known price before the event. A new set of contracts reflecting the new set of candidates could subsequently be offered.⁷

Analogous rules could be applied to policy and legislative contracts where appropriate. These rules, either directly administered by the CFTC and related associations, and/or required of exchanges, would firmly address outcome manipulation.

Because of their importance and sensitivity, these contracts also require special measures to ensure against price manipulation. However, it is important to note that election and policy markets have typically been traded as binary event options. Such contracts expire at a specific time according to a well-defined objective event and in that way are more resistant to manipulation than futures and perpetuities, the prices of which are unbound in one direction and always open to interpretation based on unobservable factors and developments in related markets. At the same time, the relative detachment of event contracts from the web of more familiar asset prices may make manipulation more difficult to prove.

As would be expected, large trader lists could be maintained and closely followed. A more powerful option is the enforcement of extraordinarily low position limits, which would greatly reduce the potential of price manipulation. At the same time, position limits should respect outstanding risks participants may have and be otherwise unable to hedge, as with traditional hedging and speculative limits. Low position limits also address trader protection concerns if such contracts were to be offered in a non-intermediated fashion. Leverage might likewise be limited. Several tiers of opt-out protection could be available to traders of various capitalization and expertise. Contracts might also be restricted to limit orders in order to curb short-term feedback trading.

Election and policy contracts ought to be restricted to domestic accounts only. This will avoid possible extradition problems where disciplinary action is required. In the case of event contracts that may reflect tax rates, this restriction will also determine that the Department of the Treasury will not lose revenue on a net basis.⁸

FLEXIBLE LEGAL IMPLEMENTATION

Instead of, or in addition to, claiming jurisdiction over some event markets, the CFTC has at its disposal a range of public interest exemptions, including some that interpret the 7 U.S.C. § 6(c)3(K)⁹ qualification clause liberally in order to include participants who might not normally trade in traditional futures and options markets. From my perspective, such exemptions may allow for a more flexible development of event markets in a less heavily-regulated environment. For example, it might allow for a contract in research science claims where trader-researchers capable of determining the outcome are not readily identifiable, or provide for trading in the sorts of narrow, business-specific questions previously mentioned. From the CFTC's perspective, a public interest exemption may be desirable in order to avoid making a firm jurisdictional claim. However, the outcome of this comment process should be a decisive policy statement from the CFTC, not a sequence of ad-hoc actions. It is hoped that any future public interest exemptions would be offered alongside a substantial list of requirements and guidelines that would at least signal jurisdiction over a class of event markets possessing certain characteristics. Legal certainty is perhaps the most important outcome in this process, and it is not desirable for the CFTC to extend exemptions in a manner that leaves its jurisdiction completely ambiguous with respect to the markets so exempted.

This leaves aside the question of who may operate such markets. If exempted exchanges are to operate for profit, a jurisdictional statement from the CFTC is all the more necessary in order to ensure their legal standing. Exemptions directed at non-profits may be superfluous from a perspective of legal certainty, especially if such exchanges only offer trading in States where the predominant factor test holds.

The CEA allows that public interest exemptions may be issued for specified time periods. The CFTC may wish to consider to what extent exemptive or no-action letters with renew-by dates attached might be a useful tool in light of evolving legal conditions and technologies.

Note that theoretically the CFTC could also assert jurisdiction over all event markets and then direct no-action letters to the finite list of sports and gaming exchanges as a facility to repudiate jurisdiction over such markets. Typically, exempting markets formed principally for speculation would be considered against the public interest. However, if the CFTC finds no satisfactory way under the CEA to take jurisdiction over only those event markets that are associated with economic consequences, no-actioning sports and gaming exchanges would be in the public interest on a net basis, and would best promote interstate commerce. Furthermore, in some cases such exchanges operate under their own regulatory bodies and protections. It is also seldom that such exchanges allow for leveraged trading by beginner participants. In general, most gaming takes place via over-the-counter transactions.

THE PUBLIC INTEREST

I have neglected to argue for event markets in terms of the public interests they promote as these facts have been covered by others and have no doubt been obvious to the CFTC for a long time. I will only note some cases that are more subtle:

Information and estimates can be revealed in conditional form, as in the "decision markets" hosted on Intrade.¹⁰ One such market pays 100% if a Democrat is elected President in 2008 and the national debt rises in the calendar year preceding October 2011. Since the probability of the former event is also available on Intrade, by P(A | B) = P(A & B) / P(B), we can say that the probability of a Democratic president leading to a rise in the national debt is the decision market price divided by the election market price. This type of market is thus able to predict the result of electoral or legislative decisions, and different decisions can be so compared. With this in mind, consider that while prediction markets are usually described as ways to aggregate information, they are likely also useful in terms of collective problem-solving, even in cases where all information is transparent.

In terms of risk-sharing, eventually the utility of political event markets might begin to address some well-known problems with representative government. Consider the typical special interest problem in which a few relatively well-funded individuals would gain heavily by a particular piece of legislation such as an industry subsidy, and so will lobby heavily for it. Even if the legislation is not in the public interest, the costs will be distributed over so many tax payers that they will not care to argue against it, and most will not even realize what’s happening. When mature legislative and public policy markets are in place: (1) the dispersed interests will have the recourse of hedging against policy they dislike, (2) special interests will also have the option of hedging their legislative fortunes, which might lead to an overall reduction in lobbying, and (3) legislators may find compromises to be easier, since interests would be able to voluntarily "meet each other half way," with price being the arbitrator. This could ease political log-jams, making law-making itself more flexible and efficient. Sensible yet otherwise politically infeasible measures such as unwinding entrenched subsidies could be made viable.

Even if iterations are required, the outcome of this comment process should be a clear statutory interpretation and policy statement from the CFTC regarding event markets. The CFTC should also publish self-certification guidelines for those markets that it determines are within its jurisdiction. Once jurisdiction and/or a public interest exemption framework is determined, it should not be ambiguous whether, for example, a contract based on a presidential election would be approved by the CFTC in principle.

There is good deal of apprehension among those who study prediction markets that regulation will stifle innovation. In truth, exchange requirements may not be as onerous as they are often portrayed, and in most cases are perfectly appropriate. A related, implied fear is that the CFTC may not approve certain contracts such as those on election and legislative events that undeniably possess economic purpose due only to their political sensitivity and considerations of the CFTC’s source of authorization and funding. I hope that this process will assuage such fears. I encourage the CFTC to act decisively and comprehensively in accordance with its purposes.

Sincerely,
Jason Ruspini

Footnotes:

¹ For example, a market on infrequent terrorist attacks would not be approved for the simple reason that outcome manipulators could not reliably be identified beforehand.
² cf. Robert Hahn and Paul Tetlock, “A New Approach for Regulating Information Markets,” AEI-Brookings Joint Center Working Paper (December 2004).
³ Justin Wolfers and Eriz Zitzewitz, “Using Markets to Inform Policy: The Case of the Iraq War,” NBER Working Paper (June 2004).
Justin Wolfers, Erik Snowberg and Eric Zitzewitz. “Partisan Impacts on the Economy: Evidence from Prediction Markets and Close Elections,” NBER Working Paper (March 2006).
Erik Snowberg, Justin Wolfers and Eric Zitzewitz, “Party Influence in Congress and the Economy,” Quarterly Journal of Political Science: Vol. 2: No 3, pp 277-286 (2007).
⁴ F-test (α = 0.1126). If we instead only consider the Wednesdays following election day compared to all other days over this same period, α = 0.0246.
⁵ The "Stop Trading on Congressional Knowledge Act".
⁶ Trading prohibitions on insiders will also avoid a situation in which candidates are able to enjoy a multiplier effect on their campaign funds by shorting themselves. For example, Candidate A has a campaign fund of $2, and candidate B has $1. By hedging, candidate A can maintain a $2 risk while spending $4 on campaigning while candidate B can only spend $2 to maintain a $1 risk.
⁷ cf. Intrade rules. A more challenging possible scenario involves manipulation preceding the event such that the forced settlement locks-in profits, presumably just as market power is exhausted. See note below on restricting market access to US-based accounts.
⁸ Such restrictions would however tend to limit the growth of such markets and/or result in risk premia accruing to short tax-rate positions.
⁹ “Such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections.”
¹⁰ For background, see: Robin Hanson, “Decision Markets for Policy Advice,” Promoting the General Welfare: New Perspectives on Government Performance, pp 151-173, Brookings Institution Press (November 2006).

The CFTC safe-harbor option for event markets

2008-05-28T21:03:00.014-04:00

The recommendation for safe-harbor of a group of influential economists to the CFTC aims squarely at the 4(c)3(K)* clause of the Commodity Exchange Act. The CFTC may approve a public interest exemption under 4(c) provided that the affected contracts are traded only between "appropriate persons". 4(c)3(K) is the only qualification that would accommodate "retail" trading in the style of IEM, allowing, "Such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections." Regarding "other qualifications", the economists recommend:

"that three types of entities be eligible for safe harbor treatment. The first would be not-for-profit research institutions, including universities, colleges, and think tanks wishing to operate exchanges similar to the Iowa Electronic Markets. The second would be government agencies seeking to do research similar to that of nongovernmental research institutions. The third group would consist of private businesses and not-for-profits that are not primarily engaged in research, which would only be allowed to operate internal prediction markets with their employees or contractors.

Regarding the applicability of regulatory protections, the economists recommend that such markets should be limited to small-stakes, low-fee contracts. This limitation addresses consumer protection because the CFTC is typically much less interested in non-levered transactions, and there is little chance of being able to manipulate a market with a small-stakes account. Possibly, consumer protection measures could completely satisfy 4(c)3(K).

The safe-harbor proposal looks like an expedient option that would avoid the problems of treating event markets as excluded commodities (or exempt commodities), which were touched on last time. One problem the CFTC faces is selecting a principle that would include only markets that pass an economic purpose test within their jurisdiction, and the safe-harbor proposal avoids this problem. Although there doesn't seem to be anything in the CEA to indicate that an exempted market could possibly lie outside the agency's jurisdiction, Congress has determined - significantly - that, "Rather than making a finding as to whether a product is or is not a futures contract, the Commission in appropriate cases may proceed directly to issuing an exemption."

Arguably, if someone were to set-up non-profit small-stakes exchanges similar to the ones the economists describe, they would not need CFTC safe-harbor anyway - especially if they restrict trading to States where the predominant factor test applies. Safe-harbor would, however, allow for exchange profits.

I believe that a combined approach would work best. Treating event markets as excluded commodities would not contradict granting some exchanges public interest safe-harbors, which would especially be appropriate if they wanted to host markets like research science claims, where a trader might be in control of the outcome. Exchanges seeking to host larger stake markets useful for hedging could do so with a trading prohibition for people who might be in control of the outcome. From the CFTC's perspective, the safe-harbor would be a less complicated option with regard to their jurisdictional scope. Ultimately, statutory clarification is needed.

* This section is listed 7 USC 1, section 6(c) here.

CFTC regulation and election contracts

2008-05-26T20:07:00.012-04:00

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.

Foreseeable pathologies in political event markets

2008-05-26T11:18:00.000-04:00

Last Month, Marc Groz of Topos Capital graciously invited me to deliver a guest lecture to his class at NYU. The talk, "Measured Enthusiasm for Prediction Markets", was given to about 20 students. It introduced prediction and decision markets, then went off into tax and policy markets. As the title suggests, it wasn't evangelical, but I hope to have excited a few students about this new frontier. The presentation includes a couple of problematic scenarios that I have not seen discussed yet.

Some of these issues such as hedged manipulation could be addressed if the CFTC begins regulating event markets. More on that shortly..

Tax Futures TV appearance

2008-05-26T11:07:00.001-04:00

In February, I appeared on BNN, Canada's business channel, to discuss the tax futures that had recently launched on Intrade.

One clarification: after some more careful research, the predominant factor test technically does not hold in New York State, although small-ante gambling participants are rarely prosecuted.

The contracts are still, um, not exactly eurodollars.

Tax Futures, "In Real Life"

2008-02-06T23:55:00.000-05:00

I am very pleased to announce the world's first explicit tax futures on Intrade. I thank John Delaney and everyone there for their help and enthusiasm in getting these off the ground.

The contracts will forecast the highest marginal single-filer federal tax rates for 2009, 2010 & 2011. I expect trade to be concentrated in the 2011 contracts, as Bush's 2001 tax cuts are scheduled to expire that year, reverting the rate in question from 35% to 39.6%, while the lower bracket rates each increase by 3%. While it is less likely, Congress may also alter the Bush tax cuts for tax years before 2011, but such changes would probably impact 2011 as well.

If reasonable liquidity can be sustained in these markets, I hope that contracts will be added to predict corporate taxes, and other factors that contribute to individual effective tax rates, like the Alternative Minimum Tax and the social security cap. Given the tremendous hedging utility of such markets, maintaining a liquid two-way market might be tricky, although there are some obvious ways for any market-makers to hedge what might become a position more short of taxes than usual.

Please read the last post on "Policy Event Derivatives" below for some background on the potential benefits of such markets. I should add that while I am confident in their long-term value of making better group decisions and sharing risk, I am sensitive to some foreseeable pathologies, and don't want to give the impression of being too cavalier at this point. There are potential problems and side-effects stemming from the use of such markets that will be addressed later.

Policy Event Derivatives

2007-05-22T21:36:00.000-04:00

The essential purpose here is to advance the ideas of public policy markets and tax futures. To this end, we can once again show that such markets help to address well-known problems that arise in government.

Consider the typical "special interest" problem as described in public choice economics. A concentrated group stands to profit from a legislative decision. Say, for example, there are one hundred people in an industry, and that each one would make one million dollars from a proposed government subsidy. They will lobby heavily for this subsidy, and indeed spend money in the process. On the other hand, if there are 100 million other taxpayers, they will each have an additional implied tax burden of one dollar (or likewise a tiny reduction in real purchasing power) and thus individually they will not care to oppose the subsidy and likely will not even know about it. And so the bill goes through, irrespective of its true merits.

Yes, there is more at work among voters than rational ignorance. Voters do have irrational biases on certain issues, but this fact is not a challenge here. If anything, it underlines the desirability of being able to hedge against bad legislation and policy.

Now, when markets that predict the outcomes of legislation and future tax rates are in place:

The dispersed interests, by betting on outcomes otherwise negative for them, will have a recourse specifically against involuntary transfer payments, and generally against government overspending and other bad policies.
Risk-averse concentrated interests will have the option of hedging legislation, by betting against their natural desirable outcomes.
The demand for congressional "favors" and lobbying itself might be reduced. Instead of embarking on costly and uncertain lobbying campaigns, special interests can quickly reduce risk in the market.
The legislators may find compromises to be easier, since private individuals would be able to voluntarily "meet each other half way", with price being the arbitrator. This could ease political log-jams, making law-making itself more flexible and efficient. Sensible yet otherwise politically infeasible measures such as unwinding entrenched subsidies could be made viable.
All interests will be able to make decisions with less uncertainty about the future.

All of the above advantages stem from the risk-sharing capacity of these markets, but the informational value of their prices could ultimately be even more valuable.

Such markets should improve the quantity and quality of public debate on relevant issues, since it will be more likely for large wealthy concerns to have a stake in what would otherwise be a dispersed interest.
Consider a pair of markets predicting some macroeconomic variable such as unemployment, conditional on whether or not a certain policy is adopted. The market prices will give a clear signal as to which policy is more desirable according to the pooled knowledge and expertise of the participants. In this case, market rewards would be established for policy expertise.

Much of the literature on policy markets has in fact focused on such informational aspects. Only a few to date have considered the benefits arising from the risk-sharing itself, but what research there is suggests yet another positive result:

The existence of hedging markets could improve the efficiency of outcomes of elections in which candidates promise redistributive policies. That is, if total wealth will be greater in a certain outcome, the existence of hedging markets will make that outcome more likely.

This is the argument of Ole Jakob Bergfjord, and, in an under-appreciated paper, David Musto and Bilge Yilmaz. (Note that we are now talking about a contract on an election with redistributive implications, though this is essentially the same as a contract on a piece of tax or subsidy legislation.) Like all models, the one developed by Musto and Yilmaz carries assumptions that may not hold in the real world. Specifically, they ignore transaction costs, which can be crucial when one of the interests is heavily dispersed. (Musto and Yilmaz also predict that elections will be determined by ideological positions to a greater extent when risk-sharing markets are in place. Let us call this a neutral effect of these markets, for now.)

Turning to the likely development of policy event derivatives, although the special and dispersed interests are natural counter-hedgers, which is an oft-cited condition for a successful market, it is likely that speculators will stand in for the dispersed interests at first. Commonly, the speculators will try to capture a premium by providing insurance to the special interests, and the first speculator to join the market should capture the largest premium.

Though we often use the term "futures", and enthusiasts of new markets are biased towards exchange-traded contracts, it is likely that such markets will begin in an over-the-counter environment. The news suggests markets with regularity: the estate tax, energy windfall taxes, the ethanol subsidy, etc. In fact it is surprising that we have not heard of such deals yet. In addition to all of the positive effects listed above, this could be the biggest untapped business on earth. People in finance are usually not reluctant to interject themselves into trillion dollar flows.

Leo Melamed, while developing the now $2 trillion/day foreign exchange markets in the early 1970s wondered, "if offering 'dollar futures' [...] was so logical, why hadn't anyone else thought of it? I wasn't sure if there was an obvious reason why it wouldn't work." With policy event derivatives, there are clearly many legal and regulatory obstacles in the way. At the same time, the idea of betting on government strikes many as unnatural and suspicious, a rough beast slouching towards Washington, so to speak. This anti-market bias has helped to keep people from thinking about such markets, and of course, businesses already having success in conventional areas are reluctant to raise the eyebrows of Washington.

There are other potential issues with these markets that we've addressed before, but none of them seem to be insurmountable. Even if these markets come to be explicitly outlawed in a given country, one can be confident that they will be given their fair try somewhere in the next ten years. As the old Nymex slogan goes, "evolution is inevitable".

Previous:
Tax futures and the libertarian paradox
Tax Futures
Some benefits of legislation-linked derivatives
Why we don't have tax futures

Tax futures and the libertarian paradox

2007-03-22T20:49:00.000-04:00

The libertarian paradox whereby free markets spur wealth creation which in turn supports the growth of the state suggests a potential issue with tax futures. Tax futures are hedging markets that predict future tax rates and could trade alongside more specific policy event derivatives. Such markets are naturally attractive to libertarians but, as with liberal institutions, we have to be wary of unintended consequences. This specific issue echoes the broader libertarian paradox and is summed up in this brief exchange with Patri Friedman last year:

Me: Yes, this is one of the deepest worries with ideas like futarchy or legislation-linked markets. The latter have a libertarian slant insofar as they mitigate the state's ability to redistribute wealth, but if they were actually widely used, these effects might be canceled-out — or worse. Maybe the state and its taxing/spending would balloon as it would be more tolerable given the recourse of hedging against it.

Patri: Well, we've already seen taxing/spending balloon because its tolerable. I think that's the greatest cause of the difference in tax rates between the 19th and 20th centuries. We are so rich that the half our money the government takes isn't worth that much to us. In the old days, people rioted over tiny taxes that meant a lot more to their standard of living.

There is no easy way to ensure against this danger, but its existence might actually make tax futures more attractive to those on the economic left. It is a "package deal" as Tyler Cowen says, using one of Rand's favorite colloqualisms. Cowen's bottom line is that, "human beings have deeply rooted impulses to take newly acquired wealth and spend some of it on more government and especially on transfer payments. Let’s deal with that."

Yes, let's, literally.

Non-obstacles to CFTC-regulated political event derivatives

2007-02-10T14:44:00.001-05:00

Now that the CFTC has effectively begun regulating event derivatives, what obstacles might lie in the way of a DCM-hosted election market? Is there now greater ambiguity between futures trading and legal gambling? After all, couldn't a game of roulette be described as an event option? (I see no current statutory basis for that CFTC's policy of using "economic purpose" as a condition for jurisdiction over non-hybrid instruments.) The roulette example is a limit case, but Las Vegas bookmakers do quote spreads in presidential elections. Could such examples make the CFTC hesitate in approving more unique event derivatives?

No, they should not for the simple reason that Las Vegas propositions are not exchange-traded contracts. They are more like OTC forwards and warrants than futures and options. The CFTC has lilimited authority over non-forex, non-fraudulent off-exchange transactions.

Also, casinos do not derive any material revenue from games corresponding to the types of event contracts the CFTC would consider for approval, thus there is no real chance of casinos lobbying the relevant Congressional committees, the members of which have little affinity to gambling interests in any case.

Finally, there cannot be any doubt that political event derivatives serve an economic purpose. I think the chances are greater than 50% that presidential election contracts will trade on a DCM within the next 16 months. If not, the CFTC should seek statutory clarification of event derivatives going into their next reauthorization, although this should not be necessary in light of their approval of credit event futures and Hedgestreet's economic release options.

Legal "prediction markets", sooner than you think.

2007-01-29T21:49:00.000-05:00

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.

Aloha, Poker Players Alliance

2007-01-24T20:57:00.000-05:00

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.

The LindeX Currency Exchange

2007-01-20T18:27:00.000-05:00

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]

Yootle interest rates and inflation

2007-01-08T20:10:00.000-05:00

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

2007-01-08T19:10:00.000-05:00

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.

NYMEX to launch Property Damage Risk Futures

2006-12-14T19:57:00.000-05:00

The New York Mercantile Exchange today announced that it intends to list Property Damage Risk contracts based on Gallagher Re's planned "Re-Ex Index", which will track losses due to catastrophes, defined as events causing more than $25 million in damages by ISO's Property Claims Services®.

The contracts bear a close resemblance to Hedgestreet's hurricane markets, although NYMEX will allow hedging against other types of catastrophes. Larry Tucker of Gallagher Re notes:

Despite the relatively benign hurricane season this year, demand for property damage cover continues to vastly outstrip supply and the way in which reinsurance contracts are currently negotiated, which has remained virtually unchanged for decades, serves only to frustrate that process. Against this backdrop, the market has seen an increasing presence of the capital markets, particularly hedge funds, within the reinsurance space challenging existing methods by providing cover directly such as collateralised reinsurance contracts and cat bonds.

The business method used in trading and the contracts themselves are patent-pending.

[Cross-posted from Midas Oracle]

Flora of North America (CFTC regulation again)

2006-12-14T19:51:00.000-05:00

Tom Bell argues that the CFTC does not have authority over event and prediction markets. At the core of his argument is the definition of commodities subject to CFTC jurisdiction in the CEA: "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in." Bell claims that prediction markets offer "present delivery of conditional rights", not "future delivery of unconditional rights". Thus prediction markets are spot markets. However, this critical assertion hinges on whether "delivery" in the CEA definition above refers to delivery of rights. This is not the only possible reading, and I would bet that it is not the most common. Delivery could instead refer to delivery of a thing, or of cash, the amount of which is conditional. Bell also does not cite a relevant part of the CEA's definition of "excluded commodity": "an occurrence, extent of an occurrence, or contingency that is [...] associated with a financial, commercial, or economic consequence". This clearly could apply to an event or prediction market (though a market in science claims might not be considered "beyond the control of the parties to the relevant contract").

In any case, the CFTC has approved a few event markets with little challenge. With the caveat that I have no special legal expertise, I believe that the agency has legal jurisdiction over prediction markets, but does not want to exercise it for the reasons listed last time. Keep in mind that this whole legal and regulatory challenge is only relevant to exchange-traded retail contracts. If someone has a bright idea for a larger-scale commercial, industrial or governmental contract, there are plenty of options available, including an EBOT or OTC transactions. The "safe-harbor" suggestion of Paul Architzel might also entail stifling limitations. When the CFTC granted safe-harbor status to swaps in 1989, it did so under the conditions that the contracts: 1) have individually tailored terms, 2) be used in conjunction with the counterparty's line of business, 3) not be settled using exchange-style offset or a clearinghouse, and 4) not be marketed to the general public. Is it possible to negotiate a prediction market safe-harbor that would allow for some level of internet-based retail trading? Maybe, but what would it take? Likely more than a bunch of bloggers and scholars. In order to persuade the CFTC to spend time entertaining such a request, it would help greatly if you have a viable business ready to launch (and one which serves an uncontroversial social function). There is simply too much money at stake on the CFTC's other operations for them to devote resources to help someone disinterestedly sow seeds — even if the agency is completely sympathetic and agreeable in principle.

The no-action possibility seems to be off the table, especially if you want to operate an exchange for profit. On the gambling law front, it is encouraging that state prosecutors have left IEM alone for so long, but this is also probably a function of its non-profit status and lack of advertising.

All of that said, I continue to be optimistic about the possibilities of a real-money prediction exchange operating legally in the United States in the not-too-distant future. Finally, we all owe Tom Bell many thanks for the work he has done on this topic.

