Macro Shares: Prediction Markets via Stock Exchanges?

Today the American Stock Exchange started trading the first pair of a new kind of security that works in roughly the way prediction markets could be designed if SEC regulation and a stock market style user interface turn out to be the best way to run prediction markets. They are based on Robert Shiller’s idea of macro securities, which he describes on pages 126-128 of his book The New Financial Order (and may describe more fully in his book Macro Markets, which I haven’t read).
This first pair of such securities created by Claymore MACROshares merely helps investors do through a stockbroker roughly what existing oil futures markets provide, but Claymore expects to add other securities that provide exposure to things that aren’t currently traded, and there are no obvious barriers to basing them on the ideas that prediction markets trade.
One drawback is that Claymore owns patents covering this approach.
While it seems unlikely that SEC regulation is what I would want for prediction markets, it is nice to see signs that such an option is available should CFTC regulations pose a bigger obstacle than I currently expect to prediction markets that resemble markets the CFTC regulates. Alas, it also increases the risk that stock exchanges will see prediction markets as competitors and lobby to create barriers.

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  • http://riskmarkets.blogspot.com/ Jason Ruspini

    I had the same thought on the SEC being a more desirable regulator for prediction markets than the CFTC. Then again, I am especially interested in large legislative event markets, and the SEC doesn’t have to worry about raising eyebrows in Congress as much as the CFTC.

    Some think the agencies should be merged at this point, which is sensible given the increasingly arbitrary jurisdictional lines:
    http://www.economist.com/business/displaystory.cfm?story_id=8316406

    This is only part of the conversation because of US gambling laws, unfortunately. Legislation exempting information markets from gambling laws would be preferable.

  • http://profile.typekey.com/halfinney/ Hal Finney

    Following the link I see that they have two oil-based funds, the “up” fund and the “down” fund. The price of each started at (roughly) $60, and then the price of the “up” fund tracks the price of oil, while the price of the “down” fund is effectively $120 minus the price of oil. So the value of the “down” fund goes up when oil goes down, and vice versa.

    It’s nice for them because as the issuer, they do not bear any particular risk as long as equal numbers of people buy the up and down funds.

    However I’m not sure what happens if the price of oil approaches $120. At that point the “down” fund will have its value fall towards zero. This causes two problems. First, if the price of oil climbs above $120 the whole system breaks down, so presumably they have to cap the value of the fund at that level, meaning that “up” investors face risk with no reward, so they will abandon the fund. Second, investors in the “down” funds are suddenly faced with an extremely volatile investment, whose value could easily double or triple during a day, or fall by similar factors, just due to normal oil price fluctuations. This is an artifact of the fund structure and does not match the risks normally associated with exchange traded funds like this.

    There are similar funds which just track the oil price, such as http://finance.yahoo.com/q?s=uso . These would be the same as this “up” fund without the artifacts and risk. The main innovation here is the “down” fund, which normally you would get by selling something like USO short. But I don’t know if short selling is allowed for typical ETFs.

  • http://profile.typekey.com/bayesian/ Peter McCluskey

    Hal: I presume that as oil approaches $120, they will introduce a new pair of securities that add up to $200 or $240, and sensible investors will sell the original ones and buy the new ones. This is inconvenient in roughly the same way oil futures investors often want to roll over their investment to contracts with settlement dates further in the future.
    They hint that the pairing let’s them add t-bill or similar returns to what you’d get if you just bought the oil (I don’t know whether USO provides these added t-bill returns; futures brokers have created some ability to get those t-bill returns, but often not in a convenient way or in a way a small investor could use).
    ETFs can be sold short under the same rules as regular stocks (which means the most liquid ETFs can almost always be sold short, and with less liquid ones it can be hard to predict whether your broker will be able to borrow the shares needed). For some good and some poor reasons, many investors are reluctant to sell short securities that have no predictable maximum price. Macro shares provide a clear limit to the risk.

  • http://profile.typekey.com/halfinney/ Hal Finney

    I think the advantage is that the fund doesn’t have to invest in any oil! It just has to arrange that the amount invested in the “up” and “down” funds is roughly equal, and then they can put the money into government bonds and make their profit. They could create funds on anything in the same way.

    One problem with USO (a traditional oil based ETF) is there is some question about whether the fund is putting its money into oil in such a way that the fund price will fully reflect the oil price. It always bothers me that USO’s price doesn’t match what is reported in the news as “the price of oil”. The Macro shares do a good job of matching that value.