Date: Mon, 07 Jul 2008 10:12:46 -0400
To: secretary@cftc.gov
From: Robin Hanson <rhanson@gmu.edu>
Subject: Comment on “Concept Release on the Appropriate Regulatory Treatment of Event Contracts”
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I am an event market innovator, having published the first detailed discussions envisioning their widespread application, having designed a widely used trading mechanism (the market scoring rule), and having co-developed the first internal corporate markets (at Xanadu), the first public web markets (the Foresight Exchange), and the aborted-but-influential Policy Analysis Market.

As I am less well trained in law than social science, I will not comment on what the C.F.T.C. is legally authorized to do, but only on how various policies correspond to public interest and public opinion. I speak here only for myself and not for any organization with which I may be affiliated.

The degree and type of regulation appropriate for a financial market depends on traders’ motives. Long ago most everything beyond direct physical exchange was widely discouraged or prohibited as “gambling” or “speculation.” The motives imputed to traders seemed to be some combination of mistakes, overconfidence, thrill of action, love of risk, and showing off one’s confidence and risk tolerance.

While public opinion on gambling has changed little, eventually legal exceptions were carved out for markets where, though speculation was still possible, enough participants had more sympathetic motives to garner public support. Securities markets allowed business managers to hedge ownership, insurance markets allowed hedging of various idiosyncratic risks, and commodities futures markets allowed hedging of various common risks.

It has long been noted approvingly that such speculative markets often had the desirable side effect of inducing people to collect info and aggregate it into prices. But until recently such info was not considered or accepted as a primary explanation or justification for a market’s existence. Given the myriad ways our society now suffers, often dramatically, from failures to aggregate info, I am very optimistic about the long term potential for such markets to offer substantial social value. However, the question remains of how such info-motivated markets should be regulated today.

Ideally an entire new regulatory regime would be carved out, on par with regimes for securities, insurance, and commodities futures regulation. But who would bother with such an effort before such markets had proven themselves able to realize substantial social value? And how could such markets prove themselves without at least tentative legal spaces in which to experiment? I know of no good reason why the C.F.T.C. should not provide one of the first such spaces.

Two key issues face a new regulatory regime for info-motivated event markets, especially one carved out of a common-risk-hedging commodities-future regulatory regime:

• How does optimal regulation of info-motivated event markets differ from that of common-risk-hedging markets?
• How can regulators ensure that this new regime is not used as a back door to escape prohibitions on other commodity futures trading, or to escape general prohibitions against gambling?

How Does Optimal Regulation Differ Here?

On the first question, the largest difference I see, by far, is the appropriate scale. When hedging risks it makes sense to focus first on risks, and hence trades, which are a large fraction of the wealth of the individuals or organizations involved. If risks are common there should be many who trade if any trade, and so market volume should be many times individual wealth levels. It also makes sense to devote a small fraction of this volume to efforts to avoid foul play. I have heard that it costs on the order of a million dollars to jump the regulatory hoops to gain approval for such markets, and I cannot say that this is not roughly the right cost magnitude.

For markets whose main function is to collect info, however, the appropriate scale seems far smaller. To collect info on a topic, those who know or could find out need only be offered a sufficient incentive to bother. In the lab, experimental economists see substantial effort and price info aggregation when only a few tens of dollars are at stake, and field data seems consistent with this estimate. If most of the social value from info-motivated event markets were concentrated in a few very important topics, it would not matter much if regulatory barriers prevented markets on topics with small info values. But if, as seems more plausible, much of the value is found in a long thick tail of smaller topics, then to realize this social value it is essential that regulatory barriers to creating such markets be reduced to the lowest feasible level.

For example, consider a topic where a social value of one thousand dollars could be realized, if only people were allowed to trade in a market on that topic. It is hard to see how this value could actually be realized if the regulatory cost to create this market were more than a few hundred dollars. If there were a million such topics, the total social value such markets could create would be one billion dollars.

