The Great Debate

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.

The Trojan Horse of cost benefit analysis

By John Kemp
The writer is a Reuters market analyst. The views expressed are his own.

LONDON – Should federal government agencies have to prove the benefits of new regulations outweigh the costs before introducing them?

It sounds like a simple question with an obvious answer. But the role of cost-benefit analysis in writing federal regulations (and even laws) is shaping up to be one of the biggest battles between the Obama administration and business groups in 2012.

Speculators abandon oil for the moment

Bullishness about the short-term prospects for crude is evaporating among banks and hedge funds, as the market fails to sustain rallies above $80 and girds for widespread refinery shutdowns to work off bulging gasoline stocks.

The urge to buy on the dips, trade the range and hope for a breakout seems to be fading. Banks and other swap dealers boosted their net long position in WTI-linked futures and options by a meagre 7,000 contracts to just 22,000 in the week to Aug. 17, even as prices tumbled from over $80 to around $75.

The last time the market pulled back this far, swap dealers were carrying a net long position of 65-75,000 contracts, according to data published by the Commodity Futures Trading Commission (CFTC).

Senate vote exposes Wall Street impotence

Wall Street’s diminished influence in Washington was made plain yesterday when the Senate voted to approve financial reform legislation by 59 votes to 39.

Industry lobbyists will point out the bill only just managed to scrape the required votes needed to end debate and forestall a filibuster. It fell far short of a lopsided bipartisan majority.

But the formal tally on HR 4173 (Wall Street Reform and Consumer Protection Act 2009) as amended by S 3217 (Restoring American Financial Stability Act 2010) conceals a much wider bigger majority of 63-37 for enacting far-reaching reforms.

from Rolfe Winkler:

Go for it Gary

Gary Gensler -- regulator and, yes, Goldman alum -- has distinguished himself in Washington. As CFTC Chairman, he's fought to impose stricter rules on OTC derivatives and recently proposed rules that would cut the leverage currency traders are allowed to deploy from 100:1 to 10:1. Lest we all forget how dangerous leverage can be when traders misuse it, there's LTCM to serve as exhibit A. In a clear sign that Gensler is fighting the good fight, traders are screaming about the proposed rule. Fantastic.

From Carolyn Cui and Sarah Lynch at WSJ: Foes take on leverage curbs from CFTC

An attempt by regulators to protect investors from volatile global currency markets has triggered an uproar among lawmakers, currency dealers and thousands of small traders.

The Commodity Futures Trading Commission has proposed rules that would reduce the amount of borrowed funds that retail investors can use when investing in the U.S. foreign-exchange market to as much as 10-to-1, from the existing 100-to-1 for major currencies.

from Commentaries:

CFTC prepares to recant speculators’ influence

johnkempcrop-- John Kemp is a Reuters columnist. The views expressed are his own --

Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.

Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year's oil price spike, according to a report in the Wall Street Journal.

While it might seem a minor shift in emphasis, it is a radical reversal of the Commission's previously stated view that there was "no evidence" that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.