[Cross-posted from Midas Oracle]

Credit Event Futures and other fauna

2006-12-13T18:47:00.000-05:00

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]

Is the hedging economic purpose test ambiguous?

2006-12-13T18:42:00.000-05:00

Apropos of Andrew Gelman's comments on the questionable benefits of betting markets, if insurance can be understood as reducing variance in wealth, consider the effect of diversification at the portfolio level. Uncorrelated assets such as those attached to political events, weather, sports or even poker hands could be used to improve the risk-adjusted returns of more typical portfolios.

Not to say that hedging, insurance and reducing variance in wealth are actually identical concepts. For one thing they are not treated the same in terms of accounting and taxation, but with some refinement this sort of idea could be useful for proponents of financial innovation in the United States.

[Cross-posted from Midas Oracle. JC Kommer later linked to a speech by Leo Melamed, in which he asserted that financial pioneering needs no economic justification. I largely agree, but offer this argument as a matter of pragmatism.]

Economic Derivatives Auction trader motivations

2006-12-13T18:31:00.000-05:00

The National Association for Business Economics' experimental auction data for the October payrolls release seems to be unavailable, but let's compare their forecasts to CME's economic derivatives auction for the September release.

NABE:

CME:

The CME numbers had more variance and fatter tails. Specifically:

NABE: Less than 5% in the less-than-0k and greater-than-250k tails.
CME: 10.1% in the less-than-0k and greater-than-250k tails.

NABE: Approximately 75% between 75k and 175k
CME: 47.7% between 75k and 175k

One possible interpretation is that the tails of the CME auction are overbought (by hedgers?). I have not seen the CME data recently, but from what I hear it does not actually show a longshot bias over time. This suggests that the tails were underbought in the NABE auction. We don't have enough NABE data to analyze, but since their participants were fully-funded we might expect them to herd around the consensus number. Justin Wolfers has also suggested that what we see in the NABE auction is overconfidence, which would dissipate in an auction with larger stakes.

In any case, hedging against the payroll release has recently been an absurd exercise. The number reported for September was 51k, but this was later revised to 148k. This revision was reported on the day of the October payrolls release, along with a second revision to the August number, which now stands at 230k. That is, the numbers on which the CME auctions for August and September were settled were low by a total of approximately 200k. Revised numbers were a well-known inevitability to the market's designers and traders, but this had to be exasperating for anyone actually hedging a fixed income position with the October release auction. If this theoretical person had been long fixed-income, he probably would have hedged by buying the upper tail of the payroll outcome: a result likely to embolden the fed and send bonds lower. The October number actually came in on the low side, and our theoretical trader would have happily accepted his hedging loss, but wait a minute... the numbers for the earlier two months were simultaneously revised much higher, causing the largest one-day sell-off in bonds in months.

This begs the question of whether our theoretical hedger exists. A recent article by Howard Simons at TheStreet.Com echoes the earlier opinions of JC Kommer and myself that the economic derivatives markets mainly represent a new avenue of speculation (which is perfectly admirable). Using the risk-based definition of gambling (which I am not endorsing), Simons writes, "The risk, however, is attached to particular markets, not to the number. [...] But in the absence of a tradable instrument created for the sole purpose of assuming that risk -- our definition of gambling above -- the number carried no actual risk itself."

The massive effects of revisions only reinforce the argument against the existence of substantial hedging in economic derivative auctions, but even without hedging utility the auctions still fulfill an information discovery function.

[Cross-posted from Midas Oracle]

Discounting and prediction market prices

2006-11-26T13:25:00.000-05:00

The prolific Alex Forshaw asks why 2008.GOP.NOM.HUCKABEE trades above 7. But should you sell even an impossible event for less than 100-(100/((1+(r-r_m))^T)+ c? Here, T is the years to expiration, r the risk-free rate, r_m the yield on your margin (which is zero for most Intrade traders), and c is the trading fee, which is currently less than or equal to 0.5 + 1/(1+r)^T (a 0.5% price-taker's entry fee plus the present value of the 1% in-the-money fee). The price of 2008.GOP.NOM.HUCKABEE seems more reasonable with this is mind, but traders are only interested in selling the whole set of possibilities for more than 100*(1+(r-r_m))^T + Σc, or buying them for less than 100/(1+(r-r_m))^T - Σc. This will mitigate any discounting "bias". (Play-money markets also have a discount rate, but it is logically and empirically much less. Play-money markets also show some evidence of yield curve inversion.)

Discounting returns may not bias prices for a number of reasons, including de-biasing by large interest-earning accounts, a short average trade horizon, and gamblers' "irrationality". Insofar as rates (and commissions) are found to affect prediction market prices, then perhaps an "implied probability" or "delta" metric to supplement price is inevitable. In that case, if we interpret price as probability, then the price will be biased, but only because of our interpretation.

Political Factor Analysis

2006-11-12T23:19:00.000-05:00

David Pennock, Lance Fortnow and others on Marginal Revolution and DailyKos explain the "failure" of prediction markets for Senate control as stemming from the assumption that state-level elections are independent events, an assumption that ignores national movements in sentiment.

Is there a way to test this idea? If a general anti-Republican/pro-Democrat wave swept across the country, decreasing the independence of individual elections, it might be expected that those Republicans who best represented the party line would fare the worst compared to what prediction markets and polls projected.

Voting records such as those available at the Washington Post can serve as a simple proxy for how representative members are of their given party. A legislator will be "typical" if their votes nearly always correspond to their party line. Now do the electoral fortunes of legislators who are more typical in this sense in fact exhibit a higher "beta" to general sentiment shifts? If (possibly after trimming special cases) this did not appear to be the case in the last election — if prices were not worse in proportion to how typical the Republican candidate was, then the lack of independence explanation is suspect. In that case, no explanation should be required either, since after all, 70% != 100%.

This is only a first pass, as an issue-level factor analysis should be more enlightening than one that remains at the party-level. This would also allow us to take the challengers' views into account when modeling individual races.

In terms of the "defense" of prediction markets, apparently it needs to be pointed out ad nauseum that the question is not about their absolute success, but their success relative to alternate tools. Empirical findings confirm the superiority of prediction markets to polls, and the logic of motivation is clearly in their favor. In terms of anecdotal evidence, consider these opinions submitted in response to a television survey on confidence in polls conducted on 11/5/06:

I tell the pollsters the exact opposite of what I'm planning to do. It's none of their business anyway.
Carole, Columbus, OH

I don't believe in polls. I keep a penny by the phone. 'Heads I'm a Democrat, tails I'm a Republican.' I like to keep them guessing.
Tom, Seattle, WA

Maybe polls should be more emotive and oblique, and ask questions like, "What issues anger you the most?" and "What issues most affect your day-to-day life?". Prediction markets would then be able to digest this data and better gauge the independence of elections.

In any case, both political factor data and analysis techniques will see development before the 2008 elections. On the latter side, this will include working through ambiguities and accounting for correlations in issue preferences (which constrain party platform "optimization").

[Cross-posted to Midas Oracle]

The Bottom-up Approach to Legal Prediction Markets

2006-10-15T23:02:00.000-04:00

As hoped, the gambling crackdown is beginning to energize efforts that will eventually lead to legal prediction markets in the United States. As expected, some call for CFTC regulation, while others would prefer an exemption of the kind currently protecting horse-racing and fantasy sports, while libertarians tend to favor legal and regulated internet gambling in general.

The most flexible outcomes are also the most expensive ones, at least if one discounts the option of openly starting a real-money exchange and then relying on a combination of the skill/chance distinction and one's good intentions to receive a favorable ruling. The CFTC option would be the most restrictive, but the least expensive since it might not require any lobbying. Proponents of the other two options are left to wonder where the money behind a lobby will come from. Prediction markets have apparently not yet "made millions in decision-value" for anyone. The overseas exchanges and books might have made millions in commissions and spreads, but the US government considers them illegal, and their US clients have little net profit to speak of. In terms of a more general gambling legalization, real prediction market allies actually seem to be few and far between. The Poker Players Alliance is going its own way, turning its back on skill-based contests with appreciable social benefits. American casinos don't seem as hostile as they once were, but remain on the fence. Unfortunately, there is plenty of money on the opposite side, including all professional sports leagues.

Tom W. Bell's suggestion that lobbying campaigns take place at the state level could therefore be helpful. Efforts that would be ineffectively small at the federal level could be marshaled and directed at the most favorable states. The markets would only be legally open to those states' residents, and the operators of the markets should make the good-faith practice of blocking clients from states were gambling is clearly illegal. But there is reason to suspect that if such a law is passed in one state, others will follow, in part from precedent, in part as a tax-dollar rush. At some point, a network effect will help the process along. Within a couple of years, a "confederation" of states where prediction markets are legal could be bootstrapped.

Leaving aside the possibility that a federal backlash might remove the safe-harbor section of the Wire Act described by Tom Bell, what are the most propitious states for such a plan? States that lack casinos are the natural places to start in order to avoid opposing interests. Using the summaries provided by gambling-law-us.com, what follows is a list of states that have no commercial or tribal gambling industries, no explicit law against online gambling, and whose definition of gambling at least questionably applies the dominant factor test of chance over skill — at least according to gambling-law-us.com. In order of population: Pennsylvania(p), Ohio (f), Georgia(d,f,p), Virginia (f), Massachusetts(p), Tennessee(d,f), South Carolina(p), Kentucky(f), New Hampshire(d,f), Hawaii(d,f) and Vermont.

By my own reading of the appropriate laws, there are some unfortunate caveats:

d: The dominant factor test may not actually apply. Often the laws read as, "notwithstanding that skill of the contestants may also be a factor therein", or "dependent upon chance even though accompanied by some skill". Thus bets may be considered illegal even if skill is the dominant factor.

f: Aggravated gambling is a felony. "Aggravated" mainly applies to ongoing businesses that capture some fee for taking (or matching) bets. If the dominant factor test applies and the markets don't touch specifically prohibited subjects, this may not matter.

p: There are specific prohibitions against betting on a political election or nomination outcome (though not against betting on policy events).

There are doubtless many other issues that I am unaware of that will disqualify or reinforce some of these choices, including precedents and interpretations on the chance/skill distinction. There may also be good reasons for including some that were left out. For one thing, it can be argued that the sorts of markets we may be interested in will have a different clientele than the slot-machines and blackjack tables of traditional casinos, and so the lack of opposing interest criterion can be demoted. This is a headwind that prediction markets do not share with poker and the PPA.

That said, another danger to this plan is that national interests may intrude in those states where they currently have little presence, not to mention the federal government applying funding-related pressure. This sort of dynamic is surely in part responsible for the homogeneity of US state laws, but a more experimentalist regime in which laws meaningfully diverge would be more productive and beneficial to the nation in the long run.

To give-in to a sweeping analogy, from its very beginning, biological evolution is made possible by barriers. Barriers allow and promote diversity, which leads to the lucky strikes, the better ways of doing things.. that survive.

In any case, the good intentions of proponents of markets on science and policy claims should be clear, and they will no doubt be in contact with state Attorneys General offices in the coming months.

"All the iridescence of the beginning of the world"

2006-10-09T00:44:00.000-04:00

The World Economic Forum dropped the United States from first to sixth place in the 2006-7 Global Competitiveness Report, released on September 26th. As Dave Altig points-out, America still holds the top position in microeconomic efficiency, and its downgrade results from its suggestively ominous yet difficult-to-interpret macroeconomic position. But microeconomic conditions include things like flexible regulation, and these factors are also beginning to show cracks in the United States.

More significant than the recent embarrassment of HR 4954, the Sarbanes Oxley Act of 2002, and specifically, section 404, has made it prohibitively expensive for companies to list their equities on US exchanges. The stringent auditing and corporate governance requirements imposed by Sarbanes Oxley helped to push 24 of the 25 largest initial public offerings to overseas exchanges in 2005 (though several were nationalized companies being locally privatized, and the list included Partygaming). Between 2003 and 2005, European exchanges went from listing 10% as many technology IPOs (greater than $15 million) as the US, to 93% as many. As of September 20th, this year has witnessed 17 IPOs totaling $6 billion on the New York and Nasdaq exchanges versus 59 totaling $16 billion on the London Stock Exchange. Optimists in the US seem to think that European and Asian exchanges will adapt similarly rigorous listing requirements. They are wrong. International and (hopefully) interstate competition will continue to punish bad laws.

And to quote F. Scott Fitzgerald again, "it had limits — from the tallest structure he saw for the first time that it faded out into the country on all sides, into an expanse of green and blue that alone was limitless."

The "top" of the anti-gambling movement?

2006-10-01T17:39:00.000-04:00

In the oh-so-very important crusade against internet gambling, Republican law-makers, led by Bill Frist and Jon Kyl, scrambled to include a version of the Unlawful Internet Gambling Enforcement Act in the Safe Port Act as the clock approached midnight on Friday. Ostensibly a defeat for proponents of online speculative markets, the passage may actually be a blessing in disguise and signal a weakening anti-gambling hand in the US. Consider these bright spots:

Only the section eliminating payments to online gambling establishments from US-based institutions was passed in Congress. The broken Wire Act of 1961 was not amended, and the legality of placing non-sports bets online is still ambiguously intact in most States.

The commercial banking sector and other financial institutions (which are far larger than the casino and gaming industries) have 270 days to cooperate with the law upon final passage. Because of the high cost of compliance, along with the risk of blocking lawful transactions, it is possible that the eventual procedures may lack effectiveness. Significantly, the prescribed regulations are in the hands of the Secretary of the Treasury and the Federal Reserve Board, who only have to "consult" with the US Attorney General. Since not blocking a restricted transaction is not in itself initially a criminal offense, and might only result in an injunction, it is not hard to imagine that consultations with financial institutions might actually carry more weight than those with the Attorney General. (The financial institutions must not, however, "own" "unlawful" gambling businesses, as we know that many in the past have, in the form of stock.)

Even if there is effective implementation of payment blocking, options such as NETeller (NLR.L), FirePay (FPA.L) or MoneyBookers are somewhat untouched by the legislation. In reality, little has changed for US traders. Overseas internet gambling companies will bear the main brunt of the legislation, as US clients may be reluctant to use alternative payment methods, and even if they do so in large numbers, gambling companies will then face increased counterparty risk. At least one alternative payment company might actually benefit from this law.

Opponents of online gambling are further disgraced. It was embarrassing enough that they were already catering to the interests of casinos, lotteries and exempted gambling interests in an almost cartoonish fashion. Now they also being called negligent in terms of national security. Anti-anti-gambling animus is growing.

There are rumors that "tax haven" nations such as Gibraltar and Antigua, among others, are considering legal action against the United States, which was already in violation of a previous WTO trade treaty ruling.

The most worrying section of the bill to some concerns Internet service providers and reads that enforcement, "be limited to the removal of, or disabling of access to, an online site violating section 5363, or a hypertext link to an online site violating such section, that resides on a computer server that such service controls or operates". The question is then: does "reside on a computer server" apply to "an online site", or, more generally, "access to" an online site? The latter interpretation is far stronger and would suggest that ISPs can be prevented from redirecting connections to gambling sites, but I think enforcement of that interpretation would be highly contested, and comes back to the central difficulty of internet regulation. Since UIGEA principally makes the acceptance of gambling payments illegal, and overseas companies are not governed by US code, the entire bill is arguably devoid of force with respect to them. Financial institutions made to comply with the law might say as much in the 270-day window. The venal nature of exemptions for favored gambling interests will only help to undermine the law one way or another.

10/3/06 Update: The market strenuously disagrees with my appraisal of the alternative payment companies like NETeller and Firepay, but it is unlikely that such companies will be specifically targeted in the recommended procedures of The Secretary of the Treasury and The Federal Reserve Board — after all, they also process non-gambling transactions. This leaves the companies with a choice: respect US law though they are (arguably) not governed by it, or take the opportunity to gain market-share in a vacuum of sorts. I would guess that at least one will take the latter path. The market is instead saying that they will be somehow targeted, or meekly fold like 888 and Partygaming (who the DOJ already considered to be in violation of the Wire Act, not to mention tax evasion). NETeller's statement gives no indication that they will be voluntarily closing-off their US business. As Gambling911 reports, 888 and Partygaming seem to be pursuing buyout strategies at this point. Yesterday, considering that each group was down about 60%, I suggested a spread trade (long the processors, short the casinos & books) on Patri Friedman's journal that is working out nicely so far.

Meanwhile, The Poker Players Alliance is taking an increasingly parochial viewpoint. The organization's president was recently quoted as saying, "Our desire is to achieve the same type of exemption from legislation that other interests have received (Horseracing, Lotteries, and Fantasy Sports). [...] This is our most immediate short-term goal" Well, everyone is a special interest of course, but perhaps they ought to rethink that goal as it won't gain them any friends outside of their immediate sphere. Perhaps a more robust, longer-term goal would be appropriate considering that in the "short-term", poker is a game of chance.

Speaking of gamers, I notice from my access logs that a certain three-letter agency read, among other things, my post on the gambling that might be taking place in virtual locales operated in the United States. Yet something else to keep an eye on.

The State of Louisiana vs. X: Put my money on X

2006-09-27T22:28:00.000-04:00

Or behind X, where internet gambling is concerned, at least. A few months ago I wrote that, "it may take an attempted crackdown to galvanize support for online gambling in the US."

Well, we may be getting there.

Adding to its singular accomplishments, the great State of Louisiana is now lending a hand to the assault on the future competitiveness of United States financial markets. The recent arrest of SportingBet Chairman Peter Dicks apparently signaled a wider crackdown on unregulated internet-based speculative markets, but it's unclear to what extent federal agencies were actually involved in this case. Considering the history of gambling prohibition, it isn't at all surprising that Louisiana may have been acting at the behest of local casinos who feared online competition. Fortunately, there is reason to suspect that Louisiana's legal efforts will prove to be feeble, and may be rebuffed in New York with a suitable level of disgrace. Companies accepting or brokering online wagers might also be able to escape Louisiana's wrath by simply blocking IP addresses originating in the State. (In any case, I hope that other writers, especially in the UK, Europe and Australia, will continue to take every opportunity to chide the United States and its paralyzing rat's nest of archaic federal and borderline corrupt State laws.)

Still, many enthusiasts, not to mention entrepreneurs, of unregulated markets are frustrated and wondering how to proceed. Actually, the securities and investment industry lobby - already the 5th largest - could be a natural ally to these dispersed interests. It's worth noting that a few large and well-respected investment banks at one time held positions in both SportingBet (SBT.L) and BetOnSports (BSS.L). Most of these positions have probably been exited by now and these banks (or their clients) are among the many shareholders hurt by the burgeoning crackdown, which currently has destroyed around 2.4 billion pounds in market capitalization. Also, consider that commercial bankers were the most weighty opponents of the "Internet Gambling Prohibition and Enforcement Act".

More generally, new markets mean profits for banks, both in terms of brokering and trading capacity. Of course, the vast majority of these new markets will be too small to attract interest from investment banks, but the risk-sharing markets (e.g. tax futures), at least, have the potential to be large enough. Risk-sharing markets presently fall under the jurisdiction of the CFTC, which is reluctant to approve any contract that would raise the eyebrows of Congress.

Now, the SEC, alongside the banking lobbies, would be in a more politically secure position to oversee exchange-traded contracts like policy event derivatives. The jurisdictional dust-ups between the SEC and CFTC are well-known, and the Senate Banking Committee, which oversees the SEC, seems to be taking an increasing interest in the activity of the CFTC. So, both in terms of legalization and robust, flexible regulation, banking interests are perhaps the best hope - however indirect - for proponents of new online markets.

9/29/06 Update: As hoped, Dicks is free to return to the UK. After consulting with Eliot Spitzer, New York Governor George Pataki has refused to sign the extradition order to fourth-rate power Louisiana.

Nymex: "Evolution is Inevitable"

2006-08-23T00:06:00.000-04:00

Nymex seatholders have for some time been contemplating the value of their trading rights versus the equity value in the eventually public exchange. On September 4th, Nymex will begin offering physically settled electronic energy futures. Although it was known to be in the works, this announcement is significant and cues the end-game of futures floor trading in the US. Nymex first launched regular-hour electronic contracts in 2002, but the addition was a half-hearted gesture given the exchange's commitment to floor trading at the time. Volume on the electronic side languished until last year, when competition from the ICE motivated Nymex to back the contracts more fully. Recently, full-size electronic contracts were launched as part of April's agreement with the CME. But even though the electronic side is seeing better volume, it is missing something important: physical settlement, which can only be found on Nymex's floor. Some speculators do prefer cash settlement, but hedgers and even banks, who are among the largest exchange customers in terms of open interest, demand physical settlement. Next month they will be able to get it electronically, and transparently.

Michael Sankowski's comments on bootstrapping markets reminded me of my experience with the Nymex electronic contracts from 2002 to 2003. Essentially what we had on the oil side were 10-20 market-makers and arbitrageurs — and virtually no-one else. Active markets need a diverse set of traders with different motivations and time-frames. You can't build a market with market-makers and arbs only, even if they are well capitalized. You also need to attract long-term (fundamental) traders, short-term (technical) traders, and of course hedgers, ideally on both sides of the market. (Participants that derive entertainment from their trading can help too.) In the case of Nymex, it wasn't that they didn't "know better". They knew their business well and didn't get behind the electronic contracts until competition made it a necessity.

Leo Melamed, who pioneered financial futures, once said, "[a market] is more than a bright idea. It takes planning, calculation, arm-twisting, and tenacity to get a market up and going." Likewise, Mark Fisher advised me before I left the Nymex scene, "Jason, you don't think right because you think everything is about thinking." This was an exaggeration but he was basically right. Then, at least.

The rise of electronic trading at Nymex is a reminder of how long apparent inevitabilities, or great ideas, can take to develop. This pertains both to developments of new markets and developments within markets. CNBC loves to stress the speed and excitement of markets, but perhaps what is more impressive is how slowly - how painfully slowly - things usually play out. Stocks in the late '90s. Housing in recent years. The current account deficit and the dollar. Concerning new markets, take Robert Shiller's housing futures, which were over a dozen years in the making &mdash and three ~~seconds~~ months after launch many want to write them off as a failure.

Why we don't have tax futures

2006-08-12T13:49:00.000-04:00

I was encouraged by the comments when Tyler Cowen linked to my last post on tax futures. There is, unfortunately, an obstacle that wasn't touched on. Tax futures would have a tremendous hedging utility and would therefore likely fall under the jurisdiction of the CFTC. The CFTC must be reauthorized by Congress every five years, and must pass through the Senate and House Agriculture Committees. (Incidentally, the House committee is headed by Rep. Bob Goodlatte.) The CFTC is also currently funded by the anachronistically named Senate Appropriations Subcommittee on "Agriculture, Rural Development, and Related Agencies". (Incidentally, this subcommittee of fifteen includes Sen. Byron Dorgan, who led the charge against the Policy Analysis Market and, ahem, always demonstrates such a kind eye toward market mechanisms.) In recent years, the Senate Banking Committee has begun signaling jurisdiction over the CFTC. This could point to an eventual merging of the CFTC and SEC under the Banking Committee. The combined agency would be in a more politically secure position, which would make tax futures incrementally more acceptable.

For now, I suspect - well, know - that the CFTC will not approve contracts tied to acts of Congress. The question then becomes: In which countries would tax futures be most feasible from a political and regulatory standpoint?

Tax futures came back to mind upon learning of Cato Director Jim Harper's WashingtonWatch, which estimates the "cost" or "savings" to households of various bills passing through Congress. While still in an unrefined state that ignores specific tax incidences and basically just gives one an idea of the total revenue or spending attached to bills, this resource seems perfect for use with tax futures. The hedging utility of tax futures would give dispersed interests recourse against government spending and implied future tax burdens. If contracts were attached to specific bills, then concentrated interests could also hedge against losing a subsidy or other special treatment, for instance. This might decrease the demand for congressional favors and ease the unwinding of wasteful spending legacies.

On "Digital Maoism"

2006-08-09T22:02:00.000-04:00

It's difficult to boil-down Jaron Lanier's essay on the limits of online "collectives", but these are the most salient points:

Collectives are stagnant and threaten to smother the voice of genius by enshrining consensus. Genius and creativity will naturally not correspond to average opinions.
Collectives are too volatile and chaotic, and need to be filtered by individuals
It is misleading for collectives to masquerade as objective when they might well contain some personal bias.
The collective fails in matters of subjective taste.

Notice the tension among these assertions, especially between the first two. This essay has received plenty of criticism already. Here are some paraphrased examples:

Lanier is attacking strawmen and taking phrases like the "Wisdom of Crowds" too seriously without considering how they are really used.
Voluntary collective efforts should not be identified with coercive forms of "collectivism". The word "collectivism" in the essay is generally spread too thin over too many distinct endeavors and technologies.
Projects like Wikipedia are not actually anonymous collectives, but are largely the undertaking of known, independent individuals operating within some degree of hierarchy and editorial control.
All minds are ultimately "hive minds" insofar as they are connections of neurons.