A related difference is when it makes sense to limit participation. If most of a certain kind of risk is held by wealthy individuals or large organizations, then it can make sense to limit participation to such traders. But for info collection it is crucial to allow participation by the sorts of people who could plausibly obtain that info. For a great many topics these people will be spread out in the population, and not easily distinguished from most other people. A broad permission to participate will thus be desired in such cases.

How Can We Distinguish When This Regime Should Apply?

On the second question, we seek a reliable way to distinguish markets where the info collected is a strong rationale for its existence, a rationale strong enough to justify overturning the usual public presumption against generic speculation, and strong enough relative to hedging rationales to justify using this new regulatory regime, rather than other hedging regulatory regimes.

One proposed distinguishing criteria includes the size of an individual trader’s stake, and the number of traders. The Iowa Electronic Markets are limited on both of these parameters. Such limits do succeed in preventing large hedging markets from masquerading as info-motivated event markets. But they do little to prevent generic gambling markets from masquerading as info-motivated event markets.

Another proposed distinguishing criteria is the form of the organization that hosts the market. Some have proposed that tax-exempt, research, and government organizations be given wider latitude than for-profit businesses. I understand that this matches a common public perception, but honestly it seems mostly wishful thinking to believe that such organizations are substantially more likely to create markets with a strong info rationale, or to avoid whatever problems one fears with for-profit businesses.

Some have suggested that topics could be used to distinguish the strength of info rationale. Markets on sporting events might be presumed to have low info rationale, while markets on public policy might be presumed to have high info rationale. This approach seems to open a proverbial “can of worms,” however, requiring a great and continuing effort to categorize topics.

To ease this effort, one could inherit some other topic categorization. For example, regulation of speech distinguishes topics where free speech is presumed to perform very valuable social functions, and so has strong legal protection, from topics where such functions are less clear, allowing speech to be more easily regulated. Event markets might be permitted on topics where free speech has a strong legal protection.

In contrast to such weak indicators let me propose a stronger indicator of when a speculative market has a strong info rationale. I am not proposing that only markets which sport this indicator be allowed, but rather that at least such markets be allowed. My proposal is to permit markets where a sponsor pays to ensure that traders on average do not lose financially from participation, as this payment creates a strong presumption that this sponsor expected to gain substantial value from that info.

It is hard to see many of the benefits that traders may gain from trading, but we can more easily see the average financial costs that traders suffer. Traders may have to pay for permission to trade, to deposit into a system, to check prices and trading history, for each trade, and to withdraw their winnings. In addition, trader deposits may not earn competitive risk-adjusted rates of return. Payment is sometimes in the form of seeing ads. Such fees are essential to the profitability of “gambling” businesses today that rely primarily on traders’ speculative motives.

If for a particular topic, a sponsor were willing to ensure that traders paid none of these common trading fees, that sponsor would have credibly suggested that his or her market would not exist if that sponsor did not expect related info to have substantial value. If this sponsor furthermore subsidized this market, allowing traders to gain on average by trading against ignorant automated market makers, this would show even more clearly that this sponsor valued the resulting info. Such measures would ensure that traders suffered no average financial loss from their participation, though traders could still lose on average, such as by wasting too much time dealing with these markets.

Of course we do not expect sponsors to arise to support all topics where info collected by trading would have substantial social value. We expect businesses to sponsor markets on topics where they can profit from info, and charities to collect donations to support markets on topics they consider more broadly valuable. But we also expect many coordination failures, where each party prefers that others pay for commonly valuable info. So the case for prohibiting markets that fail my proposed criteria is much weaker than the case for permitting markets that meet this criteria.

It also remains possible that even when a sponsor finds info to be valuable enough to pay for, the social value of that info could be much less than the private value to this sponsor. If we could identify classes of such cases, these classes might form the basis of exceptions to this general permission I propose.

I have many other opinions about how such markets might be defined and regulated, but I’ve already gone one for quite a bit here – if you like what you see here and want more, you know where to find me.

