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Opalesque Futures Intelligence

Prediction Markets Look To Gain Regulatory Acceptance in US

Friday, January 13, 2012

Should investors have the right to hedge their portfolios based on election results in the U.S.?  Some might say the ability to hedge political risk currently exists to some extent through existing futures contracts on stock indices, interest rates and currencies.  Others say the ability to bet on election results is damaging to democracy, while still different voices defend the need for small business executives to hedge political outcomes.

Enter the North American Derivatives Exchange (NADEX), which is petitioning the CFTC to allow regulated trading based on U.S. presidential elections and control of the U.S. House and Senate. The system offers new potential for hedgers and speculators, but also has raised important questions.  Is an election prediction market just raw gambling?  Can the process be corrupted by politicians to influence the results of public opinion or an election?  How does the market making process ensure enough liquidity so that the market cannot be whipsawed?  These questions were put to Dan Cook, spokesperson for the emerging Chicago-based futures exchange that is apparently targeting retail investors.  Last year the exchange traded near 1 million contracts in energy, stock indices and currencies - a far cry from the nearly three billion contracts traded at market leader CME.

Sidebar: How it Works

The NADEX binary options can be purchased outright or in the form of a bull spread, only offered on political contracts.  A binary option pays a fixed amount at maturity and suffers from time decay.  The price is influenced by volatility and the option contract has a limited loss provision and does not subject the buyer to a margin call, unlike a futures contract.  A bull call spread is a limited reward options trading strategy that purchases a near the money option and sells the further out of the money option.  The market making system will be similar to that used by other futures exchanges, with firms that commonly provide liquidity to Chicago-based futures and options exchanges providing liquidity to NADEX, according to Mr. Cook.

Is a Prediction Market Gambling?
"OFI""What's wrong with a small business owner who has concerns regarding a candidate with tax packages or other economic risk wanting to hedge?" said NADEX spokesperson Dan Cook.  "The prediction markets offer the opportunity to hedge election risk and provide an economic benefit."

While some might define gambling based on the subject of the "bet," Mr. Cook provides a different view: "Gambling never offers an opportunity to hedge nor does it offer transparency and price discovery."

Some question if the prediction market is even necessary, if existing futures and options contracts don't fill that role.  The Chicago Mercantile Exchange (CME) enables hedgers and speculators to take a position on exotic items such as snowfall and frost levels, through weather futures and options, as well as the strength of the housing market, through futures on the Case-Shiller Home Price Indices.  The University of Iowa currently engages in an unregulated prediction market it claims is used for academic purposes, capping potential investments at $500.  Those who want to speculate on everything from the next Academy Award winner to bird flu potential have the ability to go offshore to what is potentially the world's leading prediction market, Intrade. According to estimates, 70% to 80% of Intrade's volume comes from the U.S. Mr. Cook made the point that "prediction markets already exist and it is better that they be regulated in the U.S."

Key issues regarding the concept of a prediction market might center on the potential to manipulate U.S. elections and potentially enhance the influence of financial markets in politics.  For instance, if such prediction markets start to replace opinion polls, could politician's political operatives or well-healed supporters flood the market place with buy or sell orders to influence the markets?  NADEX claims that its proposed position limits of 2,500 contracts per user may eliminate such activity, and the fact they would be a regulated exchange and price discovery would be transparent.  Further, politicians and members of the Electoral College are prohibited by rule from trading these contracts.
"Position limits wouldn't stop a small group of interested folks from making some play in unison at an opportune time," noted CFTC commissioner Bart Chilton. "Think hypothetically about all the presidential candidates that have come to the top in the polls.  These markets could in theory be used to propel electoral popularity at opportune times, thus taking away the power of actual votes -- something at the very core of our democracy."

"While some folks might see betting on elections as fun, I'm not sure it is the stuff for serious risk management markets that help facilitate the economic engine of our democracy," observed CFTC commissioner Bart Chilton. "Betting on elections is illegal even in Vegas."

The CFTC has posted NADEX's submission on its website and is seeking public comment on the proposal during a 30-day comment period. In addition, the Commission is seeking public comment on specific questions related to political event contracts to assist in its evaluation of NADEX's submission.

The 30-day public comment period ends on February 4, 2012, and the Commission's 90-day review period ends on April 2, 2012.

For more information: www.CFTC.gov; www.NADEX.com



 
This article was published in Opalesque Futures Intelligence.
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