There's no need to rehash all of the criticism here, so let's focus on what specific relevance the essay might have for prediction markets. It's not clear that any of Lanier's concerns particularly confront these examples of crowd "wisdom". Prediction markets always resolve on something objective and have a strong meritocratic element. Even if subjectivity underlies a market, as with predicting box-office receipts or album sales, those traders with "good" taste who recognize quality work by underappreciated and underpriced artists will be rewarded far more in the long run than those who merely bet with the consensus. No-one is advocating using any sort of collective effort to legislate the aesthetic and reverse the long-tail trend in entertainment and culture. It's also unclear how "collectives" would hinder the emergence of a Dylan or Hendrix or Ellington as Lanier suggests. For all the talk of Googlization, older forms of media where those stars rose were much more centralized.

The title of "Digital Maoism" was a very strange choice and one guesses that it was chosen to emphasize the suspect point that collaborative, anonymous endeavors might present themselves as objective while containing significant biases and personal imprints. Lanier of course prefers that collective efforts be guided by individuals, so long as this takes place in the open. Apart from concerns about quality and innovation, he also fears instability:

One service performed by representative democracy is low-pass filtering. Imagine the jittery shifts that would take place if a wiki were put in charge of writing laws. It's a terrifying thing to consider. [...] The calming effect of orderly democracy achieves more than just the smoothing out of peripatetic struggles for consensus. It also reduces the potential for the collective to suddenly jump into an over-excited state when too many rapid changes to answers coincide in such a way that they don't cancel each other out.

First, this passage gives an idea of the measured world-view of the piece, which sneers at both socialism and anarcho-capitalism. (The latter would develop its own mechanisms of regulation and stability much like wikis have.) Second, the phrase "answers coincide in such a way that they don't cancel each other out" should pique the interest of prediction market advocates, as this is a textbook problem-case for such markets. Fortunately, these scenarios should be relatively easy to identify. Logically, one can ask questions like "Are all relevant interests/departments represented?" or "Is there a predominance of hedgers?" Empirically, if one has market data over a long enough period covering a set of sufficiently similar questions, one might be able to weight opinions based on similarities in past biases.

There is one further idea to parry: that there is really nothing emergent in an aggregation of opinions. This is best summed-up in one of the comments on Edge, by Yale Law Professor Yochai Benkler:

This leaves the much narrower set of moves that are potentially the legitimate object of Lanier's critique: efforts that try to depersonalize the "wisdom of crowds," unmooring it from the individuals who participate; try to create ever-higher-level aggregation and centralization in order to "capture" that "wisdom;" or imagine it as emergent in the Net, abstracted from human minds. I'm not actually sure there is anyone who genuinely holds this hyperbolic a version of this view. I will, in any event, let others defend it if they do hold such a view.

James Surowiecki, earlier:

I would question the implicit assumption in Tyler's post that the "knowledge" these markets are trying to tap is something that one employee (or a very few employees) have and that most employees are completely without. No one person knows what a company's sales are going to be in forthcoming quarters, or whether a given product is likely to be a hit or not, or whether a software project will be done in time. The information that's relevant to answering any of these questions well is not concentrated in the hands of one person or a few people. Instead, it's distributed among lots of people, each of whom likely has a small bit of knowledge that's germane.

This seems to just be another terminological straw-man; Surowiecki is talking about specific objective knowledge here, not "wisdom" in the broad sense. Prediction markets might be good at providing objective answers in many situations, but as Jaron Lanier aptly points-out, asking the right questions can be more important.

Random laws and real-money market possibilities

2006-07-24T23:36:00.000-04:00

A few weeks ago, I hinted about possible strategies available to US-based firms seeking to operate "hybrid" real-money markets. What I had in mind was the example of Sony's EverQuest and other MMORPGs where virtual game items are sold in secondary online markets for real-money. Such examples have been popular since 2001, so it's a bit surprising that they are almost never brought up in the context of prediction market legality.

One reason for this is the "catch-22" involved in establishing a viable real-money market in play-money. In the early stages, if someone wants to buy the play-money (enabling someone to sell it), they are essentially paying to play the associated game, but if you've designed a game so fun that people are willing to pay to play it, you have already solved your "liquidity" problem, and you might be able to monetize participation directly, as with monthly fees. So allowing player-traders to exchange play-money won't hurt participation, but won't by itself cause a breakthrough either.

It is useful to think of play-money markets as games however, and consider the games they are competing against for attention. Trading games (play-money prediction markets) do not substantially compete with MMORPGs. They are more likely to compete with fantasy sports leagues (which enjoy legal protection, exempting them from anti-gambling laws) and any online game that doesn't require large, contiguous demands on one's time.

Frustrated entrepreneurs that wish to run real-money markets should - so far - be encouraged by the example of Sony's Station Exchange, an in-house auction system launched in June 2005 where users can buy and sell virtual items for real money. By hosting the market and promoting trade, Sony is acknowledging that players can win or lose things of real value in the game (which, at one point at least, contained casino-like sub-games in virtual locales). Forum discussions have popped-up here and there on the legality of such arrangements.

The defense of EverQuest/StationExchange would seem to be two-fold:

1) EverQuest is a game predominately of skill: This is the crucial point, and if EQ/SE is viable in this respect, this is excellent news for non-sports real-money prediction markets. Clearly there is some element of chance in EverQuest, as there must be in markets linked to future events. Then again, it's disturbing that poker is not considered a game of skill — and this is why I'm uncertain whether HR 4411 will apply to prediction markets. (Chris Hibbert and I agree that it ought not). Again, we come back to the notion that the legality of various games is often based more on the influence of interested parties and historical vagaries than anything intrinsic to the games themselves.

2) EverQuest players don't risk real money: More precisely, their losses are capped by the participation fee, but if that's the case, what's to stop others from specifying "participation fees" as a way to get around gambling laws? Also, wouldn't it be possible for an EverQuest player to buy virtual goods only to have them looted-away or otherwise lost in the game, resulting in a more substantial real-money loss?

Someone closer to the game should be able to shed more light on these points. How EverQuest/StationExchange is treated legally could have a significant bearing on real-money prediction markets in the US, and could determine which interests cast their lots in together.

Self-interest under the guise of morality

2006-07-24T00:38:00.000-04:00

From Gambling and Speculation, which should be on the bookshelf of anyone concerned with overcoming the obstacles to financial innovation:

In 1776 all public lotteries were consolidated in the Loterie Royale modeled on the very successful Lottery of the Roman States sponsored by the pope, and all private lotteries were outlawed. The reason given for the last step was to prevent the French from playing in the foreign lotteries, which were more attractive than their own, and thus losing foreign exchange. But one wonders if there was not another and more important reason lurking behind this act; namely, to augment the treasury's receipts at a time when the kingdom had a budget deficit of 37 million livres. (my emphasis)

Proponents of gambling prohibition will unsurprisingly claim to be serving other interests, not protecting state monopolies or otherwise limiting competition to established favorites. Typically, the cited interests are the young, the poor, compulsive gamblers — basically, those who can't take care of themselves and whose examples are used to threaten everyone with state paternalism, no matter how insignificant the problematic cases actually are, percentage-wise (and no matter how badly cause and effect may be confounded).

Very often, moral concerns have been expressed that gambling is wasteful and diverts people from more productive activities. Alongside this idea, one would formerly hear that gambling instills a poor work ethic, or encourages "idleness", or places too much emphasis on chance over providence. Even here, real interests can be masked. Although the English laws of 1699, 1826 and 1906 were claimed to help the poor, there is reason to suspect that their establishment had more to do with maintaining the status quo and keeping the poor in their place. The higher classes had more to lose, and so had less of a need for variance than the poor. The 1906 law, orginally known as a "class law", was eventually recognized as outdated and unenforceable, and was discarded in 1960 when the Betting and Gambling Act legalized betting shops in the UK.

Over here in The Colonies, the 45 year-old Wire Act is showing its age. Turning the tide against prohibition must start by defeating the Goodlatte/Leach bill in the Senate, which fortunately seems unlikely to come up for a vote this session, or be passed by 2007. Considering their numbers, the information at their disposal, and their combined talents, there is no need for online gambling, poker and prediction market enthusiasts and businesses to remain passive. It should be feasible to: 1) marshal funds from these dispersed groups, 2) model the legislature with respect to special interest contributions and voting bloc patterns using tools like opensecrets.org, and 3) contact or deploy contributions to those legislators most likely to swing relevant votes.

This framework is crude and simplistic, but it's a start. Earlier in the year, the idea of a prediction market industry group was floated, perhaps along the lines of an IGC, but not much became of it. As I suspected, a crisis might be required to spur follow-through on such a plan. There is still plenty of time.

(As a footnote, I don't mean to imply that all of politics is reducible to self-interest, nor that there is no difference between productive work and gambling.)

You heard it here first. Well, not really...

2006-07-09T21:45:00.000-04:00

On July 11th of last year , I observed that:

As VIX [the US equity implied volatility index] makes new multi-year lows, David Merkel at RealMoney [$] notes: "many investors have become yield hogs, and have sold puts and calls to increase income in a tough environment. This is akin to the problems that bond managers face today in their quest to find yield." Meanwhile, Brad Setser is becoming more persistent in his suggestions that the U.S. housing market and, more generally, household wealth owes much to China's trade surplus and its impact on yields. Most intriguing is Tradesport's contract on whether the yuan will be revalued by January 1st; for it seems to be tracking the VIX since the beginning of the year.

Ten days later, China nominally discarded its currency's peg to the US dollar, revaluing by 2.1%. Lo and behold, the VIX has not been lower since the day before that surprise move (which also saw the lowest level since 1993):

Why Intrade's market seemed to track the VIX leading up to the announcement is open to debate, but the following crescendo reinforces the suspicion that it wasn't a meaningless coincidence. One interpretation is that someone was using the market as opposed to expressing a subjective probability of revaluation. It might be silly to suggest that someone was using the market to hedge against another position, and only $21,000 traded in the Dec05 contract (with $111,000 in all maturities), but this would be a straightforward explanation. In any case, this is one of the more interesting prediction markets to date.

(By the way, ten year yields bottomed in June 2005, over a month before the revaluation, and right about the time gold started gaining against all currencies.)

Thanks to Intrade for providing their data.

The Open Question About Prediction Markets

2006-06-30T19:16:00.000-04:00

So enough about hedging for a while.. Let's talk about prediction markets as such. Can we throw away all of the open questions on prediction markets but one?

As Robin Hanson succinctly put it, "the whole idea of prediction markets is that someone who wants to know the answer to a question might be willing to pay to create a market to entice traders to help answer their question." Identifying these sponsors along with the best means of subsidization and the best way to aggregate diverse, knowledgeable traders is THE open question of prediction markets. Real-money markets whose primary purpose is to reveal information and that provide no significant risk-sharing, capitalization or entertainment value must be subsidized, otherwise no-trade conditions will snuff-out activity. Why trade against someone with better information unless you are consciously paying them for it? (This could be what Chris Masse means when he says that aggregating information is not the primary purpose of prediction markets — that a pure prediction market is an imaginary locus.) And needless to say, the market participants can't be in a position where they would be able to otherwise comparably profit from their information without the market structure.

There is also a trade-off to the sponsor in terms of making such markets public in order to attract as diverse a set of traders as possible. Insofar as the sponsors consider the information they are seeking to be valuable, maybe they don't want to make it immediately public through an open market?

If the markets are subsidized via market-making as with a market scoring rule, this presents another reason why binary options might not be the best fit for aggregating information: the sponsor is exposed to much higher percentage losses.

There is no general overarching answer to "the" question, but rather many specific answers that depend on identifying individual niches and inefficiencies. Once these are identified, issues such as interpreting prices are secondary. Promoting corporate prediction markets does approach a general answer however, and here the subsidization happens by way of the company paying for the infrastructure and letting employees' time be diverted, as opposed to direct real-money market-making. Not that corporate prediction markets must operate with play-money. It's not too hard to imagine employee-traders being rewarded by varying their end-of-year bonuses by market winnings or losses, and perhaps the markets could be shuttered during normal working hours to mitigate any time diversion.

Here insider-trading laws may intrude, which brings-up the legality issue that many, including myself at one time, have considered to be the most important open question on prediction markets proper. But perhaps the legality issue is a little overrated and US-centric? Real-money markets in much of the Anglosphere and play-money corporate markets are relatively untouched by it, and there may be some viable strategies for US-based firms seeking to operate hybrid markets. More on this last point in the coming weeks...

Retail hedging?

2006-06-30T01:21:00.000-04:00

Hedgestreet is taking a lot of heat lately from bloggers who focus on prediction markets. Steve Roman has labeled their official strategy of catering to retail hedgers an "imaginary niche". If this is the case, why? Consider that both John Delaney of Intrade and Robert Dubil, Hedgestreet's Chief Economist, have recently stated that many traders prefer binary markets because of their greater volatility. One would expect retail hedging of things like home and gasoline prices to occur in long-dated index contracts, not short-dated options. Hedgestreet offers both capped futures and options, and experiences better volume on the options side. The futures side seems to be dwindling, and almost has a vestigial feel to it.

Even the CME doesn't offer housing futures more than one year out although the contracts were originally touted for their hedging utility. The low overhead of running an electronic market combined with the aggregate wealth of potential retail hedgers seems outweighed by the danger of liquidity cannibalization. In other words, it's not worth introducing long-dated contracts that would cater to retail hedgers because these might dilute the liquidity of existing short-dated markets. How much of the lack of retail hedging is reducible to attitudes towards risk versus education and ease-of-use? Or is the public smart to not hedge certain risks?

It could be that the general population is not risk-averse with respect to some prices, or that many do not even perceive their risks. For instance, on the latter count, Robert Shiller and others combat the notion that housing prices drift permanently upwards. Even if risk appetites and perceptions are partly responsible for the lack of retail hedging, this may not be the most cogent answer to the question. After all, the person who is likely to sign-up and trade in an online market is typically a speculator (and possibly a "sensation-seeker"), so basing this conclusion on the dearth of retail hedging in that particular environment could be misleading. Maybe it's just that electronic auctions are not the right means for retail hedging?

At the beginning of the month, General Motors and Ford introduced sales promotions that amount to gasoline hedges. GM's "Fuel Price Protection" program provides new car buyers with pre-paid gas cards that cover the cost of any gas above $1.99 per gallon. What if such cards were offered at gas stations and sold at a premium to current fuel prices? Or cards that entitled their holder to X gallons of gas, a la the USPO's plans for the "forever" stamp? What if similar features were offered as credit card promotions or as capabilities embedded in private banking websites? The idea would be to push hedging instruments at the general public "on the ground" so to speak, in environments where their utility will be especially tangible, and in which their usage will be straightforward, or at least much more straightforward than setting up an account on an online exchange and explicitly trading options.

The pricing of these new "user-friendly" options would of course be somewhat less clear to consumers, which is why someone might want to sell them, and this brings us to the last possibility: that the public is largely wise to not want to enter hedging markets. To what extent would hedging be taking a guaranteed loss? Are premiums and transaction costs fair? Now, you could say "Wait a minute - many insurance premiums aren't 'fair' and that's a huge business." Yes, but there is a practical difference between hedging against a massive and irreversible loss and hedging against an incremental, reversible one. A crash in the housing market could qualify as the former for some, but in those cases the education and ease-of-use perspective would seem to be more apt.

Maybe housing and even gasoline prices just aren't volatile enough to spur retail hedging, and the public won't reach for the morphine drip until it experiences more pain.

The Poker Face of Wall Street

2006-06-25T18:08:00.000-04:00

The July issue of Active Trader magazine has an excellent interview with Aaron Brown, head of credit risk architecture at Morgan Stanley and author of The Poker Face of Wall Street. This is a must-read for anyone interesting in "prediction markets" and the supposed moral aspects of gambling. Brown contends that gambling plays an important economic function, a function in many cases more important than official market purposes such as hedging. He has even claimed that, "Serious poker is a positive sum game." Here are some excerpts from the full article:

Because if the markets are all about price discovery and capital allocation, then they're really like used bookstores. But it sure doesn't look like a used bookstore, and traders make more than people who work in used bookstores.

[...]

And I started thinking that it couldn't be a coincidence that credit-fueled volatility and clearing came at the same time, at the same place. Also, I noticed that if you jumped in a body of water near every city that had a poker game named after it and every city that had a futures exchange, you'd float down to New Orleans.

[...]

The conclusion I came to was that you have to have a lot of gambling, because you have to move a lot of goods randomly around and you need a lot of people who are good at matching up random goods. Because if you tried to manage the economy just in terms of what the downstream people want vs. what the upstream people want, you'd never get anywhere near the optimization and speed that actually occurred.

[...]

[John] Law's ideas about credit and volatility, which are only beginning to be appreciated today, combined with the Native American network economic principles, grew into the modem global economy.

[...]

You have to make things jump around and shake them up — then you can get to your new optimum. As a result, you add some risk in the derivatives market. It's like taking an economy and shaking it up a little bit so it can settle down to a better optimum.

[...]

Without the right game, the right people don't show up.

[...]

If you really believe that finance is not gambling, you do stupid things. You design insurance products that people don't want to buy, and you misprice them. You don't understand why stocks are so volatile, and you mismanage portfolios. You miss the point of commodity, currency, and fixed income markets.

The book contains a foreword by Nassim Taleb that describes the "ludic fallacy": thinking of risk or randomness as something that can be defined, as with the throw of dice. In real life one is never quite sure of the rules of the "game", or what game one ought to be playing.

Another book of interest is 1990's Gambling and Speculation (of which JC Kommer was kind enough to mail me a copy). The authors Reuven Brenner and Gabrielle Brenner make a distinction similar to Taleb's but with different terminology:

The reason for using the word 'speculation' (or 'betting on an idea') is that when individuals carry out the act they do not have enough evidence available to prove whether they are right or wrong. This situation is in contrast to the gambling situation. The latter refers to situations that have been and can be repeated many times, and where the probabilities as well as the monetary gains and losses are the same for everybody and well known.

Since poker involves bluffing, it's a more rich and realistic game than something like blackjack with respect to "legitimate" financial markets.

Infrastardom in America

2006-06-21T23:58:00.000-04:00

This week's Economist piece on inequality in America shows why "minimizing variance in wealth" is an incomplete caricature of (left-leaning) distributive justice:

Inequality is not inherently wrong —— as long as three conditions are met: first, society as a whole is getting richer; second, there is a safety net for the very poor; and third, everybody, regardless of class, race, creed or sex, has an opportunity to climb up through the system.

I fretted over the first criterion in the last post, where I also cited Robert Shiller's proviso, "We will tolerate substantial income inequality. What we surely do not want is gratuitous, random and painful inequality." I take "painful" inequality literally, to mean lack of habitable shelter, food and basic healthcare. This is essentially The Economist's second criterion, although the healthcare aspect isn't clear and merits a separate discussion. The Economist's third criterion stresses meritocracy. This is also what Shiller is aiming at with his reference to "gratuitous, random" inequality, although he is likely saying something stronger. "Gratuitous" suggests that more than just equality of opportunity is required, and that outcomes should be commensurate with merit. It implies, for instance, that if human abilities or propensity to work are normally distributed, there is something objectionable about wealth tending towards a Pareto distribution. This is a more precise characterization of left-leaning distributive justice than "minimizing variance in wealth".

America is a major engine of entertainment in the world (sports aside), an area where income seems to be particularly disproportionate to innate talent. A number of papers have examined the winner-take-all aspect of stardom. In 1981, Sherwin Rosen observed that, "small differences in talent become magnified in large earnings differences, with greater magnification of the earnings-talent gradient increasing sharply near the top of the scale." Moshe Adler later argued that superstars may emerge even among the equally talented. His work and others stress the role of the public in the production of stardom, where the social dimension of consumption means that, all else being equal, one will prefer what others prefer. This can cause initial random advantages in popularity to snowball. We can see why anyone who clings to the intrinsic theory of value would find this frustrating. (By the way, what is the intrinsic value of watching soccer compared to its social value?) More recently, in a strange and original paper, "Untalented but Successful", Olivier Gergaud and Vincenzo Verardi test these claims by considering the prices of Pokemon game cards. Their findings corroborate Adler.

Robert Shiller and the Gordian Knot of for political philosophy

2006-06-15T22:54:00.000-04:00

Tyler Cowen asks the possibly rhetorical question, "What is new and essential in political philosophy?" and meets a wall of silence. One commenter aptly notes, "What's astounding is how much distributive justice dominates the political philosophy scene. Justice has become nothing more than the question of how to cut the cake fairly or how to manage emergency room resources in triage." To what extent does political philosophy take justice to be synonymous with minimizing variance in wealth? To what extent is minimizing variance in wealth incompatible with raising average wealth? It is safe to say that insofar as it's possible to do both simultaneously, the solution requires more expertise than that commanded by philosophers "who don't know any actual psychology, economics, or statistics". What then is the contribution of Philosophy? To ask, but not to answer — that's its remaining husk. (Even in countries where philosophy is celebrated, it subsists as a fascinating though impotent Hegelian exercise in web-spinning and knot-tying.)

In The New Financial Order, Robert Shiller adopts a similar principle of distributive justice to that of John Rawls. Specifically, "We will tolerate substantial income inequality. What we surely do not want is gratuitous, random and painful inequality." As with Rawls however, we can still ask to what extent is it possible to remove "random" inequality without lowering average or aggregate wealth. By no means do we wish to lump Shiller (nor Rawls) in with the clueless Left and other futile thinkers, or to imply that he doesn't appreciate these difficulties. Some find the fascination with hedging to be unhealthy and counterproductive, but Shiller is quick to outline cases where risk-sharing encourages productive risk-taking. Nonetheless, the question stands.

Considering Shiller's "macro markets", if GDP has an upwards bias, do we really want to hedge it directly on any significant scale? Hedging is usually done to lock-in an otherwise variable spread that corresponds to some profit margin, which in turn causes wealth to accumulate. Even before transaction fees, hedging directly against a drift will only result in less wealth — unless the situation is quite morbid, in which case the hedge is only treating symptoms.

Shiller's "inequality insurance" is a more obviously Rawlsian idea. Inequality insurance would replace the system of taxation based on tax schedules with one explicitly designed to prevent growth in income inequality. Under this "insurance", the government would determine the total amount of taxes raised and after-tax income inequality (by fixing the Gini coefficient of the Lorenz curve). Again, what becomes of total income? By lowering relative wealth isn't there a significant danger of reducing absolute wealth? Shiller addresses this question and suggests that framing the tax as insurance will mitigate incentive effects at higher income levels. This is doubtful and Shiller doesn't make any strong claims on this point, admitting that incentive effects might very well limit the feasibility of inequality insurance.

Robert Shiller doesn't profess to being a political philosopher, but some of his ideas have a certain resonance with the difference principle, or "maximin". Again, the problem with Philosophers as such is that they ultimately aren't equipped to provide answers. Even if one agrees with them in principle, their lack of technical expertise puts any solutions they venture in peril of spawning undesirable side-effects, or even of having the opposite outcomes from those intended. Unlike economists, philosophers seem particularly vulnerable to neglecting the adjustments that agents will make under new systems. Maybe "reducing variance in wealth" is an incomplete caricature of Left-leaning distributive justice, but even so, the above concerns apply.

Effective spreads

2006-05-29T11:16:00.000-04:00

Chris Masse and JC Kommer agree that traders' demand for liquidity destines futures markets towards monopoly, and that once a market is entrenched, it's almost impossible for another exchange to successfully launch a competing contract. JC Kommer, however, offers a possible counter-example in which Eurex managed to steal away the bund future from LIFFE, and points-out that it was only able to do so because of "technology". Eurex is an electronic platform whereas LIFFE was committed to open outcry floor trading. Degree of transparency has an effect on liquidity, and is an important issue in the competition between futures markets. Physical open outcry markets may be very deep, but lack of transparency can cause effective bid-ask spreads to widen. Floor traders who work side-by-side on a daily basis have quite a "bandwidth" advantage versus traders submitting orders remotely. (Official trading fees could make a difference too, but exchanges that have captured a market should have pricing power anyway.)

These kinds of concerns strongly apply to NYMEX, whose website has for some time begrudgingly proclaimed that "evolution is inevitable". Among US futures exchanges, NYMEX has been the most die-hard in support of floor trading. This stance was the main reason cited when merger talks collapsed with the CME in January. Days later, the largest NYMEX clearing firm initiated legal action against ICE, claiming they had engaged in anticompetitive behavior. Meanwhile, CME seemed poised to launch its own energy contracts, and rumors swirled that the Chicago exchange had takeover interest in ICE. Then, suddenly, in early April, NYMEX and the CME agreed that NYMEX energy and metal contracts would be listed on Globex, the CME's electronic platform. The Globex agreement marked a capitulation of sorts by the New York exchange, but a good one, as the pact staved off competition from both rivals. NYMEX seems to have benefited from the example of the LIFFE/Eurex bund contract. Now some are saying that ICE is increasingly "out in the cold". Others are speculating that ICE might have interest in acquiring or competing with the LME, which is the last European futures exchange to retain a trading floor.

