One of the joys of structuring financial products is that, when a regulatory door is closed, a window / chimney / possibility of sawing through a non-load-bearing wall is opened, and you get to look for it, and if you find it you get rich.* So I for one look forward to the response to this:
On Monday, the Commodity Futures Trading Commission rejected a plan for so-called political event contracts, wary that mixing politics and trading would create a dangerous cocktail. The agency ruled, in part, that such trading amounts to gambling — and that it could unduly influence election results.
“This is a very slippery slope here,” said Bart Chilton, a Democratic member of the commission. “We need to be supercareful about handing part of our electoral process over to the trading pits.”
So now you can’t go on NADEX and buy presidential futures – have I mentioned that all my money is in Rick Perry futures? I will sell them to you at cost if you’d like – but you have, I suppose, some other options. You can buy mine, of course, or whatever else is kicking around on Intrade, and if you’d like more size you could probably go to our Anonymous Sports Book Manager, if you can find him.
But if you’d like a lot of size I guess you’d go to your area investment bank and ask them to write you an OTC contract that pays out if Barack Obama [is | is not] re-elected. Would they do it? Well, now they can’t hedge it with an exchange-traded contract. Can they hedge it with macro indicators? Meh, not really.** Can they hedge it with … health insurer stocks? (Defense contractors? Oil? Solyndra lookalikes? Automakers? Publicly traded private equity firms? Corporate jet makers? Other? It’s gold, isn’t it? It’s always gold.)
Sure, whatever, I don’t care. Here’s something the CFTC said and I doubt they’re entirely wrong:
WHEREAS, the unpredictability of the specific economic consequences of an election means that the Political Event Contracts cannot reasonably be expected to be used for hedging purposes;
Which goes the other way too – if you can’t hedge your financial life with political event contracts, you can’t hedge a political event contract with financial things. Which means that a bank is unlikely to sell you that contract.*** Which leaves you out on your own to hedge your risk of Barack Obama [being | not being] re-elected in some approximately correlated way, and if you’re doing the hedging instead of a bank, knowing you, I’m pretty sure you’ll be doing it by buying gold.
You could have a view of financial transactions that is either discrete or continuous. The discrete view is something like “I have bought this stock and it will make me rich, huzzah.” The continuous view is something like “I have these risks in my life, and within some margin of error they’ll probably do this if these macroeconomic variables and these businesses’ operations go this way, and now I’ve bought this stock and it changes the net sum of those exposures by this much,” etc.
The discrete view blows back Bart Chilton’s hair with terror at the thought of money being involved in politics: the CFTC actually says “the Political Event Contracts can potentially be used in ways that would have an adverse effect on the integrity of elections, for example by creating monetary incentives to vote for particular candidates even when such a vote may be contrary to the voter’s political views of such candidates,” which, y’know, what are “political views” and how finely can you distinguish them from “personal interests,” don’t answer that. But, yes, if your life consists only of (1) purely disinterested veil-of-ignorance political views and (2)(A) an election futures contract or (B) no election futures contract, then (2)(A) and (2)(B) will potentially product different behaviors.
The continuous view is more like, there are states of the world where Barack Obama is re-elected, and in those states of the world your portfolio is likely to be [down | up], and you might want to flatten out that risk a bit by directly hedging it. And, sure, your economic interests may change your voting behavior, but I do not buy that Bart Chilton knows in advance whether hedging or not hedging them is more likely to lead to deviation from your idealized political views. (Like, maybe Paul Singer looooves Obama but has to support Romney to keep his taxes down and would vote Obama if he could hedge those tax consequences?) But, anyway, you probably won’t lose too much sleep if you can’t buy that hedge, because the correlation of Obama’s re-election with your portfolio probably isn’t that great, and the direct-Obama-hedge would leave you with a large residual of risk that the hedge pays out when you don’t need it or doesn’t pay out when you do. So you go find some things that have less basis risk to your overall position than Obama’s re-election, and you buy those things instead.
A while back there was this silly idea that there should be an “FDA for financial products,” and it was silly, and then Gretchen Morgenson endorsed it this past weekend, so update your priors, and now Ryan Avent has a good piece on some of the reasons why it remains silly, including but not limited to:
It requires the regulator to have near-perfect foresight about how a product will be used in the future. … Problems primarily develop when products mutate and become so prevalent they pose systemic risk. Many new products never get to this stage; if they’re ill-conceived they die an early market death. The challenge for regulators should not be predicting the evolution of every new product, but rather monitoring financial markets to detect innovations that have become large enough to pose real danger.
It’s not the bad products that’ll kill you, it’s the good ones! This is a useful rule for life.
But my big problem with it is that it is so bluntly discrete: you can have Interest Rate Swaps or No Interest Rate Swaps, but you can’t think a little about your rates exposure and structure some transactions that have the effect of adjusting that exposure. I’m obviously more of a continuous finance kind of guy; I like the notion that, if you have a little too much beta or gamma or vega or zomma or whathaveyou, you nudge out a little beta or gamma or vega or whathaveyou and then you’re happier.
Anyway. I guess the point is, you could help me out a lot by writing in Rick Perry in November.
CFTC Issues Order Prohibiting North American Derivatives Exchange’s Political Event Derivatives Contracts [CFTC]
Panel Rejects Proposal to Allow Election-Related Trading [DealBook]
Futures regulator rejects gambling on Obama’s future [Reuters]
* Another of the joys is that sometimes you get rich.
** Here is a sentence from Nate Silver: “If you see models that claim to have more explanatory power than this, it is because … the model has been jury-rigged to maximize its ‘fit’ on past data in ways that will contribute little to its true predictive accuracy.” Words to live by.
*** Also the CFTC’s ruling against the exchange-traded contract does not exactly bode well for the OTC flavor. The CFTC basically said “looks like gambling to us!”, which means that if you write this contract and then try to enforce it, there’s a good chance a court is all “unenforceable gambling contract” and then where will you be? Unhedged is where.