For years now, a criticism of Intrade has been its lack of a positive carry in long-term markets. In contrast to regulated futures exchanges, Intrade does not pay out interest on deposits to most traders. While understandable, this discourages liquidity and can skew prices near extremes as future winnings are discounted, exaggerating any favorite/longshot bias.
If carry can be seen as a type of liquidity subsidy, it need not be provided by the exchange. It could be paid by other traders, or passed-on by traders that happen to have interest-bearing accounts. Consider a contract that is set to expire at 100 with certainty at a future date. Offers below 100 then represent a carry payment, and prices in such a market imply something like a discount rate. This is not a true interest payment or discount rate because no funds are being loaned, but in some situations the buyer will gain the benefit of reduced margins on subsequent trades in addition to “-interest”-.
Take the new “-tax futures”-, which are structured as a “-ladder”- of binary options. Currently the lowest rung expires at 100 if the highest marginal tax rate is equal to or greater than 34% and zero if it is less than 34%. The next highest rung pays when the highest marginal rate >-= 36%, and so on. Say we add a new rung that pays-off if the rate is greater than 0% and has no transaction fees. This would seem to be a relative certainty, and an offer below 100 represents carry. Furthermore, the buyer of this contract can then sell short higher rungs at reduced margin.
For example, with the 2011 maturity contracts, the current bid/ask on the “->-38″- rung is 85/87.5. If a “->-0″- rung existed and someone sold it for 95, the buyer can then go out and short “->-38%”- at 85 with 10 margin (corresponding to his worst-case scenario of negative tax rates: 85-95!) instead of the usual 15 margin frozen, plus collect the carry of 5 in the “->-0″- contract by maturity. In absolute terms, the margin is only reduced by the unannualized carry of 5, but if the trader is right, he will capture a return on frozen margin of 900% ((85+5)/10-1) instead of 467% (85/15-1).
Likewise, an “-impossible”- contract would subsidize buyers. The 2009 contracts are currently 35 ask for “->-38″-. If a “->-100″- rung existed and someone bought it for 2, the seller could then buy the “->-38″- with 33 margin frozen – a subsidized 203% vs. a regular 186% profit in this case. (The “-sponsor”- is not interested in profiting directly on that trade and so the fact that the government would be owed all winnings if they are a US citizen doesn’-t matter.)
Now it’-s fair to ask why you couldn’-t accomplish the same subsidy by just consistently selling for slightly less than and buying for slightly more than what you judge to be fair value. Aside from the facts that this could widen the bid/ask spread and make prices less reliable, the more explicit carry of the system described above is psychologically reassuring and should lead to more trade. It is very hard to distinguish between a 65% and a 67% chance of the next president being a Democrat – for good reason. How can a trader practically determine if a 2% difference in price is a subsidy? At the same time, the sponsor’-s risk is more defined if they stick to contracts with near-certain payoffs. In many cases the sponsor will also be a market-maker, but this system allows those functions to be decoupled.
It could be argued that the risk-profile of the average Intrade trader is such that they are insensitive to these kinds of incentives because they are generally trying to grow small sums of money by orders of magnitude, as opposed to preserving larger sums. Even if this is an issue, the multiplier effect described above should mitigate it.
A more likely problem with this system is the danger of free-riders taking carry without providing liquidity to the sponsored market. The sponsor could deal with this by only extending small subsidies at any one time and ceasing to do so if he doesn’-t see reciprocation. The fact that frozen margin on the trade earning carry is unfrozen only when an offsetting trade is made on the same ladder also discourages free-riders. The system could somewhat easily unravel though, with the “-discount rate”- collapsing to relatively useless levels. This would not be surprising, especially in the “->-100″- contract, although subsidizing tax short-sellers with the “->-0″- contract is more important in this market.
Remember, this entire idea is meant to work within the technical and legal structures as they exist.