While we're on the subject of liquidity and network effects, one hesitates to say anything at this very early stage, but the lack of trading in the first week of CME's housing futures was surprisingly low. Granted, it was hardly the best week for liquidity and the kind of risk-seeking that would encourage bids, but it seems like more interest on both sides should have been lined-up ahead of the markets' opening day. Here is a good Futuresource link to track the daily activity of all the contracts.

"Our friend dere in Burbank - You want I should pay him a visit?"

2006-05-26T01:20:00.000-04:00

Mark Cuban's new venture Content Partners will buy equity in films and tv shows. The company will offer up to $25 million to established actors and other talent in exchange for 50 to 100% of their "back-end" participation rights, which are shares of profit in specific projects. The film industry seems to be moving away from paying talent based on sales alone, and towards such arrangements. Steven Soderberg, who worked with Cuban on "Bubble" had recently stated, "There should be a true partnership between those who make the films and the people who finance it. That means, initially, a lot of people who are being overcompensated up-front [via revenue-sharing, or "first-dollar gross"] would have to be willing to take it on the back [via profit-sharing]." Such a trend would clearly bode well for Content Partners, but to the extent that profits aren't paid-out with interest by studios, rising rates will work against them.

Barring an industry-wide move towards profit-based compensation, one wonders though why actors would agree to the higher risk/reward profile of back-end deals only to sell away their upside (a call-like cash flow) to Content Partners. The initial story by Jane Wells of CNBC stressed the difficulty and time involved with collecting the back-end profits from studios. Since the "enforcement" will largely fall to people already employed by the talent, which will just represent some incremental cost, this angle is only marginally convincing - to this Hollywood outsider at least.

Content Partners apparently has no plans to regularly sell the profit rights they buy. While a full-fledged secondary market would be interesting, it might create conflicts of interest. Likewise, the majority of deals will probably be hammered-out before money starts flowing in. As always, contract language is important.

Following Cuban's abandoned plans to start a sports-gambling hedge fund, some had speculated that he would become involved in prediction markets. While by no means a prediction market venture, Content Partners is certainly an innovative business, is obliquely reminiscent of HSX, and expands the set of tradable interests.

Crytpophilia

2006-05-21T19:35:00.000-04:00

When of the first things most people realize when they get into systematic trading or "technical analysis" (if they are rigorous and honest with themselves, at least) is the danger of trading rules that are excessively tailored to the vagaries of past data. Whether this methodological pit-fall of data-mining is called "data-snooping" or "back-fitting", the idea is the same: the specific prices and desired result of testing had too much influence on model selection, and out-of-sample predictiveness may be lacking. Over-complicated trading signals that produced excellent returns in the past will tend to fare worse going forward, and in markets that weren't included in their development. Even apparently significant and elegant signals are more likely to fall to this sort of mean-reversion if they were developed through an intensive search. Likewise, John Holland in Hidden Order, while outlining his model of complex adaptive systems, favors simplicity in order to avoid what he calls the "unwrapping" problem. The mark of a good scientific model/theory is its capacity to make additional predictions outside of the immediate questions it was designed to address.

Considering this background, it is perennially amusing to hear about decoded bible messages and the like, in which there is little doubt that the cipher was the message, and many ciphers had been tried on a large body of text in order to produce a handful of messages. Sure enough, it's another version of the "uncertainty principle". Paranoia, both the everyday variety and the clinical condition, follows similar a pattern. Namely, projecting meaning into possibly random circumstances (and, additionally, overestimating small probabilities). Ron Howard's portrayal of John Nash comes to mind.

In light of how misleading code interpretation can be, what is its source of fascination? It is a decidedly literal version of proverbial "search for meaning", and also carries a subversive attraction. On one hand it can be an appeal to authority, and on the other, an act of resistance. Intentional codes, including metaphor and other tropes, can disguise the transmission of knowledge to kindred spirits in a possibly hostile environment. The word "code" can likewise refer to the ordering principles of a group, as in a secret society. In the end, everyone wants to be an "insider".

In today's political climate, is it surprising that during the "war on terror" and related controversies regarding privacy, the right to encrypt has not faced a greater challenge? Probably not. It would be difficult to enforce, and intelligence agencies might feel, as is often (amusingly) the case in the corporate world, that an email's sender and recipients can be just as telling as its content. Insofar as an encrypted message would then in itself constitute a "red flag", steganography would become more important anyway.

In the 1980s, David Chaum of MIT produced some crytpographic research with a potentially more intimate bearing on politics. Namely, a cryptographic protocol for online elections. The special problem that online elections represent (from a cryptographic standpoint, at least) is as follows. The election results must be verifiable and correct. Only registered voters should be permitted to vote and only once. However, voting must remain anonymous. It should not be possible to determine who voted for whom. Chaum overcame this tension through an ingenious use of public key cryptography and blind signatures.

While the specific cryptographic problem was nicely solved, many obstacles still remain for the implementation of such a protocol. It is more work to forge physical identification, and so online voting might encourage the buying and selling of votes, or the identity theft of non-voters. Some actually argue that allowing votes to trade freely might be a good idea, but in any case, the more serious obstacle to online voting likely involves more gross and obvious methods of falsifying results outside of the encrypted transmissions, as one hears with regard to the Diebold systems in the 2004 presidential election. These systems were laughable in their security features, and fell far short of Chaum's work, regardless of the partisan circumstances. Clearly, traditional physical voting systems are also subject to fraud. Online elections might actually be more secure as data could be stored in multiple locations and later cross-verified to detect tampering by local agents. When I implemented such a protocol in 1997 as part of an undergraduate project, I also noted that online elections might have interesting effects insofar as they reduce the "cost" of physical voting, and that such technology could be used for "less serious" opinion collection where participants might also wish anonymity, as with television ratings and viewing habits. In a way, this is reverse data-mining: aggregating information while obscuring certain relations, with the aim of maintaining privacy.

Housing futures margins

2006-05-18T23:58:00.000-04:00

The performance bond requirements are out. Based on a very quick glance, these appear to imply a bit more volatility than currencies, but significantly less than equities. Also, it seems that Hedgestreet has suspended the listing of its housing futures.

Beauty contests and when crowds go wrong

2006-05-13T13:42:00.000-04:00

By way of Marginal Revolution comes a study of surprising relevance to prediction markets. A 1990 paper by Judith Langlois and Lori Roggman found that "average" faces are judged to be more attractive than distinct faces. Specifically, digital composite portraits were described as more beautiful in proportion to the number of faces used in their construction, and the composite faces were more highly rated than nearly all of the individuals. Here are some rather convincing examples.

As the authors acknowledged, the idea behind composite photos was hardly new.
In the 1870s, Sir Francis Galton, creator of statistical regression and correlation, came across a set of what we would today call police "mug shots". Galton, who also later pioneered the use of fingerprints in criminal investigations, hoped to identify physical traits that might predict unlawful behavior. He had been toying with the idea of creating composite portraits by superimposing photographic exposures, and the mug shots were perfectly suited for this project. After examining some early results, Galton noted, "All composites are better looking than their components, because the averaged portrait of many persons is free from the irregularities that variously blemish the looks of each of them." Galton went on to publish a number of articles on "composite portraiture", which included a reconstruction of Alexander the Great's likeness based on six different ancient coins, a report on pedigree horses, and even an attempt at "analytical photography" in which a special process would be used to exaggerate the distinct features of a face. Clearly, there is some eugenic motivation behind much of this enquiry, and indeed the political correctness of the late 20th century has (understandably) robbed Galton of some notoriety.

Prediction market enthusiasts will probably be familiar with Galton's ox-weight guessing contest as described by James Surowiecki. The logic behind the wisdom of the crowd as exemplified there is eerily similar to the averaging of portraits. Pertaining to group judgment, individual errors and biases tend to cancel each other out as sought-after information is distilled in some aggregate measure of belief. Pertaining to beauty, asymmetries in facial structure and complexion likewise cancel-out, yielding pleasing symmetrical and robust features.

So where do crowds go wrong? When biases lack diversity, and here we can reference Keynes' "beauty contest", in which judges suppress their own opinions and vote according to their predictions of how other judges will vote, or by even higher-order predictions. This loss of independence can cause initial biases to wildly exaggerate themselves instead of neutralizing one another. Keynes suggested the beauty contest dynamic as a metaphor for the stock market, and this is sometimes apt. At least, there is pervasive feedback and momentum trading in established markets, and these markets deal in objects much less tangible than oxen and jelly-bean jars. Insofar as returns on a given scale don't seem to fit a normal distribution, these dynamics might well play a role. Though, like many fiercely independent critics, they might overstate their case, Taleb and Mandelbrot warn, "One can safely disregard the odds of running into someone several miles tall, or someone who weighs several million kilogrammes, but similar excessive observations can never be ruled out in other areas of life."

Ghosts of Futures Past

2006-05-09T21:59:00.000-04:00

Mortgage futures have had a rather tortured existence on US exchanges: CBOT GNMA-CDR 1975-87, GNMA-CD 1978-81, GNMA-II 1984, Cash-settled GNMA 1986, MBFs 1989-92; COMEX 1979-8?; ACE/NYFE 1978-81; Hedgestreet 30yr 2004-present. Still others made it to late planning stages but never materialized.

GNMAs, the world's first interest rate futures, enjoyed some initial success but were supplanted by treasury bond futures within a few years. CBOT had hoped that the large underlying market would ensure liquidity, but design issues with the contract undermined its effectiveness in hedging mortgage-specific (prepayment) risk. Several refinements of the contract were tried, but it was too late. Lower basis risk couldn't entice traders away from the already impressive liquidity of the treasury markets.

One hears similar concerns about the upcoming housing futures. That is, if housing prices are largely determined by interest rates, why not hedge in the more established and liquid markets, despite the greater basis risk? Is this just the latest manifestation of the restless mortgage futures spirit? Well, for one thing, the relationship between the Case-Shiller Index and interest rates is unclear. Quarterly returns from December 1995 through 2005 give a correlation of only 35% between the composite CSI and the cash 10-year treasury bond. (Using various lags or mortgage rates didn't seem to improve the significance of this result.) This suggests that the basis risk involved in trying to hedge real estate with fixed income is too large, but note that the CSI only had 3 down quarters in this period, and one might expect the correlation to be more pronounced in a nasty downturn — precisely when the hedge is most valuable.

Second, there is an aspect of the current investment environment that should work in favor of housing futures liquidity. The failed contracts of the '80s and early '90s did not have the advantage of institutional speculation in the form of hedge funds, at least at nothing like the current scale. Recent years have also seen volatilities and credit spreads grind almost relentlessly lower. The global "savings glut" and concomitant yield-seeking seem to have something to do with these trends. There is even anecdotal evidence of funds getting involved in especially unusual investments like baseball teams and film productions. Taken together, these conditions point to an auspicious time to launch new markets — speculators are looking for investment capacity, and this desire will help to mitigate the previously described imbalance.

Some time before the current "prediction market" wave which roughly includes Hedgestreet and INREEX, property futures were given a direct try on the London Futures and Options Exchange. This market, which included a commercial real-estate contract, was open from May to October of 1991. (Robert Shiller recently noted that its launch corresponded with a significant top in real-estate.) The "London Fox" chapter was a bit of a fiasco, as the exchange was found to have created artificial volume via wash trades. The discovery of this mischief hastened the contracts' demise. Perhaps we can write this up to an "execution" failure on the part of the exchange.

In any case, when Shiller, Case & Weiss wrote "Index-Based Futures and Options Markets in Real Estate" in 1992, they seemed more concerned about the failure of the Consumer Price Index futures, which traded on the Coffee, Sugar and Cocoa Exchange from 1985 to 1989. CME and Hedgestreet currently offer CPI contracts, and these also see very light volume. The reasons for the CPI contract's unpopularity are numerous and include the stand-bys of the literature: no cash market, a questionable basis, and similar, more liquid, markets. On the last point, the newer incarnations have to face competition from TIPS spreads, economic derivatives auctions, and even Fed Funds futures. Infrequent updates and manipulation fears were also cited as reasons for lack of trade in the original contracts, and so it would be nice to see greater transparency in the CSI methodology, as was promised. Market imbalance was a problem as well. The government would be the most significant natural seller of inflation, but there is little motivation for such a hedge.

Overall, the housing futures have been in the works for a long time and score reasonably well on the above concerns. We've belabored the market imbalance issue enough for now. Basis risk may be a problem, especially for individuals, but institutional trading and hedgers with large exposure will drive the market. Note how CME is only going to launch with contracts extending one year into the future. Surely, individual homeowner interest would gravitate towards longer maturities. The time doesn't seem ripe for retail hedging just yet. Hopefully, the general public won't catch-on at the worst possible time.

Economic Derivatives Observations

2006-04-28T20:32:00.000-04:00

One small bone to pick with yesterday's CME Economic Derivatives reception: Gartman and others perhaps overstated the hedging utility of these auctions. After all, how many traders have exposure to economic releases as such? They probably have fixed income, currency or equity positions and there are already plenty of ways to hedge these. While the economic derivative markets were repeatedly billed as a way to hedge risk "more precisely", it seems that they actually provide traders a hedge with more basis risk, and, more precisely, open-up a new avenue of speculation. One can guess why so much emphasis was put on hedgers, as their image gives the fledgling markets a robust glow and implicitly beckons to speculators. In terms of reducing systemic risk, the fact that the auctions reveal the distribution of expectations might be as important as their use in hedging. Insofar as they are used to hedge against surprises, one might expect the tails to be overbought as is typical for parimutuel auctions, but the degree of this tendency is still unclear.

Now, in a way, ignoring measurement and Goodhart's Law-esque issues, economic derivatives certainly are more precise, and address risks captured only roughly by more established markets. These risks are the sort that develop over time though and might be better served (at least in terms of certain grand visions of risk-sharing) by standing markets as opposed to sporadic auctions on "noisy" releases that are only open to institutions.

It was actually surprising that Dennis Gartman brought-up the IEM election markets. More exciting, he spontaneously asked a representative from the investment bank most closely associated with the auctions if they might extend the infrastructure to political events. While this wasn't ruled out, frequent events with more direct economic relevance were stressed in response. An equity earnings release auction was cited as a possibility.

Interest in earnings release markets was predicted here at the beginning of the year, with the caveat that these numbers are heavily managed and that they are rather easily skewed by a penny or two. Earlier in the week, Victor Niederhoffer described a typically enlightening little study on just this point. The sample of earnings surprises was nothing like a normal distribution, and was quite suspicious in terms of the asymmetry between small upside and downside surprises. Earnings release markets would operate in light of such irregularities.

One can't help but notice that tax and subsidy related markets can be described as political, economically relevant and reasonably frequent. In spite of the arguments in favor of such markets, they would inevitably be somewhat controversial. Perhaps it will take an organization with a certain amount of gravitas to forge ahead in that area, especially in the United States.

Tax Futures

2006-04-21T01:13:00.000-04:00

Readers will be unsurprised by this concept, as we've referred to markets linked to legislative outcomes somewhat frequently, especially tax and subsidy legislation. If such markets are to catch-on, it may be possible to hedge against future tax burdens. The $2 trillion tax cuts pushed through by the Bush administration are set to expire by 2011. Budget concerns and a somewhat-related defensive posture by Republicans make it increasingly unlikely that they will be extended. The CBO estimates that lengthening them through 2016 would reduce government revenues by $1.5 trillion. Could a market develop around these large risks?

Consider a set of 0-100 markets predicting the rates of the higher US (inflation-indexed) tax brackets in 2012: {27, 30, 35, 38.07}. Assume that no margin deposit is required or that deposits earn interest, so there is no material cost-of-carry. Since the current bracket rates are {25%, 28%, 33%, 35%} and, without extension, they will revert to {28%, 31%, 36%, 39.6%} in 2011, these prices can be seen as implying a 33% chance of extension.

Setting the markets up in this way avoids referring to any specific piece of legislation or policy. In practice, such markets might not refer directly to marginal bracket rates, but rather predict effective rates for income levels. It just seems more clear to present this example in terms of the bracket rates. Markets based on effective rates and income levels would have to take inflation into account, in which case the interpretation of prices would become more ambiguous. In any case, most of the trading will occur in the higher brackets or income levels.

Some of the earliest and most popular prediction markets (per se) have been linked to elections, but predicting tax rates is much more to-the-point in terms of financial risk-sharing. The existence of such markets would also frame the operation of the government in a way that would encourage fiscal responsibility, and give dispersed interests some recourse against inefficient spending.

At present, it seems that the US tax schedule will either shift upwards or remain the same, but such markets would also allow for pricing the chances of the slope, the progressivity, of the tax schedule changing. To complement the bracket rate markets, contracts could be established to cover the other cuts set to expire such as the estate tax (2011), capital gains/dividends (2009) and the marriage penalty (2009), or AMT-related changes — any piece of legislation that determines one's final tax liability. Markets could also be formed around corporate taxes or more general modifications in the tax code, and might ease the passage of sensible yet otherwise politically infeasible changes, as the interested groups could hedge with one another.

The problem is that in most scenarios, everyone is a natural buyer. Every tax-payer has exposure to higher tax rates, and this may severely limit trade. The natural seller would be the government itself, but this is unlikely since it would probably lose in such markets at the most unfavorable times, as when taxes are raised to bring the deficit under control. Overseas speculators could account for some selling, as could domestic special interests that receive subsidies or industry-specific tax-breaks, suspecting that they might be lost if taxes are brought lower. Alas, the selling from these groups probably would not be very substantial. Contracts related to industry subsidies and tax-breaks would be more feasible in terms of market balance, but those might be better served by OTC arrangements.

In the coming weeks, we'll examine some notable past failed futures markets.

Housing Futures: "Mark your calendar"

2006-04-20T23:51:00.000-04:00

Apparently, the launch of the CME housing futures is being pushed-back from next week to mid-May. The margin requirements are still unknown, and their determination is a bit unusual since the historical volatility of the Case-Shiller Index is probably deceptively low.

In general, would it be crazy to suggest asymmetrical margin requirements and/or trading fees in order to make a market more balanced and liquid, at least temporarily?

4/21/06 Update: CME just released an official advisory targeting May 15th as a tentative launch date.

Open Questions About Prediction Markets

2006-04-10T23:45:00.000-04:00

Unsurprisingly, the first one is: What is the legal/regulatory future of such markets in the United States? How long will the status quo of unclear, unenforceable laws last? What event will trigger change? Who will lobby for change?

The legal status question actually contains Wolfers' and Zitzewitz's "How can markets attract uniformed traders?" to some extent because two of the answers there are hedging and entertainment (gambling). However, hedging markets invite the regulation of the CFTC, and gambling markets of course are subject to general official prohibition in the US. There seem to be at least three schools of thought developing here. One group invites CFTC regulation in varying forms as the most expedient, if awkward and potentially limiting, solution. Others argue that information markets are conceptually distinct from markets designed for risk-sharing, capitalization or entertainment, and that they deserve their own legal status. Still others argue for full-scale legalization/regulation of gambling. Anyone interested in these topics should read Tom W Bell if they haven't done so already. Additionally, as noted here before, the gambling/hedging distinction isn't very strong in theory or practice. Some are even implicitly questioning the CFTC's service of the public interest as it relates to the risks faced by sports-related industries.

What will be the first major corporate PM success story? The recent Marginal Revolution discussion summarized the issues pretty well. The consensus seems to be that it is just a matter of time, but there are worries. Even in cases where managers are open to being second-guessed and corporate cultures are sufficiently free, maybe the benefits of prediction markets won't be material over the existing implicit prediction/reward structures in firms. Perhaps firms with relatively "flat" management hierarchies already sufficiently approximate the "wisdom of the crowd". Securities regulation, time-diversion, bad incentives and accounting for the effects of hedging on prices are further obstacles. Also, even if traders are anonymous, questions relating to project targets and the like focus open scrutiny on specific managers and divisions, potentially creating a poisonous environment.

As Chris Masse suggested, perhaps external corporate PMs will prove to be more useful than strictly internal ventures. This is plausible so long as the outsiders actually have relevant information. It is a known problem that prediction markets tend to fare poorly in projecting outcomes determined by a relatively small and closed group of decision-makers. Enumerating such problematic cases is another open issue.

Related to the corporate PM success question, one wonders how often will information markets actually be directly subsidized? In order to justify setting prediction/information markets aside as a separate class of market, the information they reveal should be valuable enough that it attracts patrons willing to pay for it. Yes, there are examples of this such as the avian flu market subsidized by the Gerson Lehrman Group, but how common will private subsidization actually be going forward? If US laws are in fact holding back a tidal wave of growth in this area, why aren't there more pure information markets (as opposed to gambling and risk-sharing markets) popping-up "in the wild" where they are legal?

Now, government subsidization might raise the kinds of issues seen with PAM, and this indirectly leads to the next question. How "fit" are binary options as opposed to tradable indices? In the aforementioned Marginal Revolution thread, Emile Servan-Shrieber, CEO of NewsFutures, made a slightly heretical remark on the use of binary markets:

But event probabilities are just not actionable. People in a business environment don't know what to do with them. They need specific numbers. Not "What is the probability that I'll hit my deadline or sales target?" but "What will my sales be?" and "When will I be able to ship this?", or "What will my sales be if I include this feature or that one?".

In many cases an index market will be more practical, especially if it still implies probabilities. In addition to being more actionable, index markets will be less volatile, more conducive to regulation and less susceptible to controversy. What if it is not possible to create a market in binary form, as in the case of Bin-Laden's capture? Ah, well Bin-Laden is a specific individual, and contracts attached to specific individuals or properties seem to be considered insurance contracts by the CFTC. Insurance is regulated at the State level in the US. The CFTC is very unlikely to authorize a future that refers to a specific individual or property, even if all other criteria (e.g. risk-sharing, price discovery, public interest) are met. Such index contracts that refer to some aggregate measure or count are also less likely to invite controversy. What would have become of PAM if it had only priced indices and made no mention of contracts attached to specific (negative) events?

Other questions like contractability and separating causation from correlation are subtle and interesting, but they are also issues outside of the strict prediction market sphere. They are more general problems relating to contracts and market analysis and don't seem to be very threatening in terms of the immediate future of prediction markets.

Even the "calibration on small probabilities" question that largely captured Charles Manski's objections to the "prediction market" label doesn't seem to worry very many people in the industry. One almost never hears about the potentially very severe favorite-longshot bias caused by the fact that most traders aren't paid interest on their posted margin. By "very severe", we mean that a contract tied to an impossible event that expires in one year should only trade down to r/(1+r) where r is the risk free rate, so the "Pigs Fly" 1yr 100 point contract should be worth around 4.5! Play-money contests with rank-order prizes may be vulnerable to similar distortions.

Finally, the manipulation question is largely reducible to attracting liquidity. The argument could even be made that the problem solves itself. Again though, aside from the ways of attracting liquidity mentioned in relation to the first question, manipulation isn't really an issue particular to prediction markets. A variation on Robin Hanson's experiments on manipulation in which traders took the market price as one of their "clues" would however be interesting. Such scenarios, which would exhibit the kind of momentum/trend-following/herding/feedback trading that one often finds in more established markets, might give more pessimistic results with respect to the potential success of manipulation.

Like Wolfers' and Zitzewitz's list, this wasn't meant to be exhaustive. Please add anything that might be missing, or comment on what might have been overplayed.

4/12/06 Update: In terms of "subsidization" above, this specifically meant paying traders for the information they are revealing, although paying to upkeep a market is also a kind of subsidy.

In the case of HSX, third parties pay the owners/maintainers of the market, who do not pass this on to the traders. This is an interesting model that points to PMs replacing traditional test-marketing groups, a trend flagged here before. Of course, the trading itself has to be entertaining in order to attract uncompensated participants. It also doesn't hurt that 1) HSX has been around since 1996, which enforces the "just wait" answer to the PM success questions, and 2) One suspects that HSX is largely a poll and, in any case, traders don't have to devote time to uncovering information, apart from watching movies.

Likewise, one wonders what kind of creative thinking is going on at WSX, especially in light of the Data Warehouse story.

Developments concerning the symbiosis of politics and markets

2006-03-31T19:39:00.000-05:00

The first story is a few weeks old, but bears mentioning and gives one a chance to visit the excellent Statistical Modeling, Causal Inference, and Social Science blog, where Aleks Jakulin commented on Harold Ickes' plans to create a database of (potential) Democratic voters, replete with details that will allow for targeted messages to marginal voters, a practice in which the GOP had taken the lead. There is some controversy among Democrats about the project, as Ickes, an adviser to Sen. Hillary Clinton, is forming a private company (backed by George Soros) to develop the database. This is perceived to be a snub of Dean's DNC by the Clinton team.

