The Politics of Political Prediction Markets

(Photo: League of Women Voters of California)

For years, I have argued that the best way to track what really matters through election season is to follow the political prediction markets. The one difficulty is that these markets aren’t really available to the general public.  Sure, the University of Iowa runs a market, but because it’s for research purposes, the maximum bet is set at only $500. And while I track InTrade closely, they’re based in Ireland, and are frowned upon by American regulators. Likewise, Betfair won’t deal with American customers.  But all that may be about to change.

The North American Derivatives Exchange has proposed to run political prediction markets in the U.S. which would be regulated by the Commodities and Futures Trading Commission.  But first, they have to convince the commission that these markets serve a useful purpose. Eric Zitzewitz has put together a short comment letter which makes the case: 

We are academic researchers who study prediction markets.  We are writing in favor of allowing NADEX, or a similar entity, to offer a broad range of political and policy event futures, including the three they are currently proposing.

There are four broad reasons for our support:

  1. Existing political event futures have proven useful.  Political event futures have been offered in small quantities by the onshore Iowa Electronic Markets (IEM), and by offshore exchanges such as Intrade.  Prices from these markets have made possible a broad range of academic research.
  2. Political event futures facilitate price discovery in other asset markets.  One of the findings of this research is that firms and industries are exposed to political and policy risk.  Political event futures provide investors with a market-based assessment of outcome probabilities, which reduces investors’ uncertainty when trading other assets.  In addition, if allowed to operate onshore, political event futures markets might eventually grow to the point where they might provide useful hedging opportunities for firms.  The currently proposed position limits are likely sufficient for most individuals to hedge their personal exposure to election outcomes.
  3. The full potential of political event futures cannot be realized in academic-scale markets or offshore.  Despite the utility of the IEM and Intrade, both markets are hampered by the current regulatory environment.  An onshore exchange that allowed positions of the size NADEX is suggesting could ultimately reach a scale where it could attract liquidity to contracts that currently do not succeed on Intrade.  There are many exciting potential applications of such markets, in research and policy making.  Offering contracts on questions of great popular interest (such as Presidential elections) is crucial to attracting investors to an exchange.  Once there, they face lower costs of participating in other markets, such as those currently offered by NADEX.
  4.  Concerns about gambling and manipulation are misplaced.  Trading securities whose payoffs depend on political outcomes is no more “gaming” than trading securities whose payoffs depend on commodity or equity prices.  Clearly, one can trade any security out of gambling motives, so the key question is whether the subject of these contracts is a “game,” or an economically important event.  It is hard to argue that elections are not economically important events.

One might be concerned with two forms of manipulation:  outcome and price manipulation.  Many individuals have already large stakes in election outcomes; for example, a top executive in a public company will have will have a significant exposure via their equity holdings, as well as through any impact of the election on policies such as tax rates.  Many individuals also have substantial exposure to election outcomes via their careers.  Given the position limits proposed by NADEX, the market is likely to make at most a small contribution towards the number of individuals with meaningful stakes in election outcomes.  One might be concerned with trading by those involved in supervising elections, and it might be reasonable for policy to prohibit trading by those individuals.

Turning to price manipulation, there have been a couple episodes that appeared to be attempt by traders to influence perceptions of an election by manipulating prediction market prices.  The evidence suggests that effects on prices are relative short-lived, and effects on perceptions are often counter-productive for the manipulator (e.g., through media stories mentioning the manipulation).  Onshore election markets will likely be significantly more liquid, making price manipulation even less attractive.  A further protection comes from the fact that the outcomes of interest (election winners) will be linked to prediction market prices only through perceptions.  Concern about price manipulation might be better devoted to cash-settled futures, where contracts settle based on other financial market prices.

To summarize, we view markets in securities contingent on economically-relevant events as an innovation that generate positive externalities (by aggregating information) as well as benefits to participants.  Innovations with positive externalities should be encouraged by policy makers, not limited.  If the Commission has questions about any of the statements made or research mentioned in this letter, it should feel free to contact any of the undersigned.

Convinced?  Let’s hope the CFTC is.  I’m convinced enough to have added my signature to the letter.  If you’re a fellow academic with relevant expertise and want to sign on to this letter, please touch base with Eric.  But do so quickly — we’ve got to get this submitted by Friday.

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  1. Craig says:

    This “economically significant event” argument seems really thin. Can’t you argue that the Superbowl is an economically significant event? It’s going to affect team branded merchandise sales, ticket sales, TV viewer ship and therefore ad sales.

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  2. BrianK says:

    There are a handful of grammatical errors in that letter. You should give it another read-through before sending it.

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  3. rags to riches says:

    Between you and me, I think both parties are rooting for O.

