Why does the CFTC allow the Cantor Exchange and not InTrade?

Joe Weisenthal has a small opinion piece on why the CFTC allows real-money prediction markets on movie business, and bans those on politics or sports. The problem in the piece is that Joe is 100% wrong.

  1. Joe says that there can’-t be hedging in politics. Wrong. You can hedge your political ads on InTrade.
  2. Joe says that there can’-t be hedging in sports. Wrong. Businesses that operate inside a stadium could hedge the risk of the home team losing (which means less business for them).

So. why does the CFTC shy away from hedging on sports and politics? –-&gt- Politics. The CFTC is afraid of the US Congress, who would object to politics and sports “-gambling”-.

The CFTC is a weak institution, in the DC sphere of power. In the recent past, the CFTC lost one important battle against other parts of the US government —-even though it was the CFTC that was on the right side of the issue at the time. With politics and sports betting, the CFTC does not want to lose another battle. It is a question of survival.

The New York Times on InTrades US political election prediction markets

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The NYT writers discusses 2 (different?) issues.

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#1. There was market arbitrage opportunies in the recent past between InTrade and BetFair —-unlike 4 years ago, and contrary to the laws of economics.

- The price of the Barack Obama event derivative was cheaper on InTrade than on BetFair and the Iowa Electronic Markets. Conversely, the price of the John McCain event derivative was more expensive on InTrade than on BetFair and the Iowa Electronic Markets.

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#2. The NYT writer reports (without linking to it) the findings of the InTrade investigation about the behavior of their unnamed “-institutional investor”-.

- InTrade CEO John Delaney suggests that that institutional investor:

  1. might operate on InTrade at specific times where it might not be able to find liquidity on BetFair and/or IEM-
  2. might be a bookmaker willing to hedge its risks on a prediction exchange (a.k.a. betting exchange).

- Justin Wolfers’- PHD student remarks that that institutional investor is not making an effort to shop around for the best prices, within each InTrade political prediction market.

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RELATED: See the comments on Midas Oracle here, here, here, and here.

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Are recent historical charts now useless for short-term prediction market analysis because of the non-informational trades made by that institutional investor hedging its political risks on InTrades election prediction markets?

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How can you assess the impact of Colin Powell’-s endorsement of Barack Obama? You can’-t.

The blogger at Marginal Revolution misinforms the public by repeating the misinterpretation thrown around by liberal hack Paul Krugman about the alleged manipulation on the InTrade prediction markets.

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Alex Tabarrok writes that “-someone was manipulating Intrade to boost John McCain’-s stock price”-.

No…-!!!…-

John Delaney said that that firm has been hedging on InTrade —-a normal and beneficial activity on the other (larger and more liquid) financial markets.

InTrade is not liquid enough to weather (quickly enough) the impact made by the hedging activities, at this time, but will in the future, if growth continues.

Manipulation is bad.

Hedging is good.

InTrade offers an explanation of strange trading.

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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 and encouraging 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.

[Cross-posted from Risk Markets and Politics ]