UsableMarkets

There is some concern that financial innovation is getting a bad name due to our current crisis. CDO in particular is a dirty acronym in some parts of the world. But it is worth remembering that they were, for a while anyway, considered successful and innovative financial products.

Much of their success was due to the fact that they appeared to reduce risk in the financial system. By “distributing risk” to a multitude of investors, so the story goes, failure of some investments would effect no one very greatly, and many people (who could afford small losses) very little.

This story is now in shambles. Perhaps we can now assert that distributing a risk more widely does nothing to improve our information about that risk, and in fact leads us to care less about the risk, since the risk is “distributed.” (I.e. not our problem.)

So, financial innovation in this case (even if things had worked out smashingly for CDOs) did nothing to improve the transparency of our financial system. It merely found a way for more investors to participate in a risky investment. Perhaps, at the end of the day this is not true innovation, merely shuffling the same old set of cards.

Which brings me to Prediction Markets ….

Perhaps unnoticed in the mainstream press, InTrade and others have quietly been floating a whole new set innovative financial contracts which allow previously unhedged risks to be hedged, and (just as importantly) produce new data that brings greater transparency to the financial system.

In the past two months InTrade has floated tax futures, search engine futures, and presidential decision markets.

All three of these markets are almost entirely new and important in their own way. Their prices produce important information which people can use (e.g. what will my tax rates be next year), and they are not about distributing risk, which we now know doesn’t always work that well, but about allowing people to manage risk better (or hedge things they previously could not hedge).

In my mind this type of innovation is much more beneficial to the financial system than CDOs, for example.

It is therefore worth asking why doesn’t this type of innovation occur more regularly. It’s not as if there is a shortage of good ideas about what financial risks can be hedged. Robert Shiller proposed all sorts of new financial products in his book The New Financial Order. But of all the products he proposes, only one (that I know of) has actually been implemented: housing futures.

Perhaps the best explanation for this is the inflexibility of existing options and futures exchanges. These platforms, if you will, like products that conform to their system, and, most importantly, will generate ample liquidity (which would therefore make them profitable).

InTrade (without quite the heft of the CME, for example) is less fickle about the liquidity question, and is therefore free to float all sorts of contracts without being overly worried what the volume will be. Tax futures, for example, have fairly limited volume on InTrade (despite being pumped on Bloomberg by Jason Ruspini). No large futures exchange would take a chance on these markets, and perhaps rightly so, since they might not generate the types of profits that their shareholders demand. So the type of innovation that occurs on InTrade just can’t occur elsewhere due to the nature of their liquidity driven systems.

Step back and think about it and one sees that InTrade is playing the classic role of disrupter in the financial markets arena. Whether they’ll succeed is another story (and somewhat out of their control), but it does seem like they’re getting the strategy right.

As we say in Brooklyn: Good on ya!

Your taxes are known to us

As always, thanks for listening.
~alex

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