On another level, some have raised privacy concerns as the database will catalog rather sensitive details such as magazine subscriptions, gun ownership, and church attendance. Jakulin, however, points-out that technological efforts by the public to monitor the government are also expanding. The data-mining is symmetrical. Do see the list of such projects he compiled, as well as his work in 2004 analyzing similarities among Senators' voting patterns. This is fascinating stuff and possibly an important "Grundrisse", so to speak.

Next, anyone with an interest in legislation-linked markets will take notice of the controversy over Congressional "insider trading". Currently, it remains legal and technically ethical for members of Congress to trade stocks based on nonpublic information related to pending legislation or appropriations. A study, Abnormal Returns from the Common Stock Investments of the U.S. Senate, by Alan J. Ziobrowski and others found that between 1993 and 1998, Senators outperformed the market by 12% per year on average, whereas corporate insiders beat the market by only 6% annually. Based on his analysis, Ziobrowski has concluded that, "there is cheating going on, at a 99% level of confidence."

The SEC, which receives funding from Congress, has been reluctant to address this issue, but there is a new bill that is seeking to end such trading, as well as requiring firms that specialize in political intelligence gathering to register with the House and Senate, as lobbying firms now do. The title of H.R. 5015 is "To prohibit securities trading based on nonpublic information relating to Congress, and to require additional reporting by Members and employees of Congress of securities transaction, and for other purposes", but apparently the text also carefully includes "commodities futures". Would legislation-linked derivatives be considered "commodities futures"? Given their substantial hedging utility, let's assume so, although it's by no means cut-and-dry. Owing to partisan incidentals, there is some doubt whether or not the bill will even be passed, as Stephen Bainbridge disapprovingly observes. If it is passed, it would seem less likely that the CFTC would approve such contracts, as they are also funded by Congress. If not, legislators might be better disposed towards legislation-linked markets.

Finally, pointing even further down the road, AEI-Brookings has released a new e-book on information markets and their potential impact on public policy. Some of this collection was already available on their policy markets site, but there are some papers that you might have missed. Markets should be useful for collecting political information or hedging legislative outcomes, but thinkers such as John Ledyard, Paul Tetlock, Robert Hahn, Michael Abramowicz, and of course, Robin Hanson anticipate a time when market outcomes might influence public policy more directly.

The Housing Futures Are Coming

2006-03-23T19:32:00.000-05:00

Mark your calendar. On April 26th, futures on the newly-dubbed S&P Case Shiller Home Price Indexes will begin trading on the CME. It's not everyday that a $20-odd trillion asset class opens itself to exchange-traded contracts. This development was the subject of Tuesday's event in New York where the index's namesakes and others spoke and later fielded questions in a roundtable discussion moderated by economist and commentator Dennis Gartman.

We all know the arguments in favor of this market, and the latest contract details will soon be posted by the CME, so let's skip directly to the concerns voiced by attendees.

First and foremost, inquiring minds wished to know who the buyers would be. Hedging sellers abound from individuals to homebuilders to mortgage issuers and federal agencies to local governments. The natural buyers would be prospective home-buyers, trying to ensure that they aren't priced-out of the market, but the relative wealth of that group is - naturally - very small. This is by no means a fatal problem, but it is an obstacle to the market realizing volume and liquidity.

Ideally, the abundance of non-information traders (hedging sellers) would attract speculative buyers. Speculators, however, may be unwilling to stand against the massive weight of hedging, especially with such an infrequent spot price. Fortunately, it was announced that updates on the quarterly index would be released monthly on the last Tuesday of each month. It was suggested that the existing housing-related data releases such as sales, permits, starts, and completions would help to fill in the data void. Karl Case added that traders would no doubt gather their own information and that the futures would come to reveal this. Whether or not enough information can be gathered to overcome the influence on price of hedging, especially at the national level, is an open question. Robert Shiller noted that the term structure of the futures would likely settle into backwardation.

Lack of transparency and the "black-box" nature of the index was another big concern. Happily again, CSW announced that they would soon be publishing the full details of the methodology. Thus two of the major infelicities mentioned here in November were rather squarely addressed.

While most of the concerns dealt with the viability of the futures market itself, there was also the worry that the contract would increase the volatility of the underlying real estate, otherwise a relatively calm asset class. Robert Shiller brushed this off, saying that housing was already "like the stock market", a danger a questioner had posed. Dr. Shiller also noted the possibility of home prices being quoted in terms of futures prices. That is, rather than a fixed amount, the asking price might be advertised as some multiple of the appropriate regional index. That separate, earlier remark probably did little to sooth the worries of whoever asked the volatility question.

Skepticism inevitably surrounds new markets. Dennis Gartman recalled the eyebrows initially raised, for instance, at Nymex's crude oil futures. Again, residential real estate in the US tallies in at approximately $20 trillion dollars. One basis point (one percent of one percent) of 20 trillion is 2 billion, so volume may be impressive despite the worries. In terms of popularization, there was a good deal of talk concerning indirect trading of the futures, and it was suggested that most individuals would actually come into contact with the futures through OTC instruments packaged by institutions or through index-linked mortgages. An AMEX ETF tied to the index is also in the works.

Some Benefits of Legislation-Linked Derivatives

2006-03-14T00:45:00.000-05:00

Though tiny and not significant in a technical sense, one of the more exciting data sets to become public of late is Randall "Duke" Cunningham's "bribe menu". Cunningham, a former member of Congress where he "served" as a member of a defense appropriations subcommittee from 1998 to 2005, redirected more than $150 million in defense contracts to a single company in exchange for over $1 million in cash and other gifts. The data set in question is a list of price quotes for favors, depicted to the right and detailed below:

Defense Contract	Price
$16 Million	$140,000 + Luxury Yacht ("BT" = "Boat")
$16-$20 Million	Add $50,000 for each $1 million above $16 million
$20 Million +	Add $25,000 for each $1 million above $20 million

This is a fascinating look into the market for congressional favors. Alex Tabarrok was disturbed by how low the prices were, noting that they implied competition among congressional suppliers. The curve of this particular price scale along with the inclusion of a non-cash gift could mean that supply was only limited by money-laundering capacity. From the standpoint of the favor buyers, risking the illegal transaction provided phenomenal returns.

Returns are presumably much lower for legal campaign contributions of the sort one finds on Opensecrets.org. The outcome of legal contribution is uncertain and indirect, and some of it is probably downright futile. The lack of association between contributions and specific pieces of legislation (or contract awards) suggests that the process may be inefficient for the contributors. In many cases, prediction markets should be a more reliable and precise way for (special) interests to manage the risks of such outcomes. Promoting the creation of positive, pro-agenda legislation might still involve contributions, but when bills surface that are unfavorable to a certain group, legislation-linked derivatives will be more efficient than the current nebulous system. Actually, insofar as the current system is "efficient" for special interests, it approaches straightforward favor-buying; legislation-linked derivatives should reduce the demand for congressional favors. Sure, they could lead to a new market in congressional inside information, but this outcome would be less likely to distort the content of decisions made on the Hill.

Such markets would furthermore enjoy the advantage of natural counterparties. Perhaps competing special interests with opposite hedging needs could trade with one another, thereby partially disintermediating the government in their private affairs. More generally, any time a tax or subsidy is in play, the natural counterparties are the directly affected interest group on one side and every other taxpayer on the other side. Whenever a tax-break or subsidy is awarded to a special interest, this in itself implies an additional tax burden on every other taxpayer. The existence of markets to hedge such events from either side would, among other benefits, frame the operation of the government in a way that would encourage greater fiscal discipline.

Following the Money (and the Online Gambling Lobby)

2006-03-08T23:11:00.000-05:00

Chris Masse, who graciously named RM&P "Blog of The Year" for 2005, has asked me what transpired at the "Event Markets & The Futures World" FIA luncheon which took place in New York last month. While much less touted than the "Summit", this short meeting was perhaps more significant and more telling of the future of prediction markets in the United States.

My first answer to Chris was that I had already written about the luncheon. I had noted over on Agoraphilia that Richard Shilts, Director of Market Oversight at the CFTC, said that the agency was considering the extent of its authority over non-hedging, price-discovery markets (i.e. "information markets", although no-one used that term on that day, and I only heard "prediction markets" once). Later on, a slightly contentious discussion addressed the difference between gambling and hedging markets. The essential ideas of those exchanges were toyed with in "Schedule One".

Representatives of companies enjoying less-than-cheery relationships with the CFTC may have been a bit uncomfortable that afternoon. Indeed, the event did little to relieve the fear that America's confused (and somewhat puritanical) attitude towards gambling has forsaken the quickly growing $11 billion online betting industry to the rest of the world, particularly to the rest of the Anglosphere. However, one was able to walk away with some doubt for the meme that has surfaced here and there that America's neglect of online betting will cause the country to fall behind in a new, important area of financial innovation. If nothing else, the list of US-based attendees, which was packed with top-shelf investment bankers, regulators, lawyers, derivatives industry groups and established exchanges was encouraging in that respect. While they are doubtlessly keen on innovation, online gambling is still a rather small business to that crowd.

In any case, legal online gambling in the United States is unlikely until there is a lobby behind it, but who will take that risk? The current legal gambling industries in the US, which include commercial and tribal casinos, state lotteries and sports betting operations, are not necessarily strictly opposed to online gambling as they are often accused of, but they are unlikely to lobby for it either. On the other side, since non-US companies already enjoy the business of American bettors, they are probably not going to argue for legalization that would bring them new competition from established local brands, even if the market were to grow in total size.

The fact that the stocks of overseas gambling companies are available to US interests also saps the potential life behind an online gambling lobby. Why bother when you can already share in the ownership of this industry?

Ultimately, either in terms of participation or investment, it may take an attempted crackdown to galvanize support for online gambling in the US. Markets that provide risk-sharing or some other demonstrable utility beyond entertainment should be less controversial, but as we know, these categories aren't completely distinct.

Power/Freedom

2006-02-27T22:58:00.000-05:00

A philosophical interlude — Apropos of prohibition, Libertarians might want to address the economic obstacles to drug legalization. David Friedman once wrote that preventing someone from taking drugs is coercion, but preventing them from shooting you isn't. Unfortunately, the state of risk-sharing in healthcare is so inefficient that using recreational drugs or doing anything unhealthy effectively does impose on others' property in the form of higher insurance costs.

In order for health insurance coverage to be priced more specifically, genetic and other tests would have to be made available to insurance providers. There is an understandable concern that such information is "private", but since it is relevant to an insurance contract, there is no real justification for withholding it. Any reference to this kind of privacy is actually a Rawlsian appeal to social justice; one's bad luck or the price of one's bad habits should be shared with others. (Keep in mind, this point is basically a challenge to Libertarians.) Regarding some of the bad "luck", as disease-prone genes become more expensive, there will be greater demand for genetic intervention, thus the scare quotes around luck.

Recall that the distinction between "cure" and "enhancement" has long been a litmus test for the legitimacy of drug use. The double-negative (i.e. eliminating an illness) has been sanctioned while pursuing changes beyond the norms of performance and mood is usually frowned upon — but already legal drugs in the United States have been advertised in ways that blur the line between cures and enhancements, e.g. Viagra and its ilk. This is occurring unreflectively and points to a difficult philosophical problem on the horizon. Specifically, where is the line drawn between the elimination of hereditary diseases through gene therapy and the engineering of more positive traits? Especially when one is the "side-effect" of the other?

In relation to sports, performance-enhancing drugs are roundly disapproved, but life is not a zero-sum game. Excellence is not a negative externality. Should the same logic hold in genetics?

"Freedom" is "power" expressed as a double negative. Some of the most important philosophical problems of this century will relate to the identity and difference of these two concepts, whose similarity happens to be especially apparent in Mandarin Chinese.

Schedule One

2006-02-24T19:01:00.000-05:00

The addictive potential of gambling has often been likened to drug abuse. How far does this analogy extend with respect to the future of prediction market regulation in the United States?

Risk-sharing or hedging is usually contrasted with gambling and is an important, if not the most important, legitimizing factor in the eyes of "commodity" market regulators. The quintessential hedging market is one where traders have equal and opposite risks. In addition to the pristine aspect of legitimacy, exchanges hosting these markets have the wind at their backs, benefiting from active trade. In the past, successful futures markets have tended to deal with "intermediate commodities", where producers and consumers of some commodity trade with one another. In the example below, all of the risk is nullified. Each participant has a pre-existing risk tied to an event that might occur. They can take positions that alter this risk with respect to the event. Before and after trade, total risk is somewhat crudely expressed as the sum of the absolute risks, but this schema captures the sorts of conceptual distinctions one encounters. (The sum of market risk is of course always zero.)

	Risk Before	Market Position	Risk After
Trader A	($1)	$1	$0
Trader B	$1	($1)	$0
	$2		$0

Now consider the following "schedule" of idealized two-participant markets:

Market 5:

	Risk Before	Market Position	Risk After
Trader A	($1)	$1	$0
Trader B	$0	($1)	($1)
	$1		$1

This is the storybook "hedgers" and "speculators" scenario. The hedger transfers risk to the speculator, who is essentially gambling, though skill may be a bigger factor than luck in his fortune.

Market 4:

	Risk Before	Market Position	Risk After
Trader A	($1)	$2	$1
Trader B	$1	($2)	($1)
	$2		$2

Here, both traders are nominally hedging, but at the margin are actually gambling by over-hedging. The previous two examples cast doubt on whether total risk should be used to distinguish "hedging markets" from "gambling markets". The total risk may not rise despite that fact that all participants are gambling, and to require total risk to fall may be too strict a criterion to allow any markets to operate.

Market 3:

	Risk Before	Market Position	Risk After
Trader A	($1)	$3	$2
Trader B	$1	($3)	($2)
	$2		$4

Here there is over-hedging to the point where total risk increases. Many would consider this to be a de-facto gambling market despite the fact that some hedging occurred.

Market 2:

	Risk Before	Market Position	Risk After
Trader A	($1)	($1)	($2)
Trader B	$1	$1	$2
	$2		$4

Still more blatant gambling: traders are "levering" up their pre-existing risk.

Market 1:

	Risk Before	Market Position	Risk After
Trader A	$0	($1)	($1)
Trader B	$0	$1	$1
	$0		$2

Finally, a pure gambling market where there was no pre-existing risk.

A hedge must refer to a specific risk. If Market 1 were tied to the outcome of a recurring coin-flip or card-draw, one could not argue that this non-correlated return stream was in fact a hedge since it could be used to reduce portfolio risk. Could one??

The philosophical differences are slippery. Even Superbowl betting is not a pure gambling market since various sports-related businesses may want to hedge financial risks associated with the outcome of the game. Or, to reiterate a favorite example, Michael Jackson, his producers, gardener and zoo-keeper could have hedged their fortunes by betting in the Tradesports market tied to Jackson's trial, a market sometimes held-up as an example of pure gambling frivolity. In these cases, one might reason that while the markets do allow for some hedging, in practice the vast majority of trade is gambling-related. Ok, but where is that line drawn and by whom?

In theory, the difference between hedging and gambling can be blurred or "deconstructed". More importantly, in practice, effective hedging often depends on gambling and the liquidity provided by speculators. Returning to the drug analogy, the Greek word for drug is pharmakon, which means both "cure" and "poison". The cure always comes with some "side-effect".

By now, some readers might be thinking, "Look, you are really missing the point. I don't care what you call it. To me, the implicit normative distinction between hedging and gambling just isn't there, so it should all be completely legal!" Ok, but it is often useful to reason with opponents on their own terms, forcing them into contradiction. Otherwise, you're vulnerable to "difference of opinion" hand-waiving.

New York Summit Recap, Part 2

2006-02-11T19:08:00.000-05:00

Russell Andersson spoke about Hedgestreet, which was the only CFTC Designated Contract Market among the exchanges officially in attendance at the "Summit". Additionally, Hedgestreet is a Derivatives Clearing Organization, and its contracts are fully collateralized, making them more likely to attract "real money". Andersson noted that some investment strategies and markets might be overcrowded, and that in addition to Hedgestreet's core vision of extending futures trading to retail clients, they are thinking of markets that would build capacity for larger players like hedge funds.

Andersson mentioned many intriguing possibilities, including markets tied to merger & acquisition events, equity earnings, credit rating actions, credit defaults, bankruptcies and IPO announcements. There seems to be demand out there for such contracts despite the fact that they will be correlated to existing instruments. Hedgestreet also has an eye on economic data release derivatives. Lastly, Hedgestreet is working with external market makers in an attempt to make their markets more liquid, but doesn't have plans for automatic market-making.

Emile Servan-Schreiber, CEO of NewsFutures mentioned a series of corporate internal prediction markets, including Eli Lilly markets on health insurance costs, drug benefits, and access to physicians. Emile made a joint presentation with Bob O'Brien of Corning on a prize-based liquid crystal display market. The market aggregates information across the LCD supply chain, from component makers to TV manufacturers to retailers, and it will be interesting to see if its use reduces the volatility of LCD prices. Corning is also running a conditional market on price elasticity, i.e. LCD demand is projected given various price ranges. O'Brien expressed some concern that the markets might be exploited or contaminated by competitors, and said that suspect traders might be weeded-out over time, although specific orders were confidential. In addition to rewarding accuracy, the market's scoring rule takes into account certainty and timeliness. Only the top 3 traders in each "tournament" receive prizes.

Servan-Schreiber was eager to cite his research with David Pennock and others on the predictive accuracy of play money versus real money markets. In short, real money markets were not found to be significantly more accurate. I would add that in some cases, play money markets might actually be more accurate, as they are not subject to structural factors like hedging or interest rates. Of course, then the problems are what will compel participation and information discovery? Emile gave two suggestions on encouraging participation in play money markets. First, participants should value the information; it should be intrinsically relevant to them. Second, the interaction with other traders is important, especially the recognition that comes from successful trading. The second piece of advice might be somewhat problematic from a predictive standpoint, as traders motivated by reputational pay-offs will tend to be risk-loving, and this sort of behavior is among the litany of explanations for the favorite-longshot bias. The same can be said about discontinuous prize-based payoffs.

Citing another paper by David Pennock, Servan-Schreiber mentioned that simple averaging of predictions is not very different from averages weighted by prior trader performance. This is somewhat surprising, and perhaps discouraging for the neural-network-based Owise, which apparently had no representatives at the conference. Now, real money markets to a large extent do weight previous performance, as successful traders can redeploy their winnings.

Additionally, play money markets in corporations might have real money implications. As Bo Cowgill appreciates, this is another obstacle to running internal real money markets as they might in some cases be a reasonable proxy for a company's publicly traded equity.

David Pennock of Yahoo Research Labs reviewed his dynamic pari-mutuel markets, and described ways to maximize liquidity in combinatorial markets with generic bidding languages. Standard pari-mutuel auctions encourage late betting and do not allow for position liquidation. Therefore, it's not possible to "buy low and sell high" as/when information is incorporated into the market. Dynamic pari-mutuel markets overcome these limitations with a price function that reacts to incoming information, and a side auction where participants can hedge away their positions.

Markets that allow for combinatorial bets are problematic because with n events liquidity is potentially spread-out over 2^n outcomes or 2^2^n bets. Of course, the market will likely only need to trade a very small subset of these outcomes. A generic bidding language would allow for bets on any specific logical outcome, e.g. "I win $1 if (A and not B) or C", but then the auctioneer must decide how to match trades, and will likely choose to maximize trade by matching only those orders that leave the house with no risk.

James Surowiecki, author of The Wisdom of Crowds, interprets appeals to the "marginal trader" as a manifestation of reliance on experts and the desire for centralized decision-making. While he believes there are certainly experts in the world who are good at predicting, it is very difficult to know who they are ahead of time for specific questions, and so-called experts are notoriously over-confident in the accuracy of their predictions. (One factor may be that their expert-hood compels them towards further reputational pay-offs.) Surowiecki also described a variation on the jelly-beans-in-the-jar experiment, where after a certain number of rounds the best guessers were grouped together and played more rounds as a group — but these "expert" groups performed no better than groups assembled at random. This case is perhaps an example of retrospective overfitting, whereby some guessers just happened to do well on a previous trials. Surowiecki, like most prediction market enthusiasts, is acutely aware of what kinds of crowds tend to fail and went over the basics of what makes a good predictive group, stressing independence, diversity, and low to negative correlation in biases.

Thomas Malone of MIT argued that advances in communication technology are broadly responsible for the long-term evolution of government and the spread of democracy, and projects similar decentralization in the corporate world. However, communication technology can also abet centralized authority, and it seems that its impact must be assessed on a case-by-case basis. For example, would Charles Schwab have enjoyed so much success if existing brokers could have cheaply deployed retail-targeted trading interfaces via the internet?

Finally, it's been one week since the conference and legal issues might already be heating up in the US. During that week, Intrade's PredictionX market on whether the prediction market industry will suffer a "legality shock" in 2006 has crept from the high single digits into the teens, while the contract for "major political validation" in 2006 has fallen from around 50 to the 30s. Validation is more likely in the UK, although one conference participant claimed that "three letter agencies" in the US were very interested and open-minded about prediction markets.

Some operations seem to be rather illegal, but since the law is vague and archaic, entrepreneurs may feel that the cost of not doing business outweighs the probability and degree of legal punishment.

New York Summit Recap, Part 1

2006-02-06T23:27:00.000-05:00

The turn-out was excellent, but there were no big announcements or public tip-offs. This was more of a networking event than an informational seminar. The bankers and venture capitalists far outnumbered the university professors. Other industries with representatives in attendance included pharmaceuticals, autos, energy and accounting. Regulation is a significant concern and there is a sense that controversies over the legality of prediction markets may suddenly escalate, and that "the industry" should be prepared for this — or proactively press for changes in gambling laws. Here are some speaker highlights in no particular order. Watch for Part 2 later this week.

Trade Exchange Network CEO John Delaney expects the prediction market industry to experience 500% year-over-year growth in 2006, but played devil's advocate and examined various risks to this success. What if prediction markets are just a fad? Will the markets be able to improve liquidity? What if there is a major prediction market failure? Will the industry receive mainstream validation and how will this affect regulation? He seemed more concerned about the latter two questions, and proposed an industry association to help navigate these issues. For instance, the association could maintain a historical database of market results that would facilitate a general objective evaluation of prediction markets if there should be a notable specific failure. Bo Cowgill of Google thinks that an industry association could lobby for changes in gambling laws in the United States, but cautioned that it should also get non-corporate interests involved.

Delaney said almost nothing about the Intrade EBOT. When asked about it, he noted that Intrade is still plodding along in its quest to become a CFTC Designated Contract Market. It is unclear whether something is imminently in the works with the EBOT, or if Intrade has moved the venture to the backburner, looking forward to the less limiting DCM status. Delaney did report that Intrade is maintaining an internal prediction market on the date of their CFTC approval, but declined to give any prices. He also announced a "Prediction Market Experiment" and handed out username/password combinations to the audience which will allow them to participate in various play-money markets concerning the future of the industry and the concerns that he had previously outlined. (Some quotes will be included in Part 2.) Delaney also mentioned that rising interest rates are beneficial to Intrade, but acknowledged that higher rates will also distort the probalistic interpretations of their long-dated contracts since the interest isn't passed back to most depositors.

Charles Polk, CEO of Common Knowledge Markets, described the Turkish Avian Flu Outbreak Market, which was subsidized through the Gerson Lehrman Group. This was essentially a real-money market, but it was fully-funded. In other words, the traders competed over a pool of funds to which they did not contribute. Polk described it as an alternate way to compensate consultants (i.e., the traders). This is an interesting example with respect to gambling laws.

Chris Hibbert of CommerceNet is among the most well-versed in the legality of prediction markets and argues that such markets will improve their chances of favorable legislation if they can demonstrate that they are providing socially useful information. To this end, he seems constructive on real-money markets subsidized by information-seeking patrons, as in Charles Polk's case.