In Summary

In addition to existing regulatory regimes for ownership-hedging securities, idiosyncratic-risk-hedging insurance, and common-risk-hedging futures, it could make sense to have a distinct regulatory regime for markets whose main reason to exist is the info that they collect. Compared with existing commodities futures regulation, such a regime should set a much lower barrier to creating such markets, as much of the social value may be distributed in millions of small markets. And while it is hard to determine in general which markets would create high social info value, relative to cost, we should presume such high value when a sponsor is willing to pay to ensure that traders suffer no average financial cost from their participation.
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Robin Hanson rhanson@gmu.edu http://hanson.gmu.edu
Research Associate, Future of Humanity Institute at Oxford University
Associate Professor of Economics, George Mason University
MSN 1D3, Carow Hall, Fairfax VA 22030-4444
703-993-2326 FAX: 703-993-2323

Robin Hanson

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In its request for comment, the CFTC reminded the public that the commission should “promote innovation for futures and derivatives.” It also added that —hint, hint— the Iowa markets have been valuable sources of public information and have predicted Presidential outcomes better than polls. The 2000 act gave the CFTC the authority “to promote responsible economic or financial innovation” by creating an exemption for certain types of contracts (such as one in a prediction market). [...]

“Basically I think they’re going to expand the IEM no-action letter and take legal measures to make sure that legal contracts aren’t subject to antigambling laws,” says Chapman law professor Bell. [...]

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BusinessWeek gets it right about where the CFTC is going. (Go reading the 2 pages.)

However, I still believe that HedgeStreet has a strong argument (about the political elections being “excluded commodities”) and I wonder what the CFTC will do about it.

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HedgeStreet are saying that:

1. The political elections qualify as “excluded commodities” (as opposed to “exempted commodities”). The reason for that is that electing a Republican president can have some economic consequences for some industries (e.g., the oil industry, the health services industry, etc.), while electing a Democratic president can have opposite economic consequences, or economic consequences for other industries. Hence, the risk, and thus, the need for hedging those risks. And, so, the role of the CFTC is to guard against manipulations, etc.
2. If the political elections qualify as “excluded commodities”, then, logically, the prediction markets on political elections should be offered by Designated Contact Makers (DCMs), like HedgeStreet —and not by ECMs or by event derivative exchanges crowned with a “no-action” letter by the CFTC.

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Besides the point #2 made by Vernon Smith in his comment back in May 2008, that is the strongest point made to the CFTC —as of today, Sunday, July 6th, 2008. (Jason Ruspini bought it, too.) I can’t imagine that the CFTC will ignore this point.

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However, HedgeStreet are not saying that:

1. The topics other than political elections are “excluded commodities”, too.
2. They are “exempt commodities”.
3. They should be offered by DCMs.
4. They should be offered by ECMs or by event derivative exchanges crowned with a “no-action” letter by the CFTC.

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They just say nothing.

See, HedgeStreet make a point that the CFTC should allow them to offer prediction markets on political elections to retail traders, but do not discuss the status of all the other prediction markets —and you’ve have seen that, in their concept release, the CFTC have mentioned many examples other than political elections.

What I’m trying to do this Sunday is to analyze their silence. Would that mean that HedgeStreet wouldn’t mind a dual decision by the CFTC —as long the first part of this dual decision consists in granting (maybe, non exclusively) to the DCMs the right to offer prediction markets on political elections?

In other words, if the CFTC makes HedgeStreet happy, can they, also, satisfy (even partially) the other people? (Some people are petitioning for the right to offer all kinds of prediction markets, but they would like to do that thru a ECM or a “no-action” letter.)

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UPDATE: See also the CME Group’s comment to the CFTC. – (PDF file)

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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.

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 should not limit “no action” status to markets run by tax-exempt organizations. The no-action letters that the CFTC issued to the IEM emphasized not the nature of the hosting institution, the University of Iowa, but rather the business model adopted by the IEM itself. Profitability could not have mattered, as tax-exempt organizations can and do earn profits (indeed, as their burgeoning endowments demonstrate, many universities earn immense profits). The CFTC apparently cared only that the IEM did not plan to profit from charging traders commissions. A tax-paying organization could satisfy that condition just as easily as a tax-exempt organization could. In either event, price discovery would flourish and consumers would win a safeguard against getting fleeced.

