Ever since complex derivatives spawned the financial crisis, regulatory agencies have been approaching innovation in the field with caution. The result is that smart financial instruments are being rejected due to fears, often unfounded, that they could cause another meltdown. The most high-profile recent decision is the ban on so-called political-event derivatives contracts—essentially, betting on elections—by the U.S. Commodity Futures Trading Commission.
This decision, in my view, was misguided.
The North American Derivatives Exchange was hoping to offer simple binary options on the 2012 U.S. presidential election. For example, an option would pay $100 if the Democrats win and $0 if they lose. Similar contracts are already being offered by Iowa Electronic Markets and University of British Columbia’s Election Stock Market, but these have modest maximum investments and other limitations. Offshore betting agencies also offer such contracts, but their high fees make them poor investments.
Political derivatives have two major benefits. First, they can act as valuable tools to reduce risk. Farmers often buy futures contracts on the weather as a form of insurance against droughts and cold snaps. Political futures can work the same way. Suppose one candidate supports the construction of a new oil pipeline and another does not. Investors who would benefit from the pipeline could buy options on the second candidate as a way to hedge their risk.
The price of political derivatives also brings widely useful information, namely the probability that a certain political event will occur. Several studies have found these products to have higher predictive accuracy than methods like polling.
Regulators are concerned about market manipulation—that an investor opposed to a candidate will try to drive down the price of that candidate’s option, sending a signal that he’s unlikely to win, and discouraging donors and voters. This happened in the past: an investor on Tradesports, a now-defunct online betting platform, drove George W. Bush’s 2004 re-election contract down to zero. However, such manipulation tends to be short-lived. (The Bush option was quickly bid back up.) A 2005 study found, in fact, that it leads more investors into the market (because of the profit opportunity), increasing the market’s predictive power.
The idea that such products could cause a systemic financial collapse is absurd. The market for political derivatives is tiny compared to, say, agricultural futures. The U.S. elections are already high-stakes affairs; Barack Obama raised $760 million during the 2008 campaign alone. Letting investors buy futures on an election’s outcome does not raise those stakes in any appreciable way.
Regulatory agencies must guard against high-risk products of dubious value. But they shouldn’t use their position to stifle financial innovation.
Mike Moffatt is a lecturer in the Business, Economics and Public Policy group at the Ivey School of Business