On an interesting technical note, while discussing Zocalo, Chris Hibbert described a way for exchanges to alter the liquidity of "N-way claim" markets by posting orders that can trigger the simultaneous buying or selling of the full set of possibilities. For example, consider this $10-per-contract election market whose width is $4 (13 to buy the full distribution minus 9 to sell it). The exchange can lower the Liberal offer to 5, tightening the market width to 3:

	Qty	Bid	Ask	Qty		Qty	Bid	Ask	Qty
Conservative Party	2	4	5	2		2	4	5	2
Liberal Party	2	4	6	2	→	2	4	5	2
All Others	2	1	2	2		2	1	2	2
Total		9	13				9	12

The exchange is not exposed to the market because if someone buys their offer at 5, it immediately sells the Conservatives at 4 and the Field at 1, thus selling all possible outcomes for $10, or the full distribution at 100%:

	Qty	Bid	Ask	Qty		Qty	Bid	Ask	Qty
Conservative Party	2	4	5	2		1	4	5	2
Liberal Party	2	4	5	1	→	2	4	5	1
All Others	2	1	2	2		1	1	2	2
Total		9	12				9	12

Presumably, all other trades are locked-out of the processing queue while the exchange flattens its exposure in this manner. It is not always possible for the exchange to find such a combination of trades. Even if there is a suitable combination, having it executed may actually increase the market width, as would be the case if the last example were iterated:

	Qty	Bid	Ask	Qty		Qty	Bid	Ask	Qty
Conservative Party	1	4	5	2		2	3	5	2
Liberal Party	2	4	5	1	→	2	4	6	2
All Others	1	1	2	2		-	-	2	2
Total		9	12				-	13

Most importantly, this method always decreases the market depth. In these examples, 1 contract of depth was added while 2 were removed. Unfortunately, it doesn't work in reverse (adding 2 to remove 1) because the 2 added contracts would have to be traded by others simultaneously. Even if market depth is always removed, it might be beneficial for an exchange to make these sorts of trades in order to capture commissions. This would be the case with Tradesports and its policy of charging price-takers commission, but not price-makers.

Marco Ottaviani discussed some subtleties of market and price formation. He stressed the no-trade concept. He described how market participants exaggerate the importance of the information and analysis on which they base their trades - their "secret signals" - and this among several other factors causes the favorite-longshot bias.

Koleman Strumpf summarised his paper Manipulating Political Stock Markets, which detailed the political gambling markets of the late 19th and early 20th centuries in the United States. He does not interpret the 1919 Black Sox scandal as being important in the fall of the original election markets, although he is working on a paper involving that scandal. He finds it curious that political parties are so reluctant to hedge their fortunes by selling themselves short in political markets, especially since it might often be desirable to appear weaker in order to make the opposition complacent and/or galvanize one's own voters.

Again, check back later in the week for Part 2 of the recap, which will include Russell Andersson of Hedgestreet, Emile Servan-Schreiber of NewsFutures, and James Surowiecki.

Hedging Against Education Inflation

2006-01-25T21:09:00.000-05:00

Some costs such as education and healthcare are difficult to hedge against because there are few willing to take the other side of the trade. Take education, one of the very best investments. The average college graduate in the United States makes about $20,000, or over 60% per year more than those who stopped with high school diplomas. It is easy then to understand why college costs can continue to advance at roughly twice the overall rate of inflation. Education is a major cost for many families, sometimes comparable to housing.

Consider a market that tracked the level of the "College Tuition and Fees" component of the CPI. This market could work very much like the upcoming CME housing futures, with the monthly CPI release acting as a discontinuous "spot" price. Although the current CME CPI derivative operates as a parimutuel auction, a standing continuous double auction would probably be better here. If the futures had a long term length, this would mitigate the occasional hassle (and cost) of having to "roll" them to the next expiration. Remember, the goal is to provide a hedging tool to members of the public who wouldn't otherwise trade futures.

The fly in the ointment of course is that there would be a massive demand imbalance — there would be many buyers, and few natural sellers. (A parimutuel auction wouldn't really address the dearth of sellers, as buyers would have to commit to a certain price range, when really they just want protection from any upward movement.) The basic supply problem is that colleges aren't commodity producers, and barring potential legislation, they aren't in need of a hedging vehicle.

Aside from legislation, is there anything that might eventually threaten to bring education costs down, making such a market viable? Robert Shiller has suggested that communications technology will decrease the demand for professors. Arguably, this trend is underway in the form of some for-profit universities, but any price competition is not yet material — and rightly or wrongly, academic accreditation does not seem to be just a transfer of knowledge.

What about demographic trends? Perhaps climbing retirement ages will help by increasing the supply of working intelligence, but with the constant explosion of knowledge, this is unlikely. It is more likely that lower birth rates in the developed world will do the trick.

Now, if one believes Ray Kurzweil, intelligence might literally become a commodity by 2029. He made a "$10,000" (the effect of interest rates on prediction market prices is almost never discussed — more on this soon) bet to this effect with Mitchell Kapor on longbets.org. Well, it is doubtful whether a machine passing the Turing Test by being able to simulate a human conversation would actually possess the kind of intelligence that, say, employers would pay for. For the sake of argument, let's assume that it would, because this leads to a good example of market design. The Kapor/Kurzweil bet was a one-off, but imagine a standing Turing Test futures market. Now re-consider the education cost futures. The education futures would then be correlated to the Turing Test market, but the former would compel liquidity because of its double hedging function. One should always think about how changing the explicit content of a market will affect hedging demand, liquidity and balance. Often it might be worthwhile to dial the "beta" of a prediction market tied to a specific event below 100% in order to capture more general concerns (and in some cases, make it less controversial.) Even if there is a huge potential hedging function, there may not be enough balance in the market to realize volume, especially if there are existing ways to express correlated views. It will be very interesting to observe the materialization of the new housing futures market, which should be correlated to bonds.

Exchange Updates

2006-01-22T18:10:00.000-05:00

The Chicago and New York Mercantile Exchanges have apparently walked away from the bargaining table. The CME, the largest U.S. futures exchange, had expressed interest in acquiring a 10% stake in Nymex, the predominant American energy and metal futures exchange. The story at this point is that talks broke down, "in part over concerns about the cost of using the CME's electronic-trading system." The greatest cost of the electronic trading is of course incurred by open outcry floor traders. For Nymex seatholders, any bid for the exchange potentially carries a tradeoff between the floor trading rights and equity components of the seat price. In 2005, the 816 Nymex seats more than doubled in value, and a good deal of this was likely due to the equity component appreciating ahead of the IPO, which had been planned for mid 2006. On Friday we learned that General Atlantic increased their bid to $170 million, up from the original $135 million, but seats are still apparently hovering near $3.5 million despite significant gains in crude oil since they first traded there in November.

The industry trend is clearly electronic trading and the transparency it provides. CME's non-compete agreement in energy products with Nymex expires in June. Additionally, a WTI Light Sweet Crude contract is scheduled to begin trading on the Intercontinental Exchange on February 3rd — and Iran is planning to open its oil bourse in March.

Meanwhile, Hedgestreet seems newly invigorated in their push to reach retail clients. Their edge will continue to be the ease of use for the average person who does not otherwise trade futures, and I wish them luck.

1/24/06 Update: There is a report in Natural Gas Week that CME will list energy contracts in June. CME's stock was up over 6% today, and ICE, 10%. There is a graphic on Nymex's web site that says, "Evolution is Inevitable."

Prediction Market Predictions

2006-01-08T23:03:00.000-05:00

Succumbing to the basic human needs to predict and create lists, which are especially prevalent near calendar changes, here are some forecasts for 2006:

Prediction markets can do more than provide information and entertainment. This will be a major theme this year, especially for exchange businesses like Intrade.

Further emphasis will be placed on the risk-sharing possibilities of prediction markets. This focus has a double practicality, as it sets the stage both for robust liquidity and favorable regulation. A central issue in the development of sports- and entertainment-related markets in the United States will be the degree to which they provide a hedging function for pre-existing risks. Intrade or another firm will approach film studios and offer them a way to partially insure box-office receipts through prediction markets. Regardless of the outcome of these kinds of endeavors, the regulatory environment will remain more favorable in Ireland, the U.K. and Australia at year-end. The term "peer-to-peer insurance" will gain traction.

Interest will grow in applying prediction markets to matters of public choice. Prediction markets tied to tax- and subsidy-related legislation provide strong incentives for "latent" groups to form and give special interests a way to hedge their legislative fortunes. This thread of development will gain momentum before the more ambitious Futarchy, which needs to address how hedging behavior will skew informational interpretations of price.

There will be a paper published which models market size and liquidity based on hedging utility, degree of risk-aversion/seeking among participants and the volatility of contracts.

Attempts to seriously use prediction markets as a new form of intellectual property will encounter no-trade conditions. Leaving aside publicity bets, in some cases these problems may be overcome by identifying third parties for whom the market's information is valuable enough that they are willing to subsidize liquidity.

On the informational side, corporate internal prediction markets will thrive, led by NewsFutures. Additionally, firms will begin to explore using external prediction markets to replace traditional public test groups. This movement will eventually lead to surprising results in fields as diverse as modeling, advertising, music, publishing, and consumer products. (Fortunately, the sort of network technology that makes this possible will also relieve excessive commoditization.)

2006 will see intensified competition and consolidation among exchanges. Here are some highlights relating to firms involved with prediction markets and alternative derivatives:

Intrade's EBOT will face stiff competition from the CME, whose alternative derivative offerings will expand. A major advantage of online prediction markets is their ease of use and expanded client-base versus traditional futures markets. With the EBOT restrictions, Intrade loses this advantage and has to face an entrenched, much larger competitor. Consider one example. Intrade has indicated that it is interested in hosting a weather-related market, but in 2005, CME's US weather derivatives market grew over 350% to 214,501 contracts in volume. Intrade will of course offer distinct contracts, but the only real factor that will keep CME from competing in any new markets will be the latter deeming them too small or controversial to be worth the effort.

Plagued by low volume, Hedgestreet's business model will begin to morph into that of a broker. They will explore ways to provide look-alike contracts to CME and NYMEX futures. Instead of hosting markets, they will sell micro contracts internally hedged by the standard futures. The advantage of the smaller contracts to customers will be accessibility and size, while Hedgestreet will capture relatively large commissions. Eventually, the public will be able to hedge energy and real-estate prices as part of standard online banking interfaces. Possibly, the large exchanges will take a more active role in somehow capturing the business of smaller hedgers; given a widely distributed and inexpensively maintained interface, this could be feasible.

Investment banks and the CME will have conversations concerning equity earnings-release auctions which would work much like the current economic derivative auctions. This would give sell-side entities a more efficient way to compensate their equity researchers, and would give CME another toe in the equity waters. Unfortunately, it is too easy for the large companies that would likely be covered by such markets to manage earnings by a penny or two each quarter.

If CME doesn't actually tender a NYMEX bid, expect NYMEX's IPO to be delayed.

Mark Cuban will take an interest in a prediction market business.

Macro-economic and miscellaneous predictions related to risk:

Asian reserve policies, savings- and exchange-rates will be the main drivers of inflation, volatility and interest rates, with the latter three moving together in the same direction.

Regarding housing, the first point is a real yawner: interest rates will be the main determinate of prices. The second point is more arcane and relates to the new housing futures. As mentioned in the last post, self-fulfilling prophecies tend to be most robust when there is bad information. "Bad" here can mean a few things: 1) Wrong, as when an unfounded rumor causes a bank run, 2) The correct information is insufficiently disseminated, or 3) The correct information isn't released frequently enough. Since the housing futures will settle based on an apparently quarterly index, and there will be massive pressure to sell the index as a function of hedging, there is some chance, however small, that the new futures market will weigh on housing in a self-fulfilling manner.

Energies and metals will continue to do well, both on the back of Asian demand and as systemic and inflationary hedges.

Byron Wien will check the online prediction markets before making his 2007 surprise list. He cites at least a 50% chance that Mitt Romney will emerge as the likely 2008 candidate at some point during 2006. Tradesports gives Romney a 10% chance of winning the nomination. Experts will continue to overestimate small probabilities as a function of reputational "call-buying" which is made "profitable" by selection bias in public memory.

Chatter about the threat of a systemic derivatives "blow-up" in the financial industry is overstated. There will be none in 2006 barring a massive natural disaster, terrorist attack, or - positively - a major technological breakthrough such as a cure for cancer or fusion.

Don't forget the Prediction Markets Summit - East, which will be held in New York on February 3rd. Intrade will take this occasion to let us in on more details regarding their EBOT venture. Oh, and Chris Masse will somewhat surprisingly not renounce his French citizenship.

The Dark Side (Prediction Markets, Manipulation and Self-Fulfilling Prophecies)

2005-12-21T23:58:00.000-05:00

Ideas are almost always older than one realizes or would like to cede credit for. The subtlety of self-fulfilling prophecies was known to the ancients and was presumably employed by the Oracles at Delphi. Heraclitus mused that the Oracle's voice, "reaches to a thousand years." Messianic prophecy has likewise influenced the footsteps of would-be kings and the various re-tellings thereof far into the future.

Upon reading letters in which her husband described his encounter with the three seer-witches, Lady Macbeth effused that they "have transported me beyond this ignorant present, and I feel now the future in the instant." For the three witches had predicted that Macbeth, then a regional lord, would ultimately become King of all Scotland. Feeling anointed by fate thereafter, Macbeth went on to murder the King and assume the throne, thus lending a self-fulfilling aspect to the witches' prophecy.

What powers lie in self-fulfilling prophecies? Can we rigorously delineate their dangers as they relate to the future of prediction markets?

Koleman Strumpf presented his paper, authored with Paul Rhode, "Manipulating Political Stock Markets" at the Mini-Conference on Information And Prediction Markets in London earlier this week. Part of their study traces the development of the seldom-remembered political betting markets of the late 19th and early 20th centuries, which peaked in volume in 1916. Here is a particularly fascinating passage:

Contrary to these sanguine assessments were the frequent assertions that active partisan involvement, especially by Tammany Hall, systematically distorted the betting odds and, in selected instances, speculative attacks and manipulation sought to change the momentum of the races and influence voter turnout. [...] As an example, in 1916, Democrats charged "the money was being sent to Wall street to force the betting odds to Wilson's disadvantage" [...] "Already," one prominent Democrat said, "we are hearing that many up-State farmers are struggling between their conscience and fear that Hughes will be elected and it might be found out that they voted for Wilson." (my emphasis)

Perhaps it was no coincidence that political betting fell off by the next Presidential election of 1920 in the wake of the Black Sox Scandal of 1919. On the other side of the world, this intervening period saw the Russian Revolution of 1917, which brings to mind Karl Popper's and George Soros' idea that Marx sought to influence the course of history by claiming to predict it. The specter of self-fulfilling prophecies will always haunt political prediction markets — and since there is a good amount of prediction concerning these markets, it's best for their proponents to meet these concerns head-on.

The Strumpf/Rhode paper corroborates previous work by Robin Hanson, Ryan Oprea, Colin Camerer and others concluding that attempts to manipulate liquid markets will be largely unsuccessful. In short, the Hanson/Oprea paper argues that a manipulator's price bias can be treated as "noise," and variance in that bias can actually increase price accuracy, by enticing more market participation and liquidity. As with all models, there are many assumptions here that may not hold in the real-world. For instance, what if the market contains a preponderance of momentum/feedback traders — those for whom the manipulator's "noise" acts as new information? In actual markets, very often participants act on such endogenous "clues," and traders may have no idea that manipulation is even occurring. Also note that the cited works on manipulation specifically address the influence of price on price, whereas when we are discussing self-fulfilling prophesy, we are more precisely referring to the effect of price on fundamentals. Likewise, some studies have stressed the role of ethylene gas or hallucinogens on the Delphic Oracle's behavior and reception, but here we are less interested in divergences between reality and perception/representation than we are in cases where the latter actually becomes the former.

By "fundamentals" all that is meant here is some external influence on the market price. In self-fulfilling cases, often this exogenous factor is related to collateral or some other source of funding or liquidity. "On The Fundamentals of Self-Fulfilling Speculative Attacks" examines currency crises and concludes that while self-fulfilling dynamics may trigger the timing of major market moves, they cannot unfold without certain fundamental circumstances already in place. The fundamentals determine the "whether" of the move, while the sentiment and technicals merely determine the "when." In this 1997 interview, Paul Krugman basically agrees with this prognosis, adding that self-reinforcing dynamics usually exaggerate the magnitude of the eventual jump:

John R. MacIntyre: You would say then that there is nothing arbitrary about these crises and that it is the market responding the policy inconsistencies of the government?
Krugman: I would say that is ninety percent true. Currency crises can, in principle, arise more or less arbitrarily. One way is what is termed a self-fulfilling crisis. It is like a bank run. We all know that a bank that is fundamentally sound can nonetheless be broken if all depositors panic and try to cash their deposits all at once. [...] In practice, there are reasons why a currency crisis is most often worse than actually deserved by a country. But in no case that I can think of has there been a crisis completely unjustified by the economic fundamentals [...]

Self-fulfilling dynamics may move events forward in time or climactically intensify them, but they are not a free-floating power with respect to fundamental circumstances, at least in liquid markets with reasonably good and up-to-date information dissemination.

What about election markets where the "fundamentals" are the intentions of voters? The main Tradesports Bush contract apparently underwent a series of manipulative episodes in August through October of 2004, in one case plunging to 10% before sharply rebounding. In the proceeding months, as in 1916, there was plenty of speculation, especially from Don Luskin, on the source of those "speculative attacks." In any case, these manipulation attempts dissipated at the level of the market as the literature predicts, but let's assume that future attempts in similar markets are more successful for whatever reason, probably through a prevalent degree of momentum/feedback/herd trading. Under which circumstances could there then be a danger that the prediction will be self-fulfilled in the election? In order for a market to have an effect on the actual outcome it would have to be very well-known and -regarded, so well-regarded in fact that it would not be compelled to close any divergences from standard polls on its own. However, if this were the case, this market should be exceptionally liquid and manipulation should be all the more difficult in the first place.

Nonetheless, assume that these two conditions occur together: 1) the market is very deep, well-known and -regarded, and despite this, 2) a successful manipulation attempt occurs. Leaving aside the possible urge of voters to be on the "winning side" regardless of rational political considerations, in a two-party system with secret balloting, a prediction market should have little influence on who voters ultimately vote for. Their votes will still be based on appraisals of the party platforms and reliabilities with respect to their personal utilities or political ideologies. The fact that the market price may be bandied about by the media, even if it creates an aura of defeat for one candidate in accordance with the manipulator's wishes, will not affect voter decisions as they might if those decisions were to buy or sell some asset. However, a manipulated market price may very well influence which voters vote. Anthony Downs' great 1957 book An Economic Theory of Democracy argues that in a two-party system, party platforms will tend to converge in what amounts to political Hotelling. This point seems increasingly prescient each major election year in the US, as popular and electorate votes uncannily approach a 50/50 split. Focusing only on the popular vote for simplicity, when an election market trades near 50, apart from the fact that many voters may be indifferent to the outcome, there is a stronger impetus for voters to participate than when the projection is wide and their votes have less chance of making a difference. The effect on voters in manipulating a 50/50 race to 55/45, for instance, is actually unclear with respect to the manipulator's intentions. Will the supporters of the "favorite" become incrementally complacent, while the party of the "underdog" is made incrementally more resolute? Perhaps manipulators should actually buy the candidate they do not support — especially since this would constitute a hedge of sorts! In any case, even if semi-contradictory pre-requisites are met, the potential for self-fulfilling prophecies in two-party election markets is exceedingly tenuous. (In multi-party elections or nominations, where party/candidate differentiation and tactical voting come into play, it may be stronger.)

The research suggests two relatively assuring results then: 1) Manipulating markets tends to be difficult and ineffective, and 2) Self-fulfilling dynamics may quicken or intensify an event, but they should not cause one ex nihilo. Furthermore, political election markets do not seem susceptible to self-fulfilling manipulation, at least not in the two-party case. Now, there is another idea which people often conflate with these others, and this is a source of considerable angst and controversy regarding prediction markets. This logically separate issue exists where an unknown individual or a small group of actors can have a material impact on the final outcome of a market. This was a basic problem with part of DARPA's Policy Analysis Market: the set of potential "insiders" (terrorists, for example) was too diffuse and uncontrollable. (There are still ways to mitigate this; they were mentioned in the link above.) An open group of insiders is particularly untenable when matters of life and death are directly in play. Keen to avoid excessive controversy, Tradesports was wise to instate rules 1.6 and potentially 1.9 to all political election markets. (If a candidate were to drop-out for any reason, the contract would have been voided and all open trades reversed.) The contract for Bush to win Texas, when it traded at only 96% in early August 2004, was therefore mainly a demonstration of the longshot effect, and didn't indicate the presence of other possibly suspected embedded options. For reasons similar to insurance companies' "insurable interest" logic, this contract probably would not have been acceptable without the special rules.

The mere fact that someone may find a contract distasteful is not an argument against its existence if the contract will not reasonably encourage a negative outcome through its "insider" structure, especially if it serves a legitimate insurance purpose, or provides an informational social good. If there is a "dark side" to prediction markets, it mainly relates to those contracts that may encourage negative outcomes, and not to the realm of self-fulfilling prophecies. In the preface to the 1994 edition of The Alchemy of Finance, the great trader George Soros concludes that "in most situations," reflexivity "is so feeble that it can be safely ignored." The academic literature on manipulation suggests that the feebleness of self-fulfilling manipulative attacks in prediction markets is thereby squared. Of course, the special cases are the interesting ones.

When The Dealing's Done

2005-12-15T23:51:00.000-05:00

This morning brought interesting news concerning a potential CME bid for a 10 percent stake in the New York Mercantile Exchange. CME seems hungry to have a piece of every market, and this only reinforces my opinion, seconded by Chris Masse, that the Chicago exchange is positioned to become the leader in prediction markets and alternative derivatives in the United States.

The CME/NYMEX news comes on the heels of Intrade's release announcing their Exempt Board of Trade launch. The announcement stressed weather & economic derivatives, which currently are CME's turf.

The release also mentioned Intrade's intentions to provide markets in "credit risk." Now, bonds and fixed-income derivatives of course already represent credit risk. Is Intrade going to have contracts directly tied to credit ratings? Likewise, on the equity side, how long before someone broaches the possibility of having contracts directly tied to earnings releases? In any case, a proliferation of markets will be limited by liquidity cannibalism.

At first glance, Intrade's release does not seem to address the "eligible contract participant" restriction, which was the subject of most of the speculation over at Agoraphilia. However, I find this John Delaney statement interesting:

We bring not only our proven exchange technology to the table but will also provide a central counterparty [clearing house] to every trade and that should make financial institutions comfortable trading these markets.

Consider this successful 2002 petition from NYMEX to the CFTC, "for Treatment of Floor Brokers and Floor Traders as Eligible Commercial Entities and Eligible Contract Participants Pursuant to Sections 1a(11)(C) and 1a(12)(C) of the Commodity Exchange Act"

This petition came to mind because of this section:

NYMEX asks that its floor brokers and floor traders (collectively referred to hereafter as "floor members"), when they act for their own accounts and are guaranteed by an Exchange clearing member that is registered as a futures commission merchant ("FCM"), be permitted to: (1) Act as an eligible contract participant [...] (my emphasis)

If Intrade/TEN intends to provide a clearing house that will guarantee transactions regardless of traders' assets, perhaps they can make a similar petition? Likewise, as I suggested to Tom Bell, perhaps Intrade can create sufficiently-funded legal entities on-the-fly, as investment banks do with "special-purpose entities". A specific market on the TEN EBOT might then technically have two large counter-parties, and profits and losses could be distributed to actual traders in a pro rata fashion.

Still, I think regulators will balk at these structures if the goal is to allow for entertainment-oriented trading. Regarding these cases, Forbes writer Elizabeth Moyer notes that Intrade, "is exploring ways sports franchise owners, stadium owners and others in professional sports could trade to hedge economic risks to their industry, such as failing to make the playoffs." This is interesting, but where is the line drawn? Almost any market can be framed as serving some conceivable hedging purpose. For instance, would the Michael Jackson contract also fall under this umbrella, since it would have allowed Jackson, his gardener and zoo-keeper a way to hedge his legal fate?

Know When To Fold 'Em...

2005-12-15T13:31:00.000-05:00

A brief follow-up to a previous post: The world and the blogosphere in particular has been remiss in failing to note that the story on Mark Cuban giving-up on the idea of a gambling hedge fund was strongly hinted-at here over one month before it was officially divulged in last week's Forbes story.

The No-Trade Theorem: Looking Back to Look Forward

2005-11-25T18:46:00.000-05:00

The intuition underlying Milgrom and Stokey's venerable "no-trade" theorem is that the willingness of a trader to make a trade indicates to the market that they have new private information, and thus no-one will be willing to take the other side of their trade. As with many mathematical results, this theorem requires some assumptions which likely do not hold in real-world markets. Nonetheless, it is a valuable concept to keep in mind when envisioning possible future markets.

This preliminary paper joins the work detailing exceptions to the no-trade theorem; it shows that even if the standard assumptions for the theorem are met, trade may still materialize when the final value of the instrument is dependent on the actions its eventual owner may take, as when the controlling interest in a corporation is in play. (These situations can also throw real-world traders for a loop, as evidenced by Kerkorkian's GM maneuver in May; people tend to neglect the use-value of equity.)

Last week also brought an update on the Ladbrokes/New Scientist prediction market which, for two weeks in August 2004, allowed bets to be placed on 5 scientific breakthroughs occurring before 2010. This story suggests another exception to the theorem. Who in their right mind would take the other side of leading researchers' (long) trades on science claims? It seems that Ladbrokes accepted bets on these markets mainly as a function of publicity. (I for one had not heard of this Hilton subsidiary before this story.)