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- The American Enterprise Institute’s proposals to legalize the real-money prediction markets in the United States of America

- In the for-profit vs not-for-profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

- The definitive proof that FOR-PROFIT prediction exchanges (like BetFair and InTrade) are the best organizers of socially valuable prediction markets (like those on global warming and climate change).

- Analysis of the HedgeStreet’s comment sent to the CFTC.

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APPENDIX:

Paul Wolfowitz’s profile at the American Enterprise Institute

- How the neo-cons drove the United States of America into the unecessary Iraq war

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ADDRESSES: Comments should be sent to the Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581, Attention: Office of the Secretariat. Comments may be sent by facsimile to 202.418.5521, or by e-mail to secretary@cftc.gov.

Reference should be made to the “Concept Release on the Appropriate Regulatory Treatment of Event Contracts.” Comments may also be submitted through the Federal eRuleMaking Portal at http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov.

FOR FURTHER INFORMATION CONTACT: Bruce Fekrat, Special Counsel, Office of the Director (telephone 202.418.5578, e-mail bfekrat@cftc.gov), Division of Market Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

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THE MIDAS ORACLE TAKES:

- CALL TO ACTION: Let’s fight so that the CFTC allows the FOR-PROFIT prediction exchanges to deal with “event markets”.

- In the for-profit vs not-for-profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

- The definitive proof that FOR-PROFIT prediction exchanges (like BetFair and InTrade) are the best organizers of socially valuable prediction markets (like those on global warming and climate change).

- Analysis of the HedgeStreet’s comment sent to the CFTC.

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BACKGROUND INFO:

- CFTC’s Concept Release on the Appropriate Regulatory Treatment of Event Contracts… notably how they define “event markets”, how they are going to extend their “exemption” to other IEM-like prediction exchanges, and how they framed their questions to the public. Here are the comments sent to the CFTC.

- The BusinessWeek news article about the CFTC’s concept release.

- The Arnold & Porter lawyer’s take. — (PDF file)

- The Schulte, Roth & Zabel lawyers’ take. — (PDF file)

- The Sullivan & Cromwell lawyers’ take. — (PDF file)

- Michael Giberson’s economic take.

- Chris Hibbert’s libertarian take.

- Tom W. Bell’s libertarian take.

- The American Enterprise Institute’s proposals to legalize the real-money prediction markets in the United States of America

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COMMENTS TO THE CFTC

- Very soon, two prediction market organizations and one VIP will submit their comment to the CFTC.

- What Vernon Smith told the CFTC. — (PDF file)

- Jed Christiansen’s pragmatic take. — Final draft – (PDF file) – His comment to the CFTC – (PDF file)

- The International Swaps and Derivatives Association‘s comment to the CFTC – (ISDA) — (PDF file)

- Jason Ruspini’s comment to the CFTC — (PDF file)

- Tom W. Bell’s petition, which will be sent to the CFTC. — (Jonathan Gewirtz is in.)

- HedgeStreet’s comment to the CFTC. — (PDF file)

- A young economist rebuts the American Enterprise Institute. — (MO mirror) — Comment to the CFTC – (PDF file)

- Tom W. Bell rebuts the American Enterprise Institute.

- Robin Hanson’s comment to the CFTC. — (MO mirror)

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APPENDIX:

Paul Wolfowitz’s profile at the American Enterprise Institute

- How the neo-cons drove the United States of America into the unecessary Iraq war

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- HedgeStreet’s comment to the CFTC. — (PDF file)

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Basically, they are saying:

1. We saw that the CFTC is entertaining the “exemption” way for prediction markets on politics and on other news.
2. You have lost your sanity, folks. The “exemption” solution will bring you plenty of problems.
3. You should approve these prediction markets under the classic, regulated way (the DCM solution). The classic regulation is the right way to deal with the potential problems you mentioned in your “concept release”.

