Wall St. and Business Wednesdays: Betting On Ideas (Terror Futures Markets) by Reuven Brenner

The Pentagon, responding to a congressional backlash, pulled out the plug on its support to launch a futures-trading market that would have allowed people to price risk of terrorist attacks.

Whereas Democrats' and Republicans' stand on canceling government support for the effort is justified - as there is no reason for government to fund such or any other futures markets - the arguments brought forward against establishing these markets have been wrong-headed. Experimenting with such markets has been beneficial for centuries, much initial political opposition notwithstanding. The benefit for society isn't that some parties would profit from trading in such markets, but the fact that such markets would PRICE risks visibly and better than they do today, bringing about a better allocation of capital.

There should be no doubt. Risks of terror, of confiscation of property, of chances of war and peace are priced already today only less visibly. Owners of real estate in New York do pay insurance for higher risk of terror. High-rises pay more insurance than ones with fewer floors do. Only the price is determined in bilateral negotiations, and they are not made public. Stock markets too already price implicitly the expected consequences of war, terror and peace, as stock markets in the Middle East have done. In the month following March 17, the day President Bush gave his ultimatum to Mr. Saddam Hussein, Egypt's and Iran's stock markets rose by roughly 6%, Turkey's by 18% and Israel's by 15%. If there were futures markets trading in say, events defined as "Will the US win within 1 week?" "2 weeks?" "Will the Middle East grow by 3% after the war?" "Will the region be infested by terrorists after the war?" and so forth, investors could price separately securities based on fundamentals of a company, on one side, and, on the other, pricing risks of war, peace, and the gray areas of terror in between. They could then see far more clearly how to allocate capital. Once liquid futures markets would price such and other risks, the companies could hedge, and focus on what their lines of business are, be it education, telecom, hotels, biotech or any other.

Whereas people obviously make mistakes in pricing stocks and futures, the much discussed, headline-grabbing "Internet," "railway," "South Sea," and 17th century "tulip" bubbles just shows how relatively rare such wide-ranging mispricing is. If such drastic mispricing was either more frequent or of longer duration, one would not have had to rehash constantly 17th century stories. Financial markets would have been long disappeared into the realm of footnotes in history books. The prosperity of countries democratizing their capital markets hiccups notwithstanding - shows that allocating capital by using prices, generated by people who put their money where their thoughts are, is far better for society than the alternative of relying on dictators and bureaucrats to make the allocation. Futures in ideas would improve the allocation by completing capital markets, and pricing risks that today aren't.

However, the above does not support the idea put forward by the Pentagon. The proposal that "specialists" would buy and sell futures contracts from self-financed accounts, and defense officials would monitor their trading patterns to glean insights into the likelihood of certain events, would not necessarily lead to better pricing these events. Specialized analysts have rarely been the best to price stocks and futures. To bring about a better and more transparent pricing, the markets must be open to all, without being subsidized, though requiring both regulations and sharply defined insider trading laws. The politicians' view that 'terrorists" could profit from these new markets is erroneous. The same institutions and laws today that prevent or should prevent - terrorists to short some stocks (airlines and hotels), and go long on others (surveillance and defense), preventing them to make money from their actions, would also prevent them playing these new futures market.

So what can be the reason for politicians' ferocious opposition?

Let us first give them the benefit of doubt, and attribute it to well-documented long-standing confusion. Back in 18th century UK, stockbrokers sold lotteries along with shares. The public and politicians often considered their whole business as a type of gambling. Scandals such as the South Sea Bubble, and acts declaring public companies common nuisances, shaped then public opinion that failed to distinguish between investment, insurance and gambling. The passing of the Gaming Act of 1845, outlawing gambling was deemed necessary to reinforce the law of contract to protect "genuine" capital transactions, and make them "respectable." A somewhat similar sequence of events took place in 1905, when the Chicago Board of Trade fought to outlaw "bucket shops" (where people could bet small amounts on commodities) because they thought that trade in futures would be viewed as mere gambling too and be outlawed.

However, delusions can be very powerful when they serve one's interests. It well may be that there is much interest at stake in preventing expanding futures markets. For many years, an institution linked to Iowa University has set up a futures-market specialized in elections. The predictions derived from prices set in these markets have often been far more accurate than polls - unsurprisingly, since people put money where their thoughts were. Words are cheap: what does it cost one to make a false, serving opinion when one is polled? Polling companies cannot be expected to be in favor of expanding the visibility of such formidable competition. Insurance companies benefit from bilateral negotiations, and are not interested in futures markets that would transform pricing risks into a commodity. Bureaucrats too should be expected to be dead set against expanding futures markets. After all, the inability of markets to price some risks prevents activities from being privately financed. People wanting such activities in society, but not being aware how outlawing futures markets prevents their existence, turn then to government for financing the activity, expanding bureaucrats' roles.

Last, but not least, check out Tradesports.com, where, among many future events one can bet on, there is one concerning Democratic nominees in 2004. John Kerry (at the time of this writing) is at the top at around 32 cents, Joseph Lieberman at around 15 cents and Hillary Clinton at about 4 cents. No wonder politicians would much prefer to deal with pliable academics and journalists than see the public price so visibly in futures markets their opinion on the relative match between roles and candidates.

Futures markets are not perfect. Nothing is. But a society will allocate capital and people, politicians included better by better pricing risks, by pricing more of them, and by making the prices visible to all.


Reuven Brenner lectures at McGill's Faculty of Management. His last book is Force of Finance (2002). This article also draws on his Gambling and Speculation (1991). On Sunday, August 3, 2003, Opinion Journal/The Wall St. Journal, published, "A Safe Bet" a modified version of this original writing.

Wednesday, August 20, 2003

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