Meanwhile, at Agoraphilia, Tom Bell has been running ahead with Robin Hanson's far-seeing work. He has proposed using prediction markets on research claims as a new form of intellectual property, which he feels is superior to traditional mechanisms such as patents and copyrights with respect to funding, collaboration and hedging. I think this idea is exciting and has potential, but in my comments I broached what I called the "insider problem": "when less-informed participants actually lose money to researchers influencing the resolution of the contract, they are going to be something less than happy, and I'm not sure that's a tenable situation." While this sort of thing happens all the time in commodity futures markets, the impact on price that individual producers and consumers can have in those cases is far less material than one might find in a binary prediction market (prone to sudden and irreversible massive returns), and this seems to be a qualitative difference. Furthermore, in a standing market, if a participant's actions are seen as rapacious, they might encounter friction going forward if they cannot disguise their trades. There is no such recourse/check in a one-time market. Chris Hibbert is, however, sanguine:

Most of the proponents will argue (as I do) that the value of disseminating information outweighs considerations of making a fair playing field. As long as everyone knows that insider trading is encouraged (though malfeasance or dereliction of duty remains actionable) they should be able to anticipate and prepare for the actions of people with better access to information. The idea that the market is a lottery with only ignoramuses allowed to participate is a very bad one.

But will this produce a viable market? I will let the masters of prediction market form, Justin Wolfers and Eric Zitzewitz, answer. From the Spring 2004 "Prediction Markets" paper:

Ambiguous public information may be better in motivating trade than private information, especially if the private information is concentrated, since a cadre of highly informed traders can easily drive out the partly informed, repressing trade to the point that the market barely exists. Indeed, attempts to set up markets on topics where insiders are likely to possess substantial information advantages have typically failed.

"How to attract uninformed traders?" was later listed as the team's #1 open question about prediction markets, when they wrote:

Counterintuitively, the problem for most prediction markets is attracting sufficient uninformed order flow. Markets need uninformed order flow in order to function; with only rational traders trading whose only trading motivation is expected returns, the No Trade Theorem binds and the market unravels. Uninformed order flow can have a variety of motivations (entertainment, overconfidence, hedging), but with the exception of hedging, these motivations are usually non-economic, putting economists at a comparative disadvantage in predicting which markets will succeed.

There is clearly a tension between using markets to aggregate and reveal information, and ensuring that these markets are viable and remain liquid. Designing markets to serve a hedging need goes a long way towards making them sustainable, but to the extent that markets are used for risk-sharing (or entertainment, another sort of "use-value"), prices may be less usefully interpreted.

It is important to always bear in mind the formal aspects of markets as they impact liquidity. Companies like Tradesports might take a cue from the CME, which has the potential to become the US powerhouse of prediction exchanges. Not all markets are best served by the continuous double auction process. Brainchild of pioneer Robert Shiller, the CME/Goldman Sachs Economic Derivatives Markets, for example, operate as sporadic pari-mutuel auctions, thus providing liquidity to traders even if there is no explicit bid-offer match. The markets can operate even if there are no offers whatsoever, since bids on a given strike/indicator range/state are implicit offers on all other states.

11/28/05 Update: David Pennock, who will be presenting for Yahoo! at the Prediction Market Summit, has devised an interesting hybrid of continuous double auctions and pari-mutuel auctions, detailed here. The result combines the guaranteed liquidity of pari-mutuels with the flexibility of being able to exit trades before the final outcome is determined. The latter property allows more information to be revealed during the process of the auction.

11/29/05 Update: Robin Hanson will be out with a new paper addressing some of these topics soon. Meanwhile, here is an existing work of his on the "thin market" (no-trade) problem. He succinctly asks us to:

Consider the case where a single person knows something about an event, and everyone else knows that they know nothing about that event. In this case the standard information markets based on that event simply cannot acquire this person's information.

Dr. Hanson's design uses market scoring rules to ensure possible trading on many combinatoric outcomes, but relies on "patrons" to subsidize this liquidity. To whom would the information be valuable enough to subsidize such a market? For instance, would it be worthwhile for disease-sufferers to pool money to ascertain the probability that their affliction will be cured, or, more likely, pharmaceutical companies, essentially outsourcing early stages of research? This is an interesting and worthwhile line of thinking. Generally, providing trading subsidies (or negative transaction costs) is a much more attractive solution when the providers can be identified by non-monetary or indirect monetary interests. Tax-breaks on such patronage would help as well.

Robin Hanson's original Could Gambling Save Science? paper is, of course, the backdrop of this entire discussion. I note one apparent divergence between Hanson and Tom Bell. In this paper, it seems that Hanson would agree with me on my Cold Fusion example:

The only similar problem in idea futures is when a research lab is trying to keep a result temporarily secret before trading on it, and an employee sneaks out and trades first. This can be dealt with exactly as if it were stock insider trading, through private trading records accessible to criminal investigators.

As I asked Tom Bell, "Where exactly is the line drawn?" What if there is technically no definitive result yet, but the researchers are darn sure that they have cracked the problem? I say it is an "apparent" disagreement between Bell and Hanson because, to Hanson's great credit, the "Gambling" paper was written 15 years ago.

Finally, some (including myself) may have overstated the ability of such markets to provide funding to researchers. After all, they are not paid until the discovery occurs or some progress has been made, by which point they would have garnered success and influence anyway. Individual researchers are unlikely to be in a position to take substantial bets, and to the extent that they do they are incurring more risk for themselves. To the extent that they instead hedge their success, the market yields less information.

Cold Spots

2005-11-10T18:29:00.000-05:00

Cold spots are a staple of haunted house lore. If one takes reflexivity seriously, one might be concerned about the effect of the new CME housing futures, which are due to start trading in the second quarter of next year. They will apparently be based on the Case-Shiller Indexes®, but how often will the indices be updated? Aside from increased volatility, what might happen with a discontinuous "spot" price?

CME CEO Craig Donohue touts, "Even as the Federal Reserve valued the U.S. residential real estate market at nearly $19 trillion in 2004, there is presently no liquid market or efficient means of hedging real estate [...]" We didn't need to hear this to realize that there is going to be massive selling pressure by hedgers, and the more infrequently the spot price is updated, the more the futures will tend to drift lower under this weight. This should be a good opportunity for speculators, but they may be less willing to bid without fresh spot prices, especially in a downtrend. What will happen if we start to see red numbers under a "Housing" bug on CNBC day in and out?

Lastly, this does not bode well for our friends at Hedgestreet, but you have to hand it to the CME; they seem vastly more interested in innovation (and transparency) than another U.S. mercantile exchange that comes to mind.

11/11/05 Update: The CSW website contains some details on the current incarnation of the Case Shiller Indexes. I say "current" because I don't think the market will tolerate this lack of frequency in updates:

CSW produces index updates every quarter at many geographic levels - including by U.S. Census Division, by State, by Metropolitan Statistical Area (MSA), by County, and by ZIP Code.

Nor this lack of transparency:

CSW calculates the CSIs utilizing both published and unpublished index calculation techniques developed throughout the years by Case, Shiller, and CSW's research staff

I am sure these issues are currently being dealt with.
Interestingly, CSW has a related Home Price Forecast model:

The HPFs blend CSW's home price trend and econometric analyses with the company's home price forecasting technology for residential real estate markets throughout the U.S. HPFs reflect an objective outlook for the coming year. [...] CSW has been publishing a sample of its Home Price Forecasts (for 23 metropolitan areas selected by The Wall Street Journal) more than five years. The majority of the time, these CSW Home Price Forecasts have been within two percentage points of the actual market change that unfolds for the forecasted period.

As the CSIs become more influential, one would expect these forecasts to take on more importance as well. They could also be used to mitigate any "spot" frequency problem.

Now, with a legislation-linked future we of course have no spot prices before settlement, but in those cases we can watch the legislative proceedings and ask legislators questions, thereby collecting information that will give us a good idea of the probability of a bill's passage.

Know When to Hold 'Em...

2005-11-05T14:56:00.000-05:00

Mark Cuban is holding his cards closer to the vest nowadays, at least as far as his sports-betting hedge fund business is concerned. The fund was announced nearly a year ago and there's been almost no word since. One wonders to what extent the opportunities he was targeting such as inter-book arbitrage still exist. The uncertainty principle at work in trading is more intense than most other disciplines, and paranoia is likewise more advisable. Giving the gambling world a one year head-start may be too much to overcome. I also note Cuban's recent "What's an investor?" missive, which backs away from speculation, his definition of which implicitly includes sports gambling. It wouldn't surprise me if Cuban ultimately folds on the entire idea. To me, once the obvious hurdles are overcome, a legislation-linked futures exchange seems like a much better business anyway. Although both businesses seem a little shocking at first glance, regulators will recognize that legislation-linked futures provide a wholly legitimate form of "peer-to-peer" insurance.

Recently I've been focused on techniques of structuring markets that maximize liquidity. The primary strategy is choosing a market that will compel the participation of hedgers (insurance-seekers). This will tend to create an order imbalance, which will attract yield-seeking speculators, with the goal of bootstrapping the size of the market (and liquidity) up to its expected target, which can be guessed at by considering the total hedgers' risk and an estimation of their risk-appetites and internal liquidities.

Notice how different this approach is from a lot of the discussion on prediction markets. I stress the field and the formal aspects of the market, where others like to talk about the content of the market and debate whether the price is "correct", all the while assuming a certain interpretation of what the price should mean. Consider Greenspan's comment from Thursday: "The markets have become far more complex, and the simple relationships that the yield curve's slope indicated no longer worked." He is referring to an imbalance in the market's field that is invalidating the usual interpretation of price/yield. In the case of legislation-linked futures markets, the imbalances are more simple by orders of magnitude — and vastly easier to evaporate, largely because yield-seeking behavior resolves the imbalances in those cases!

Of course we all look forward to the day when prediction markets are used to save lives. I think this development will be coextensive with their graduation from the milieu of gambling/entertainment to something more like insurance. Most markets can somehow be framed as insurance markets, but I don't suppose Michael Jackson actually bet on his conviction, nor his gardener, zoo-keeper, etc! When trading becomes an end in itself, as a form of entertainment driven by the thrill of risk-seeking, that is gambling. Gambling is risk-seeking. Apropos of the internal/external market discussion, this explains the tendency of teams to trade richly in local betting markets, if that in fact still happens. Otherwise, you would expect more selling pressure as fans would tend to "hedge" against the subjective value of their favorite team's fortunes, rather than "levering-up."

Dorgan vs. Markets

2005-10-30T12:07:00.000-05:00

Senator Byron Dorgan seems to be an enemy of markets. "Better to be a friend of people", his supporters will shout. Since I am careful not to mistake means for ends, I agree, but Dorgan now has a history of seizing upon ephemeral opportunities for political hay-making at the expense of sane economic policy and financial innovation. Dorgan's abusive attitude towards markets may accidentally hurt citizens, subverting his intended goals.

I and many others have, intellectually if not effectively, defended the central concepts of PAM against the Senator's attack. I have gone on to argue that legislation-linked futures markets would not suffer from the same major difficulties of prediction markets linked to events such as terrorism and coup d'etats. The basic difference: in the latter cases the "insiders" and their agents are inherently lawless, while legislators are lawful. Um, that is, it would be quite something if legislators argued that they couldn't be trusted as insiders in the case of legislative prediction markets.

If there were a prediction market in place linked to Dorgan's proposed windfall tax, energy companies would have the recourse of insuring part of their potentially affected profits. Senator Dorgan claims there is $7 billion per month in windfall profit, and wants half of it. Philip Verleger, an economist and senior fellow at the Institute for International Economics, calculates that even with exploration costs offsetting part of any windfall tax, the tax could raise $3 billion to $4 billion a year (over 3 years) from each of the three or four biggest oil companies. This is potentially a far more sizable market than anything yet seen on the online prediction exchanges such as Tradesports, and since it is essentially an insurance market, participation will be compelled in ways lacking from markets that are more purely "betting" markets, such as the SCOTUS contracts.

The example isn't necessary, but as we saw with the Miers non-arbitrage on Tradesports, the wording beyond the contract titles is critical. Legislation-linked futures will most likely predict suitably general-yet-specific concepts being fully passed into law by a certain date — not specific bills being passed in specific houses, under threat of veto, etc.

Knowledge Is Not Power, Part 2

2005-10-26T21:11:00.000-04:00

Chris Masse has taken the CEO of Tradesports/Intrade to task for recent prediction market failures. As many have noted, outcomes which depend on a small group of decision-makers and involve a semi-open list of candidates are especially difficult to predict. One of Chris' points is that it is far better for exchanges to foster markets with "social relevance", where the desired knowledge is more widely dispersed. I agree with this, but I prefer to stress the risk-sharing and hedging potential of these markets more than their predictive abilities per se. Consider the Nobel Prize markets. It is unclear to what extent aggregating opinions would have been able to produce accurate predictions, but the potential hedging needs of the candidates and their publishers is clear and somewhat quantifiable. Chris' main theme in his analysis was "better marketing", and I recall from my internet start-up days that one of the things marketers like to do is to identify the potential size of markets. This is where the hedging perspective helps. For example, in a Nobel prediction market, there is at least $1.3 million on the line that could possibly be hedged by the candidates and their publishers. On the surface, this would already be a large market in Tradesports terms. The actual formation of a Nobel insurance/prediction market is unlikely for a few reasons, however: 1) There is an insider problem (although I don't think this is insurmountable), 2) The candidate list is essentially open, 3) Since the candidate list is relatively large and open, candidates would have to sell themselves short at low prices, which might be problematic since the magnitude of their selling interest would probably constitute a supply imbalance and push the price significantly lower than the actual mean perceived probability of their reward. (although the "longshot effect" should mitigate this somewhat)

In general though, I don't consider the demand/supply imbalance by hedgers as an obstacle to prediction market formation. In fact, I think it is a key to their viability. Successful futures markets tend to also be insurance markets. This is because risk-sellers (hedgers) are compelled to enter the market, and risk-buyers (speculators) are attracted to the market because the hedgers' imbalance creates exploitable value for them. The fact that a prediction market is also a peer-to-peer insurance market creates liquidity, which in most cases improves its predictive ability and reduces the ease of manipulation. The contract design question can then be seen as identifying a field in which certain markets will be "fit", in the evolutionary sense. Which markets will naturally compel participation?

The field I stress here is politics, specifically legislation that impacts taxes and subsidies. Legislation-linked prediction markets also seem politically "fit" in that they would quicken the cutting of pork from the federal budget. I am in the process of compiling a list of possible tax and subsidy markets. I have already cited the estate tax issue as the basis for one possible market. If the estate tax were to be permanently repealed, this would cost the government $70 billion per year starting in 2011. Even limiting ourselves to a time-horizon of one generation, the present value of wealth impacted by tax and subsidy legislation surely runs into the trillions. This then is my "marketing" contribution to the future of insurance, er, prediction markets.

Read Part 1

Timely Mediations

2005-09-19T20:41:00.000-04:00

Since Katrina, an increasing number of pundits and politicos are writing the epitaph on small government. This became clear even as the fiasco unfolded, and the drumbeat is still growing. Although legislation-linked futures markets appear to be on the side of Libertarianism and minarchism, ultimately they will be attractive to both the Left and Right — to both progressives and various sorts of conservatives.

Before suggesting some new examples of LLFMs, I'll say a word in defense of minarchism. It's obvious that while this administration touts small government, in the realm of doing it has actually created a fiscal mess of historic proportions — but their lack of competence (or what have you) is not in itself an argument against small government policy. I fear that the growing frustrations and ad-hominem obsessions of the Left are causing progressives to confuse ideas with people. Consequently, babies are in danger of being thrown out with bathwater. Now, I will not specifically defend "supply-side" economics. (It is potentially subjective whether you are on the right or left of the Laffer curve maximum, and correct supply-side policy only cuts taxes when you are on the right side of the maximum. Likewise, the results of such policies are difficult to prove since experimental controls are lacking. Perhaps tax receipts increase but would have actually increased more without the cuts. Perhaps any economic growth subsequent to implementation is a result of other liquidity factors such as interest rates.) Nonetheless, I don't think the basic insight of the Austrians is at all in question: that decision-making is better distributed to the many individuals who are affected by the decision(s), rather than entrusted to a distant, semi-interested authority possessing vastly less knowledge. The latter situation will inevitably result in more shortages and gluts, even if incentives are not a problem.

I am however a utilitarian first and a minarchist second. Economic efficiency is a mean to general happiness, not an end in and of itself. Now you can certainly compile a list of problems with strict Utilitarianism as we did in our undergrad philosophy classes, but I will just say that I am not an absolute Utilitarian, and I think that will suffice here. Critics of small government thinking must be careful not to mistake ideas for people and bad examples; proponents must take care to not mistake means for ends.

To me, the question posed by Katrina is not so much a general problem of big vs. small government, but more importantly, of effective government. To a large extent, the size question applies to the government's role with respect to many types of insurance, disaster relief being one of them. Which sorts of insurance should have compulsory payments and/or universal coverage, if any? How does insurance differ from infrastructure, like police, roads and courts? Those are clear, specific versions of the question.

In terms of risk-sharing, many of our practices will someday be looked back on as medieval medicine is now regarded. Advances in communication have made it possible to quickly share risk with low transaction costs in a many-to-many manner, but this is just being dimly realized, especially where politics are involved. In addition to more traditional forms of private and public insurance, I have here introduced the concepts of tax and subsidy insurance. People should be able to hedge against their taxes, and every piece of tax and subsidy legislation can be described in terms of its "implied tax effect" on every taxpayer. (This framing alone encourages fiscal responsibility.) With subsidies, legislation-linked futures markets would allow two types of hedging/insurance to occur: 1) the potential recipient could sell futures representing the probability of receiving the subsidy, and 2) every other taxpayer could buy the probability of passage, thus hedging against their implied tax loss if the subsidy is granted.

Furthermore, legislators should welcome these markets as they will help to dissolve political log-jams by allowing private entities to meet each other "half-way" through their hedging. "Pork" will be a lot less painful to cut from budgets — and there is plenty of pork still out there despite what some people say. Democrats should attack on this point and Republicans should co-opt them, retaining the better parts of their small government thinking. Legislation-linked futures markets would help to unwind all these questionable subsidies and put a dent in the spending side of the creeping fiscal crisis.

The Changeling

2005-09-05T23:28:00.000-04:00

Legislation-linked futures are likely to first make their mark functioning as tax and subsidy insurance. That is, these futures will be used by parties to hedge against the impact of tax and subsidy legislation.

Consider the estate tax repeal bill (H.R.8 / S.420). It is estimated that the permanent repeal of the tax would cost the government $70 billion per year starting in 2011. Even if this estimate is high, there is certainly room for a significant market to develop here, spurred by individuals seeking to lock-in a certain after-tax estate size. (Of course, this is contingent on whether LLFMs gain the blessing of the CFTC and to an important, but lesser extent, whether the specific contracts are deemed to fall under IRC §1256(e)(2) and are officially recognized as hedging instruments.)

As it turns out, Katrina has derailed proponents of the repeal for the time being, and this effect should have more traction than market interest rate moves seen last week in response to the disaster. Republican leadership should surmise that it will be infeasible to pursue tax breaks affecting wealthy heirs when there are scenes like this in the newspaper: "But the bodies are everywhere: hidden in attics, floating in the ruined city, crumpled in wheelchairs, abandoned on highways."

Meanwhile, progressives are seizing on Grover Norquist's stated goal of cutting government down to the size "where we can drown it in the bathtub", citing the disaster as a strike against minarchism (small government). Libertarians, et al answer that the flooding situation in New Orleans and the extent of its aftermath was precisely a failure of government. Is there a more constructive way to frame the debate? The focus here should be on making government more efficient by fostering new structures of public and private organization — which is the philosophical basis of legislation-linked futures markets. The key is for legislators to see LLFMs not as a subversion of their powers, but as means to ease political log-jams and get things done. When LLFMs are used with tax and subsidy legislation, this creates an environment where it is much more likely that political opponents will meet half-way. With LLFMs, issues in fact become partially de-politicized as decision-making is distributed to the private sector. Government becomes more efficient as a result.

Hay-Maker (PAM, Two Years Later)

2005-08-23T21:38:00.000-04:00

The Defense Advanced Research Project Agency's "Policy Analysis Market" was abandoned in late July 2003 under legislative pressure fueled by worries that it would encourage terrorist attacks, assassinations and coup d'etats. Of course, the project had merit and such event-linked futures were a secondary function. PAM's primary function was to price indices of economic and demographic prosperity in the Middle East, to which specific events of violent unrest would most probably be correlated.

Regarding the event-linked futures, the basic argument was that potential terrorists and their proxies who entered such markets would then be able to profit from terrorism. Or, more subtly, they could stay out of such markets and the market price would come to reflect only U.S. & allied intelligence. If tensions were high, potential terrorists could also "abstain" and sell short the futures since they would essentially be "insiders." To me, this was the basic problem with the event-linked futures component of PAM; the insiders and their proxies were inherently lawless. This will not be a critical problem with legislation-linked futures, where the "insiders" are legislators.

Nonetheless, I will make a couple points in defense of the PAM event-linked markets:

1) There were already plenty of highly liquid markets that would allow one to profit from terrorism by taking short or option positions in stocks, bonds, commodities such as gold and oil, or the exchange rate of the target country.
2) While it would involve overhead, it would be possible to do a background check on anyone betting on a negative event, at least as part of the settlement process. Perhaps they would have to demonstrate a legitimate hedging need? This would also dissolve the vague "moral" concerns directed at such markets, since they would then essentially be insurance markets. Viable futures markets tend to be insurance markets in the first place. The presence of hedgers, those who are compelled to enter the market as a side-effect of some other business or activity, greatly increases the ease with which a new futures market forms. NYMEX's as-yet failed crude oil and natural gas electronic markets bear witness to this, as hedgers are directed exclusively to the antiquated and opaque pit markets.

With pitchforks in hand, Senators Byron Dorgan and Ron Wyden of Oregon led the charge against PAM in July 2003. Their misleading haymaking succeeded in getting the project pulled. One could speculate that legislation-linked futures markets will face even more energetic opposition on The Hill, but ultimately there are some key differences:

1) LLFMs would be operated privately and would not receive government funding.
2) As was mentioned, there is no insider problem here. Or rather, insofar as there may be an insider problem, it is not intrinsic to LLFMs per-se, but to the legislators themselves. Legislators couldn't argue that they would be unable to police themselves. Could they?
3) LLFMs could be restricted to fiscal legislation so an insurance purpose could always be demonstrated. The first important LLFMs would probably only deal with fiscal legislation in any case.

Remember that this is will all happen under the larger umbrella of peer-to-peer insurance, which will allow ways to hedge more common risks such as home and energy prices.

Red Ink

2005-08-16T19:45:00.000-04:00

Almost exclusively, this blog contains speculation on the future of markets and their impact on politics. I consider the trends I am describing as evolutionary inevitabilities. Of course, in the short run, they will come under heavy resistance. Legislators especially, feeling the role of the nation-state slide further into the background, will probably be uncooperative. They will devise all sorts of creative labels to undermine such markets, as that is what they excel in: talking. Clearly they will use the "gambling" card and its vague immoral undertones. Eventually, someone will declare that LLFMs (Legislation-linked Futures Markets) aim to "hijack" the apparatus of the state and subvert "legitimate" democratic processes. Never mind that the legitimacy of the nation-state itself is largely a product of force. The near-religious designation of its securities as "risk-free" can be seen as an implicit recognition that they are ultimately underwritten by force - from ICBMs to the bayonets of special-ops soldiers. It is difficult to go bankrupt by borrowing in order to maintain the world's most powerful military. Instead, the technology of the printing press will be used to confiscate real purchasing power.

Perhaps this acrimony is premature. Maybe the government will welcome legislation-linked markets as a means to focus on more philosophically interesting political problems, leaving fiscal matters, the (re)-distribution of money, more completely to the private sector. Such a trend would certainly be attractive to many on the economic Right at least. In any case, the general economic sophistication of the world's population will be a more decisive factor in the development of such markets. There is no reason to believe that this sophistication will decrease with time, and thus there is no reason to believe that the scope of peer-to-peer insurance markets (that is, the super-set of legislation-linked markets) will not grow with time. In the long run, they will not be stopped by politicians' framing and name-calling, by their disingenuous negative marketing; these changes will wash over governments regardless of the words that come-out of their mouths. The plurality of governments, the fledgling market of nation-states, will help to ensure this.

In the short run, specific governments may attempt to impose special taxes on LLFM profits or outlaw them entirely. LLFMs could also be impeded if bills are framed in such a way that the probability of their passage is very likely from the start. In that case, the "longshot effect" combined with the demand imbalance of the potential hedgers would make it very difficult for the specific market to materialize. Of course, the yet-ongoing Clintonian epoch of centrism (i.e. political Hotelling) makes this route unlikely. LLFMs will work best where the aggregate perceived probability of bill passage lies near 50%, which is precisely what you tend to get under political Hotelling, especially when two parties are trying to capture the same Center.