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That’s a pretty strong argument.

(Just remember the conundrum that Jason Ruspini has exposed.) (PDF file)

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Now, the counter argument is to say that the DCM way slows innovation —thus the need to “exempt”.

That’s a pretty strong argument, too.

Indeed, one can point that it’s IEM, InTrade and BetFair who have grown the field of prediction markets —not HedgeStreet.

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DEVELOPING…

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UPDATE: Jason Ruspini seems to be in agreement with HedgeStreet. I like that. See his comment, just below.

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UPDATE: Jason Ruspini gives his understanding of the HedgeStreet’s comment to the CFTC.

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UPDATE: A second look at HedgeStreet’s comment to the CFTC about “event markets”

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- HedgeStreet’s comment to the CFTC. — (PDF file)

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The deadline looms for interested parties to respond to the Commodity Futures Trading Commission’s request for comments about regulating prediction markets (“event markets” in the CFTC’s usage). I may or may not get around to a detailed, point-by-point response to the CFTC’s many questions. In the meantime, though, I’ve drafted a general statement that many of you might agree with. I invite you to sign it with me, so that together we might tell the CFTC where to go. Please see below for details on how to sign on. Here is the draft statement:

What regulatory treatment should the Commodities Futures Trading Commission (“CFTC”) apply to event markets? We the undersigned, who represent a wide range of viewpoints, agree on three general observations. First and foremost, the CFTC should do no harm. Second, at a minimum, the CFTC should make more general the sort of “no action” status enjoyed by the Iowa Electronic Markets (“IEM”). Third, if the CFTC decides to regulate event markets more substantively, it should adopt clear and limited jurisdictional boundaries and allow affected parties to step outside of them.

First, do no harm: Many sorts of event markets—including public ones, private ones, ones that offer only play-money trading, and ones that offer real-money trading—already thrive in the U.S. They have provided a rich array of benefits without evidently harming anyone. The CFTC could help event markets achieve still greater success by clarifying their legality. Instituting the wrong sort of regulations could suffocate event markets in their cradle, however. The CFTC should exercise a light hand, taking care to do no more than offer qualifying event markets the shelter of federal preemption and freeing them to continue operating under the extant legal regime.

Second, open up the “no action” option: Thanks in part to the “no action” letters that the CFTC has issued to it, the IEM has for many years benefited the public by offering real-money event markets. No sound reason precludes the CFTC from giving similar treatment to other institutions that, like the IEM, offer event markets solely for academic and experimental purposes and without imposing trading commissions.

Although the CFTC’s “no action” letters do not specify the exact criteria the IEM had to satisfy, they took favorable note of the IEM’s account limits. Those account limits effectively prevent the IEM from supporting significant hedging functions. If the CFTC builds a similar requirement into any general “no action” guidelines, it should adopt limits considerably more generous than the meager $500/trader limit adopted decades ago by the IEM. Even a limit ten times that amount would still effectively preclude hedging.

The CFTC should not limit “no action” status to markets run by tax-exempt organizations. The no-action letters that the CFTC issued to the IEM emphasized not the nature of the hosting institution, the University of Iowa, but rather the business model adopted by the IEM itself. Profitability could not have mattered, as tax-exempt organizations can and do earn profits (indeed, as their burgeoning endowments demonstrate, many universities earn immense profits). The CFTC apparently cared only that the IEM did not plan to profit from charging traders commissions. A tax-paying organization could satisfy that condition just as easily as a tax-exempt organization could. In either event, price discovery would flourish and consumers would win a safeguard against getting fleeced.

Third, preserve regulatory exit options: If the CFTC decides to write substantive regulations for event markets, it should recognize and guard against the risk of overregulation. Even well-intentioned and well-informed regulators remain human and, thus, all too apt to make mistakes. They run an especially large risk of making mistakes when they first attempt to regulate new institutions, such as event markets. To make matters worse, regulators typically lack reliable signals to determine when they have gone too far. Industries wither away for many reasons, after all.

