One person's take on the CFTC's action against Intrade

An important headline in the Wall Street Journal (WSJ) earlier this week was ?Intrade Won?t Take U.S. Bets?. Quoting from this WSJ article, ?Intrade said it would no longer accept bets made by U.S. residents, a move that came just hours after U.S. regulators filed a civil complaint against the company over its commodities-focused markets.?

I have asked Lou Kokernak, who is a principal with Haven Financial Advisors and an expert on prediction markets like Intrade, to offer his perspectives on the CFTC?s action this week against Intrade:

One person?s take on the CFTC?s action against Intrade

By Louis Kokernak

November 30, 2012

This week, the CFTC announced a civil suit against two overseas prediction markets, Intrade and TEN. I am an occasional user of the former ? Intrade. I take small positions in their political futures markets every presidential election cycle. It?s fun and educational, at least for me. Founded in 1999 by the late John Delaney, the Dublin-based futures market has had a remarkable record in successfully predicting election winners and other notable events. Some academic analysis indicates that Intrade?s prediction markets do a better job at naming election winners than polls.

The simplified version of the CFTC?s claim is that Intrade illegally offered ?commodity options? to American investors and had done so for years. The agency claims that any such options must trade on a CFTC-registered exchange or must be traded by qualified (high net worth) investors. I can vouch that Intrade did not vet its participants to determine if they passed muster as qualified investors. However, I doubt that the these overseas prediction markets really represent any meaningful offshore commerce.

Intrade?s prediction markets have an excellent track record in assigning reasonable probabilites to various key events. They do so with relatively little money at risk from the public. It?s a testament to collective wisdom of crowds. There is a prediction market on the likelihood that the US enters a recession in 2013. The open interest represents a grand total of $31,000. Another market pays off ten dollars if a country exits the Euro within a year. That contract has an open interest of $29,000. Needless to say, these figures are dwarfed by the open interest on any contract on the New York Mercantile Exchange (NYMEX) or the Intercontinental exchange (ICE). The open interest on Brent crude oil contracts at ICE is about $100 billion. It?s interesting to note that ICE announced earlier this year that they were reorganized their over the counter products to a new format to avoid compliance costs under the new Dodd-Frank rules. Most of their oil contracts actually trade in Europe. It?s great that the ICE has the resources to avoid American regulatory creep. Perhaps little Intrade was not so fortunate.

The text of the CFTC complaint identifies Intrade?s prediction markets in oil, gold, GDP, and unemployment as falling afoul of securities law. Intrade oil, gold, and economic markets are binary propositions. They either pay off $10 in full or not at all. As such, they are completely unsuitable for hedging by institutional investors. Economics 101 suggests that oil producers can naturally hedge the value of their commodity by entering into futures or options markets. The options that trade on US amd European markets are standard put and call options which offer a continuous payout based on the difference between the strike price and prevailing market price at expiry. The holder of an Intrade contract either makes $10 or nothing at all. In effect, these prediction markets resemble the kind of bets that you would make at the office water cooler. They may be useful in terms of determining market sentiment but would have no use to institutional players that intend to sell or take delivery of a commodity. In other words, binary options won?t gain institutional traction in their current form. There is no simple way for a producer to set a floor or ceiling for a commodity price.

The CFTC has nothing to fear that Intrade that is going to siphon trading volume away from the United States. ICE might be able to do so with its modern electronic format and global reach. Maybe they were too big a target. Intrade is a small fry that provided the media and individuals with useful information at little cost. Within hours of the CFTC suit, they stopped taking orders from American customers for all their contracts, not just the ?commodity? contracts in the CFTC complaint. That?s a shame because Americans comprised a large fraction of the trading volume to the company. It remains to be seen whether they will survive this regulatory broadside.

Binary options work great for current events like elections or the Oscar nominations. They just fail when applied to continuously priced commodities. The upshot here is that Intrade?s markets are fundamentally different from those offered on real commodity exchanges. In their current form, they cannot attract the large sums of money that would make them worth the attention of the CFTC.

Maybe the CFTC should just lay off this minnow and police real commodities markets.

Source: http://risk.garven.com/2012/11/30/one-persons-take-on-the-cftcs-action-against-intrade/

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