Evolution. At some point, a certain percentage of political fiscal decisions will be outsourced to private individuals by way of the latter's peer-to-peer insurance activities (i.e, by their trading in legislation-linked futures). This percentage will tend to be inversely proportional to the one-sidedness (I will resist using the word "extremism") of the residing government. I hope the tone of this post hasn't turned-off any of our readers. Even though it is, in a sense, revolutionary, its content is very reasonable and actually hyper-American.

Dear Left, This is why you fail...

2005-08-03T22:37:00.000-04:00

I had mentioned the following example before, but I would like to re-iterate it given recent events. Stem cell research need not remain hostage to irrational currents in the government, and legislation-linked futures markets could be used by researchers to hedge these and other funding risks. This should be feasible especially at large universities that have free cash and employ people with significant investment backgrounds to manage it. Even if one or two insitutions partially hedged potential NIH grants on the order of $250,000, this would make for a significant market on the scale of Tradesports, and this would be just the beginning, both in depth and breadth of markets.

Let's take a step back and see what we are doing here. Formally, we are placing a check on the state's ability to distribute capital, but legislation-linked markets can simultaneously be used to further progressive goals. (Not that I would even describe the funding of embryonic stem cell research as "progressive"; it is simply rational.) Leftists have decried the power of capital as an inhuman force that swallows and "territorializes" everything, but they have ignored precisely its "pluripotentcy", its power to become nearly anything. So to all those well-meaning people on the Left who are naively against capitalism (including Zizek, the foremost continental socialist thinker) or are unwilling to understand and attempt to use its machinery, I say to you, "that is why you fail."

Knowledge Is Not Power

2005-07-25T18:11:00.000-04:00

Last week at Volokh and Crooked Timber, a din arose relating to recent failures in prediction markets. At Timber, one blogger cited this list:

SCOTUS nomination futures markets (note that the SCOTUS confirmation futures markets will certainly work finely)
2012 Olympic city futures markets (the markets saw Paris as the winner)
papacy futures markets (the Pope would come from Europe, said the markets, but they failed to divine Ratzinger and Germany as country of origin)
Michael Jackson futures markets (like the commentariat, the markets had him behind bars)
Purcell resignation futures market (the market said he would not resign)
George Tenet resignation futures market (idem)

Another aired the opinion that it will be a long time before futures markets such as Tradesports are "anything other than a cutesie fad."

All of this is very short-sighted. As I stressed in the Risk Markets And Prediction Markets post and suggested in Overcrowding, the predictive ability of these markets is secondary to their usefulness in hedging risks. If price does not represent probability (value) due to a supply/demand imbalance, longshot effect, etc, this simply represents an opportunity for speculators to profit. The usefulness of a market for its participants is more important and politically interesting than the somewhat academic ideal of market price strictly corresponding to value.

Todd Zywicki at Volokh can perhaps say it better:

Hayek is not interested in the centralization of knowledge for knowledge's sake. Rather, he is interested in the way in which certain institutions (such as prices, language, and traditions) centralize huge amounts of information, boil it down into tacit knowledge, and then redistribute it to decentralized decision-makers in the form of prices, rules, traditions, etc. The "purpose" is not to collect the information at the center in order to make it more "accurate" or "better"; the purpose is to send it back out to decentralized decision-makers in order to allow them to better coordinate their affairs with one another. (my italics)

Said another way, risk markets (you could call them "prediction markets") do not primarily exist for knowing but rather for doing. (Pragmatists would argue that doing is the ultimately the determinate of knowing in any case.)

Said yet another way, market prices should be interpreted as means and not as ends. In a political context, this point was a basic insight of Anthony Downs in An Economic Theory of Democracy, where he wrote, "Thus social products are usually the by-products, and private ambitions the ends, of human action." The social product (in this case, the market price and the knowledge it represents) is logically incidental to the private motives of market participants, although it may nonetheless be highly correlated.

Clear As Day

2005-07-11T22:53:00.000-04:00

Another conundrum, or a hint at the answer to the riddle? As VIX makes new multi-year lows, David Merkel at RealMoney [premium] notes: "many investors have become yield hogs, and have sold puts and calls to increase income in a tough environment. This is akin to the problems that bond managers face today in their quest to find yield." Meanwhile, Brad Setser is becoming more persistent in his suggestions that the U.S. housing market and, more generally, household wealth owes much to China's trade surplus and its impact on yields. Most intriguing is Tradesport's contract on whether the yuan will be revalued by January 1st; for it seems to be tracking the VIX since the beginning of the year, especially since the mysterious "April Fool's Day" print.

Potential

2005-07-05T20:05:00.000-04:00

Mancur Olson in The Logic of Collective Action of 1965 describes the surprising advantage that special interest groups have in being small. The idea, later expanded by Gary Becker, is that members of relatively small groups are intensely vocal in promoting their interests over the concerns of larger "potential groups", which tend to remain silent. This is due both to the relatively small share in the total loss that each member feels, and to the difficulty and costs of organization in large groups. Imagine an industry with ten members lobbying for a government subsidy of 10 million dollars. Obviously their interest in the manner is much larger than that of those who implicitly bear the cost: the millions of tax-payers who will hardly notice the difference. Olson argued that even if the difference were tangible for the taxpayers, the sheer size of the potential group prohibits its formation. Even without taking organizational costs into account, the marginal reward in joining the anti-lobby for the first member is nil. (I am taking the interest to be the essence of the group, so there can be a group with no members if people share a common interest but are not yet organized.) Can we go further than Olson? Well, we should since TLoCA was written in 1965 and subsequent technology has made group organization exponentially easier, but this is just the first step. To me, the crucial leap is to create a group structure where the marginal incentive to join is greatest for the first participant, or at least tends to favor early participants. Where would this be the case? Precisely in an online market, not too unlike Tradesports, where the special interest could hedge the outcome of legislation for or against it.

What I am saying requires many qualifications and explanations. In the future I believe new types of markets will emerge that will allow individuals and groups to hedge risks, including legislative risks. The "potential group" is the group of what I previously described here as "speculators." What I have called "hedgers" corresponds to Olson's special interest groups which lobby as a "bi-product" of some other activity. The problem for Olson was that the potential group would remain latent because of insufficient incentives to form. In my scenario, the market imbalance caused by the special interest's initial desire to hedge produces an inefficiency in market price, which represents the probability of the legislation being passed by a certain date. Whether the price is interpreted as mean belief or something else does not concern me; the point is that the special interest's relative need to hedge will skew the market price and create an inefficiency for the speculator to take advantage of. The first speculator is the first member of the "potential" group. The marginal reward to join for the first speculator tends to be maximal. I will get to technical objections like market liquidity later-on, but if you are still following you might saying, "hold-on, your 'potential' group members (the speculators who take the other side of the special interest's hedge) stand to gain from the special interest getting its way in the legislature -- this isn't what Olson had in mind at all." I think it is actually, but I want to stress an important difference. The legislation-hedge market makes the outcome of the legislation non-binary. Instead of 10 million dollars going from the taxpayers to industry X, if the industry hedged by selling at 50% probability, then both the hedger and the speculators will end-up with 5 million. The special interest isn't forced into an all-or-nothing outcome and the market will simultaneously allow people to hedge their implied tax losses by betting with the special interest hedger, against the passage of legislation otherwise favorable to the hedger. Now, notice how the goverment's ability to (re)-distribute money has changed. This will obviously attract many people on the Right from the formal standpoint of the relationship between free enterprise and government, but simultaneously the Left stands to gain content-wise, as with stem cell research funding.

I'll compile objections and answer them in subsequent posts. How the government reacts to such markets is of course one of the more significant and interesting problems here.

Kelo: What, Me Worry?

2005-06-25T18:13:00.000-04:00

On Thursday the Supreme Court upheld a local government's authority to take ordinary, non-blighted homes for redevelopment, not just for "public use" as is traditionally the case with eminent domain. Now a municipality can seize property even if they just think they can generate higher tax revenue by doing so.

A lot of people are very disturbed by this outcome, which they say points towards a dissolution of all property rights. I am a bit more sanguine. Any municipality (or government for that matter) that abuses this power will see their housing prices fall as people migrate to places where their property rights are more secure. It will be more difficult for abusive cities to justify higher property taxes, and in the long run they should see these tax receipts decline. They will almost definitely see residential property tax income decline in the long run, even if it is bolstered in the short-term by incoming workers. Taking advantage of this ruling will be a serious gamble for any city to undertake. Essentially, they will be wagering that the new commercial taxes will offset the eventual decline in residential tax income, and what happens when nearby cities announce that they won't be taking advantage of the ruling?

Now I doubt this will be the case, but it would be interesting and instructive if we someday look back on all of this and find that this ruling was the straw that broke the back of the housing market. It's easy to underestimate the effect of such a marginal change because, as Robert Shiller and Charles Manski point-out in different ways, people tend to overestimate the probability of small risks.

Why I Don't Believe In Ayn Rand

2005-06-24T18:33:00.000-04:00

I have heard Objectivists proudly cite that Atlas Shrugged ranks second only to the bible in book sales. Rand’s accessible fiction may be evangelically useful in promoting ideas about free markets and capitalism, and I would probably agree with her position on almost any specific issue, but nonetheless something has always bothered me about her writing. Her philosophy has always been uncomfortably fundamentalist for my tastes – if not dogmatic, then darn close, and so I have never found her to be, shall we say, pantheon-worthy.

Rand is fundamentalist insofar as she thinks in terms of absolutes, which is often. Given her views on the use of force, this isn’t inexcusable in itself, but dogma isn’t typically a hallmark of great thinking. It is easy to grow tired of the callow confidence that proclaims everything, when “properly understood”, to be absolute, black-and-white, and completely objective. “A is A” – but this is only true insofar as it is a symbolic tautology! Anything that exists in reality is going to exist in time, and time is something that Rand never sufficiently addresses. Rand had to repress her own thought about time because of her desire for absolute foundations, and this is where I can offer a positive alternative. The Austrian mistrust of mathematical economics partly has to do with the fact that the models are instantaneous, and deal only in re-writing symbols, thereby expressing differences as identities. In contrast, Austrian praxeology addresses time and causality. As an example where Rand neglects these aspects of reality, why does she see subjectivity as a negation of reality if thought, however divergent from current reality, can have objective consequences in time? Additionally, Von Mises held a subjectivist theory of value, recognizing that the realm of the rational is always subject to the non-rational, i.e. ends aren’t necessarily rational. This is in contrast to Rand’s philosophy which largely consists of various combinations of the words “absolute”, “reality” and “reason.” I can understand how Rand’s writing is a somewhat independent reaction to the milieu of subjectivity that dominated 19th and 20th century philosophy, but just because something isn’t absolutely correct does not mean that its absolute opposite is valid! (Rand truly excels at straw-man and slippery slope arguments, occasionally in combination.) Randians may claim that the ideas of Von Mises and Hayek are too “free-floating” and then, quite earnestly offer Objectivism as a base. No thanks, guys.

Rand would have you believe that having no absolute standards means that you have absolutely no standards. (“The Age of Envy”) Given her background, we can excuse her allergies to anything “social”, but in a society people have different perspectives and it is in fact possible for there to be meaningful values without there being one absolute, universal, fundamental value. Values can be intransitive; they may exist in a rock-scissors-paper structure. We know by Arrow’s theorem that this is true for a group of people. Rand believes that, “nothing can be learned about man by studying society” (“What is Capitalism?”) but it is possible to imagine that this can also be true for one person over a span of time without having to say that they lack values. That person’s values were never absolute, but at no point in time could they be said to be lacking values absolutely. The fact that at any point in time they may have seemed absolute is irrelevant.

The Austrian subjectivist theory of value starkly highlights an important contradiction in the logic of Rand’s work. With one hand she pounds the table regarding absolute rationality and the like, while feeling for a nebulous “sense of life” (an “emotional atomosphere”) with the other. What else is the “sense of life” but the irrational underpinning of rational values? We can guess why Rand is haunted by this theme especially in her later work. It is clear that rationality alone cannot explain Rand’s romanticism, her exaltations of skyscrapers and rockets, for instance. (The former aren’t cost-effective beyond a certain height and the practical applications of the latter are always suspect) I am not criticizing her specific sense of life, but insofar as she had one, it wasn’t completely dictated by reason, nor is anyone’s. Rand’s “sense of life” is one of those seemingly marginal aspects of a work that, when carefully scrutinized, threaten to collapse the whole in contradiction. This is just a case of not reading what one writes – that the rational ought to cause the emotional, and speaking of writing…

The “absolutism of reality” is a typical Randian phrase. The first question is one of basic word usage: why “absolutism”? Is reality only exhibiting a tendency towards or style of the absolute? If it’s only a tendency, then reality is not actually absolute. However, one can never assume that Rand is employing basic philosophical terms correctly. Case in point: Rand misuses “existential” to mean existing or being. (e.g., in "The Objectivist Ethics" and "Faith and Force") While it is fine to appropriate words, Rand has not in my opinion distinguished herself sufficiently to color outside the lines in this way. One might be tempted to think that she is simply adding syllables to simple, accurate words to make them sound more philosophical. Most glaring of all is her chronically laughable use of “metaphysical”. It is not used to mean “ontological” nor “transcendental” nor "totalizing". Sometimes it is simply used instead of "physical." Mostly it is used as literally "beyond the physical", but insofar as this is the case, it adds no information and is devoid of explanatory force. With Rand, “metaphysical” is often an almost-meaningless gesture, meant to signal, “this is a philosophical sentence.”

People want to believe in Ayn Rand for various reasons. They want to believe in an American Philosopher, a Woman Philosopher, a Capitalist Philosopher, etc. These have existed and will continue to do so with or without Rand. Again, I would probably agree with her on almost any specific political issue, but whenever I see some kind of idol made in her image, I reach for a sledgehammer.

Hedgers vs. Bettors

2005-06-17T21:02:00.000-04:00

Commentary in a recent FT claims that New York is falling behind London "in an arena of financial innovation that is rapidly converging with other forms of trading and investment", "gaming and betting sites." The article implies that America's relatively puritanical sense of morality is hampering the development of new markets.

What are the root causes, the genealogy of, the moral imperative against gambling? Perhaps Onanism, wasting otherwise productive resources and time? Likewise, gambling is seen as a stepping stone to other indulgent behaviors, not in alignment with "family values." But will moralist concerns actually threaten the development of online markets in the US? If so, the question becomes: "what is the clear line between hedging and betting?"

The article goes on to suggest a dilemma:

"It is easy to imagine, for example, home-owners or lenders placing bets on the future level of a house price index in order to protect themselves against potential loss. Would that be betting or financial hedging?"

At first, the answer seems clear. It is hedging so long as the home-owner sells the price index. If he buys the index, or if someone with no prior interest in real estate buys or sells it, that is betting. It comes down to pushing-away risk vs. taking it on, or decreasing the expected variance in your future wealth vs. increasing the volatility of expected well-being. The market will necessarily contain a mix of these types of actors and actions, but this is no different from any other mature financial market.

Now, some markets will by nature contain a higher percentage of bettors, in some cases nearly 100%. Sports gambling falls into this category. I suppose that some gamblers bet against their favorite team and this could very tenuously be considered as a hedge, though immaterial. There is also the entertainment value of participating in the market, and I dare say this is also no different from any other mature financial market! When market participation has some kind of immaterial "use" value, this does in fact blur the distinction between hedging and betting, but not critically so I think. Markets that allow participants to hedge pre-existing material risks should have no moralist legislative risk in any case.

Speculators

2005-06-16T20:06:00.000-04:00

On the one hand, the word "speculator" is associated with the far-sighted sage, who prudently stores goods in times of plenty to later rescue society during crises and famines, concomitantly, buying low to sell high. The archetypical speculator of this kind is Joseph, who foresaw seven years of plenty followed by seven years of famine and advised the Pharaoh to store food accordingly.

More often though, speculation is synonymous with bad speculation, especially with the reckless buying that occurs in bubbles. This speculator, who buys high to sell still higher, is seen as short-sighted and liable to introduce volatility, as opposed to the noble speculator who instead buffers instability by taking more contrarian, independent, positions. This second type of speculator is, at best, naive, perhaps a "mere" gambler, and possibly downright malicious. An argument could be made for the philosopher Thales of Miletus being put into this category. If the story can be believed, Thales, through his skills in predicting the weather, anticipated a particularly large crop of wine grapes and went about accumulating (cornering?) wine-presses early in the year, thereby aggravating their shortage relative to grapes.

You see, Thales didn't "need" so many wine presses, and likewise, speculating is sometimes opposed to using. For example, in real estate, "flippers" are speculators, whereas the couple buying a home to raise their family would be considered users. Of course there is nothing preventing individuals or specific decisions falling under both categories to one degree or another, especially over time. Bertrand Roehner has proposed the "speculative ratio" metric, which is the number of speculators divided by the total number of market participants (speculators + users, or the ratio could be calculated on a capitalization basis). He notes that real estate markets typically contain 20% speculators, and that the speculative ratio of a stock market is 100%. It is in fact very high but not 100% as Roehner claims; this forgets the voting rights which are sometimes critical!

Users are like hedgers. The hedger has a risk that he wants to insure against, and the speculator buys this risk. This sense of speculator most closely corresponds to the one I have used below. Once again, this distinction is often unclear as hedgers often speculate and vice-versa, but this doesn't mean that the concept is useless, and perhaps it can be re-cast in a more precise way. Specifically, by "hedger" I mean someone for whom the market activity is secondary to some other activity (often in another market or business), and by "speculator", someone whose activity is primarily an activity in that specific market. The distinction is therefore relative; the speculator's activity is, of course, most probably secondary to some other activity or goal in his life, but in any given trade, one party is the relative speculator and the other the relative hedger.

The point (yes there is one!) is that speculators tend to prefer markets not dominated by other speculators. In most cases, larger dispersions in needs, perspectives and time-frames of market participants cause larger inefficiencies and more opportunities for profit.

Overcrowding

2005-06-09T20:35:00.000-04:00

Right now people are hungry for yield and several investment markets and strategies exhibit overcrowding. Speculators thrive on market inefficiencies, but when speculators are successful and/or numerous, these inefficiencies tend to dissipate, driving their profits down. Speculators are thus always on-the-search for new markets, ideally where they can transfer a tested methodology to a hopefully naive arena. Falling yields can indicate a demand for new markets.

Strategy overcrowding is less apparent in non-zero-sum markets, and markets undergoing reflexive buying/selling episodes ("bubbles"). The reflexive buying and price-multiplier effects that accompany bubbles are however only a secondary cause. The primary cause of bubbles has more to do with the markets themselves becoming overcrowded. Unlike strategy overcrowding, this tends to increase average profits in non-zero-sum markets. The prices predicted by fundamental valuation models are sometimes inadequate when trumped by supply/demand factors extrinsic to the models. Fundamental valuation often assumes the form of yield, but yield can be pushed arbitrarily low by market forces of demand for the underlying security or property. Whether it be interest paid on bonds, or earning- and dividend-yields on stocks, or rent yields in real estate, yields can be pushed to seemingly irrational levels by extrinsic factors often relating to demographics, market structure (including globalization), and, commonly, developments in other markets.

For example, since the equity market is non-zero-sum and skewed sharply to the long side (most people own stocks as opposed to "being short" stocks), option implied-volatilities, which determine the value of options, exhibit their familiar pattern of relatively high put prices, as there is relatively more demand by hedgers (puts allow you to profit from the market going down.) Likewise, in online prediction and sports gambling markets, longshots tend to be overvalued, and favorites undervalued due to the reluctance of sellers and buyers of risk, respectively, at severely unfavorable risk/reward ratios. In both of these cases, structural factors external to the assumed exclusive content of the valuation models (which are interpretations of the markets specifying an implied probability or volatility) cause the models to malfunction and produce incorrect results, in the short run at least.

The housing market is another example where valuations are driven by factors extrinsic to yield-based valuation models, and I would like to stress the demographic aspects of the current trend. The housing market is doubly and perhaps triply driven by demographics. First, there are the oft-cited combined effects of the baby boom and increased life expectancy. Secondly, and this is an Austrian interpretation, the fact that the average age in the US is increasing at about 0.1 year per year currently should put a downward pressure on yields, especially on yields more than several years out. This is intuitive, as older folks tend to want their money more immediately. Lower yields of course help housing prices, but as people begin to retire "later" this effect will be mitigated. Perhaps the outcome of the housing market and other conundrums will be resolved around the same time as the social security debate, when the average retirement age will probably move sharply higher.

Risk Markets and Prediction Markets

2005-06-05T15:59:00.000-04:00

I use the term "risk markets" instead of "prediction markets", not as a result of Manski's paper, but because I think the risk-sharing capacities of markets are at least as important as any predictive properties they may have. I'm thinking of markets formally resembling the current online prediction markets, but with more substantially useful content, specifically, forms of insurance, risk-sharing, and hedging, much along the lines of Robert Shiller's work. Hedgestreet definitely has the right idea, offering contracts on market-specific real-estate prices, and gasoline, but I'm most intrigued right now by Tradesport's Social Security contract:

SS.PRIVACOUNTS.JUN06
Passage of US law that allows taxpayers to divert SS taxes to managed private accounts by Jun 30, 06

This is where the "politics" really starts to come-in. Of course, the critical problem faced by any new market is attracting enough participants and liquidity, but I think this is where things are going.

Drugs and Risk Markets

2005-06-02T22:57:00.000-04:00

Why not let markets take-over some of the functions of the FDA? As long as drug manufacturers publish accurate tables of known risks involved with drugs, why not let the market specify prices for these drugs in accordance with these risk premia? Part of the reason is political and has to do with, as Victor Niederhoffer points-out, "what is seen and what is not seen", i.e. in the media one hears of the 100s of cases of people killed by some side-effect, but what is not seen are the 1000s of individuals dying from known conditions while potential life-saving drugs linger in the pipelines of drug companies. The other main obstacle is the focused liability that drug makers will take-on after publishing quantified risk tables. The possibility that a risk factor published as being, for example, a 4 standard-deviation side-effect, is actually only 3 SDs because a subset of the population with certain risk-factors was not included in the trials must be insured against so that the manufacturer is not unduly crippled by such an incident. Of course, the insurance would be void if the probabilities were knowingly published at fraudulently low levels. Exactly who is to act as this underwriter will be a topic of subsequent posts here. Some of the most interesting current political problems involve risk-sharing structures such as healthcare and social security.

The public nature of information is central to other aspects of healthcare, such as the illegality of genetic screening in providing healthcare insurance. Which personal details, from genetic predispositions to behavoural risk-factors such as unhealthy eating habits should be kept private from insurers? In any case, this freedom of individual privacy becomes, at least implicitly, a social risk-sharing arrangement. The situation need not remain binary though; life insurance prices can be broken-down by cause of mortality e.g. (20% heart disease, 10% cancer X, 5%, cancer Y, 1% accident, etc), so if an individual has a likelihood of contracting a certain form of cancer at 200% the average rate, their insurance premium will increase by 2 * the weight of that risk factor. It would be inefficient to deny them coverage entirely, and eople who are less likely than average to suffer that cancer will see their premia decline, and not be compelled to take-on someone else's specific risk. Like drug-makers insuring their risk tables, insurance companies could re-insure their risk tables, although this is the information insurers would like to keep private!

Likewise, regarding illegal drugs, legalization will have to wait until risk, especially health insurance, markets mature. Almost inevitably, the increased availability and reduced price of legalized drugs would lead to wider and greater usage. While there are valid debates concerning whether or not the current legal order accurately ranks the deleterious effects of legal and illegal drugs, it is indisputable that drugs such as alcohol or anything that involves smoking pose serious risk-factors. Therefore, health problems and healthcare costs will tend to escalate if there is significant drug legalization. This would be mitigated by a reduction in the implicit social risk-sharing of health insurance caused by an increase of public information. Unhealthy activities would then have a discouraging, additional "tax" put on them.

Gold and the Dollar

2005-06-02T17:07:00.000-04:00

The resiliency of gold while dollars rallied Monday through Wednesday, along with the recent inflation fears receding, suggest that the metal's negative correlation to the dollar is softening. France's rejection of economic liberalism in favor of progressive liberalism has ended the Euro's bid to become the world's reserve currency of choice, a move which began in earnest in mid-2002 when it became clear that the U.S. intended to invade Iraq. While many had correctly predicted the result of the vote (Tradesports put the odds of a yes vote at 27% on the Friday before the referendum), the depth of Europe's aversion to Anglo-American capitalism was not fully priced-into the foreign exchange markets. Predictably, today was a day of profit-taking strength in the Euro while the markets await tomorrow's US payroll number. I would expect another leg down for the Euro some time after the release of the number. The number may however appear weak following April's strong growth and spark a short-lived squeeze.