The CFTC’s approach to regulating event markets should accommodate these policy considerations by establishing clear jurisdictional boundaries and opening exit options. Thus, for instance, the CFTC might specify that it has no jurisdiction over event markets that offer trading only to members of a particular firm, over markets that offer only spot trading in negotiable conditional notes, or over markets that do not support significant hedging functions. Then, if the CFTC enacts unduly burdensome regulations, an event market could opt out of them by changing its business model. So long as markets publicly announce that they operate outside the CFTC’s purview, allowing them that freedom of exit would harm nobody. To the contrary, it would help the CFTC gauge the suitability of its regulations and serve the public by protecting the continued viability of event markets.

Interested in signing on? Please drop me a private email (tbell at chapman dot edu) with your name, institutional affiliation, and snailmail address. I welcome your comments—I’m sure a typo or two persists in my draft—but I of course cannot revamp the entire statement without mucking up the entire process. To leave me time to get everything together and out the door before the July 7 deadline, you’ll have to contact me before noon Pacific time on Sunday, July 6.

[Crossposted at Agoraphilia and Midas Oracle.]

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ADDRESSES: Comments should be sent to the Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581, Attention: Office of the Secretariat. Comments may be sent by facsimile to 202.418.5521, or by e-mail to secretary@cftc.gov.

Reference should be made to the “Concept Release on the Appropriate Regulatory Treatment of Event Contracts.” Comments may also be submitted through the Federal eRuleMaking Portal at http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov.

FOR FURTHER INFORMATION CONTACT: Bruce Fekrat, Special Counsel, Office of the Director (telephone 202.418.5578, e-mail bfekrat@cftc.gov), Division of Market Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

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THE MIDAS ORACLE TAKES:

- CALL TO ACTION: Let’s fight so that the CFTC allows the FOR-PROFIT prediction exchanges to deal with “event markets”.

- In the for-profit vs not-for-profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

- The definitive proof that FOR-PROFIT prediction exchanges (like BetFair and InTrade) are the best organizers of socially valuable prediction markets (like those on global warming and climate change).

- Analysis of the HedgeStreet’s comment sent to the CFTC.

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BACKGROUND INFO:

- CFTC’s Concept Release on the Appropriate Regulatory Treatment of Event Contracts… notably how they define “event markets”, how they are going to extend their “exemption” to other IEM-like prediction exchanges, and how they framed their questions to the public. Here are the comments sent to the CFTC.

- The Arnold & Porter lawyer’s take. — (PDF file)

- The Schulte, Roth & Zabel lawyers’ take. — (PDF file)

- The Sullivan & Cromwell lawyers’ take. — (PDF file)

- Michael Giberson’s economic take.

- Chris Hibbert’s libertarian take.

- Tom W. Bell’s libertarian take.

- The American Enterprise Institute’s proposals to legalize the real-money prediction markets in the United States of America

-

COMMENTS TO THE CFTC

- Very soon, two prediction market organizations and one VIP will submit their comment to the CFTC.

- What Vernon Smith told the CFTC. — (PDF file)

- Jed Christiansen’s pragmatic take. — Final draft – (PDF file) – His comment to the CFTC – (PDF file)

- The International Swaps and Derivatives Association‘s comment to the CFTC — (ISDA) — (PDF file)

- Jason Ruspini’s comment to the CFTC — (PDF file)

- Tom W. Bell’s petition, which will be sent to the CFTC. — (Jonathan Gewirtz is in.)

- HedgeStreet’s comment to the CFTC. — (PDF file)

- A young economist rebuts the American Enterprise Institute. — (MO mirror) — Comment to the CFTC – (PDF file)

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APPENDIX:

Paul Wolfowitz’s profile at the American Enterprise Institute

- How the neo-cons drove the United States of America into the unecessary Iraq war

-