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  4. Jason Ruspini says:

    Unfortunately, election contracts and ALL event contracts appear to be prohibited by CFTC regulation 40.11, released in July 2011 as part of Dodd-Frank:

    “(a) Prohibition. A registered entity shall not list for trading or accept for clearing on or through the registered entity any of the following:

    (1) An agreement, contract, transaction, or swap based upon an excluded commodity, as defined in Section 1a(19)(iv) of the Act, that involves, relates to, or references terrorism, assassination, war, gaming, or an activity that is unlawful under any State or Federal law”

    “… involves, relates to … an activity that is unlawful under any State or Federal law” is very broad. Not only does it include election outcomes, which several States have explicit laws against, but Massachusetts, Mississippi, Nebraska, North Dakota and South Carolina have laws against bets on “events”.

    This is not the only reading of 40.11 and is certainly not the one Nadex holds. In the short term, it seems that any argument for this sort of contract has to address the broad interpretation above all.

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    • Eric Zitzewitz says:

      Jason,

      I’m not a lawyer, but I read that sentence as prohibiting contracts based on *commodities* that “involve, relate to, or reference” illegal activities. I.e., the question is whether the underlying commodity involves a violation of state law, not whether trading it would involve violating a state law were it undertaken by residents of that state.

      So no terrorism (or cocaine) futures, but since it is legal for Barack Obama to be re-elected, trading in a security where that is the underlying commodity would not be precluded.

      That’s probably what you are referring to as the other reading, but it’s the only reading that makes sense to me.

      If Dodd-Frank wanted to give one state the power to deny residents of the other 49 the ability to trade in a commodity by prohibiting its residents from doing so (e.g., Hawaii makes it illegal to trade corn futures, so no one in Iowa can), it presumably would’ve done so explicitly. But that would be a pretty radical change in the relationship between Federal and State securities regulation.

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      • Jason Ruspini says:

        Hi Eric,

        This rule would only apply to commodities that are event contracts, and to my knowledge the CFTC has not approved any event contracts (aside from those based on rates or prices) since the regulation went into effect. I agree that the broader interpretation sets a strange and bad precedent, especially since the Commodity Exchange Act was intended in part to supersede State gambling laws where hedging was involved. One point behind my interpretation was a specific question on the CFTC website:

        ‘Commission Regulation 40.11(a)(1) states DCMs shall not list for trading or accept for clearing any contract that is based upon an excluded commodity, under CEA Section 1a(19)(iv), that “involves, relates to, or references . . . an activity that is unlawful under any State or Federal law.” Do any or all of Nadex’s proposed contracts involve, relate to, or reference an activity that is unlawful under any State or Federal law? Please identify any relevant statutory or regulatory provisions.’

        This appears to interpret the unlawful activity as applying to the contract, not the “commodity.”

        http://www.cftc.gov/stellent/groups/public/@otherif/documents/ifdocs/nadexquestions.pdf

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  5. Brittan says:

    It seems a better (or more useful) market would be one in policy futures, rather than election outcomes.

    Let an oil & gas firm hedge their exposure to a bill that prohibits fracking or a vehicle manufacturer reduce their risk posed by potentially ever increasing cost of production caused by increased fuel efficiency standards.

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  6. John Pula says:

    I’m no economist, but this makes me nervous. Commodities and Futures trading makes me nervous in general, actually.

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  7. dave gershner says:

    Surely bright people who care about their children and their money are rooting for Obama. DJIA up over 50% in less than 3 years!!! Historic, unprecedented. Stocks always do better with Democrats in WH.

    CALL IT LUCK, WHATEVER, BUT CANNOT BE DENIED…

    IT’S A MATTER OF COMPETENCE AND THE PATTERN IS CLEAR

    Stocks Have Actually Done Better Under Democrats
    Despite the behavior of the market during the last Presidential election, over longer periods of time, the stock market has done significantly better under Democratic administrations.

    The accompanying chart shows stock returns under each occupant of the White House since the beginning of Harry Truman’s second term. I have calculated the return from the end of the November election, since stocks will react to the policies of the incoming administration when it is elected, not when it takes office.

    President Party Date Months in Office Annualized Stock Return
    Truman D 11/48-10/52 48 18.28%
    Eisenhower R 11/52-10/60 96 14.96%
    Kennedy D 11/60-10/63 36 15.15%
    Johnson D 11/63-10/68 60 10.39%

    Nixon R 11/68-7/74 69 -1.32%
    Ford R 8/74-10/76 27 17.21%
    Carter D 11/76-10/80 48 11.04%

    Reagan R 11/80-10/88 96 15.18%
    Bush R 11/88-10/92 48 14.44%

    Clinton D 11/92-10/00 96 19%—BEST OF ALL PRESIDENTS, SO IF YOU CARE ABOUT YOUR MONEY…

    ————————————Bush, G.W. R 11/00-2/06 63 -0.92%

    Average from 1948 to Feb. 2006

    Democrat 42.8% 15.26%
    Republican 57.2% 9.53%

    Overall 100% 11.95%

    That calculates into a very great difference in creation of wealth!

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