The folly of making political prediction markets like Intrade illegal
On Monday the U.S. Commodity Futures Trading Commission (CFTC) sued offshore prediction market operator Intrade, prompting it to close its doors to U.S. customers. This will likely kill Intrade in its current form. Non-U.S. customers appear sufficient to support contracts only on major political events, at least based on the modest offerings at Betfair (an exchange that does not accept Americans) and offshore bookmakers. We will likely lose real-money prediction markets on the wider range of subjects that Intrade offered (“Will the U.S. go to war with Iraq?”; “Will we find WMD in Iraq?”; “Will the deficit decline if Obama is elected?”). We will also lose a good platform for the development of new, even more interesting contracts.
Why did Intrade not operate onshore? The CFTC would not let it, or anything like it. While Monday’s complaint referenced only Intrade’s contracts on commodity prices and economic numbers, in April the CFTC rejected an application by another, unrelated firm, the North American Derivatives Exchange (NADEX), to operate onshore markets related to the 2012 elections. (This is what Intrade is best known for.) Election markets are crucial to the success of prediction markets, as they attract clients who then trade in other markets. Without election markets, NADEX has struggled to attract the volume of trades it needs for the contracts it is allowed to run.
When it denied the NADEX application, the CFTC argued that election contracts represented gaming that served no economic purpose. It argued that elections have no economic consequences worth hedging, and thus quantifying electoral risks in a market has no economic value. It also argued that election contracts could corrupt elections by creating monetary incentives to vote for a particular candidate.
I think those arguments are misguided. There is ample evidence that elections have predictable consequences for broad asset classes and specific companies. My own work (with Erik Snowberg of the California Institute of Technology and Justin Wolfers of the University of Michigan) has found that over the last 130 years, stock markets have consistently risen when Republicans win elections. Other work has shown even bigger effects for specific industries (e.g., oil, tobacco and defense). While this does not necessarily imply that Republicans are “better” for overall social welfare, it does imply that they are expected to be better for shareholders of public companies. Elections have consequences, and clearly some are economic. Pricing electoral risks in a market has value for hedging and for aggregating information that will make other markets more efficient.
The argument that election contracts would inject economic incentives to vote a certain way where there would otherwise be none is also misguided. The previously mentioned research finds that an investor with $100,000 in an equity mutual fund has the equivalent of a $2,500 bet on the election already. That same investor will also likely be a taxpayer, a government transfer recipient and a beneficiary of publicly provided infrastructure and services, and thus will have electoral exposure through many channels. More importantly, though, even a large electoral exposure translates into a very small incentive to vote a certain way. Political scientists have calculated that the pre-election odds of a particular vote being decisive are about 1 in 10 million, even for a voter in a pivotal state in a close presidential election. A $10 million election contract position, 40 times the position limit that NADEX had proposed, would create only a $1 incentive to vote.
Why prohibit something so harmless? After all, U.S. policy already allows many forms of gambling that have significant social costs and produce no useful information. The real reason may be found in debate surrounding another recent setback for prediction markets, Congress’ last-minute modification of the Dodd-Frank financial reform bill in 2010 to prohibit markets on box-office receipts planned by the Hollywood Stock Exchange (HSX).
The plug was pulled after lobbying by the Motion Picture Association of America, which argued that a prediction market forecasting a poor movie box office could lend an “aura of financial authenticity to gossip.” Translation: Even big-budget failures often have one big weekend before word of mouth kicks in, and information aggregated by prediction markets may deprive them of that.
The bigger threat is to the executives who green-light the flops in the first place. The track record of even the play-money version of HSX is quite good ‑ a real money version would presumably be better. If a prediction market can forecast a poor box office well in advance of production, it raises questions about why an executive cannot. A consultant told me about a software company that ended an internal prediction market that forecast the success of the company’s products. The problem was not that it failed to work ‑ it worked all too well, and that raised awkward questions for the egos involved.
Fortunately, politicians never green-light flops. They never launch wars, or social programs, that turn out to be expensive and unsuccessful. They never back a weak general-election candidate in the primary.
Oh, wait ‑ they do that all the time. And in their assault on prediction markets, they take away one of the most promising tools we have for identifying their next mistake in time to stop it.