InTrade fee structure discourages selling the tails?

The political betting markets seem more efficient this year, so I’m looking at narrower perceived edges and care more about transaction costs.  It looks to me like the InTrade fee structure really discourages selling longshots, if I’m understanding it right.  There are three main costs:

  • The trading fee is per-lot, and paid by the price taker.  It is slightly lower for extreme prices (3c vs. 5c).
  • The expiry fee is paid by the winner, and is 10c per lot.
  • The opportunity cost of having the money at InTrade to cover your margin is the risk-free rate minus InTrade’s interest rate (3% for accounts over $20K).

Even if we assume always being the price maker, note how the 2nd and 3rd both hurt those who sell longshots much more than those who buy them.  The seller of 1 contract at 5 will (if the price is right) pay the expiry fee 19 times out of 20.  So rather than having a return of $.50 * (19/20) – $9.50 * (1/20) = $0.0, the seller’s return is ($.50 – $0.10) * (19/20) – $9.50 * (1/20) = -$0.095 (or more simply the $0.0 EV of the bet minus (19/20) * $0.10).  Whereas the buyer only pays the expiry fee 1 time in 20, so his return is his $0.0 EV minus (1/20) * ($0.10), or -$0.005.

So starting with an even bet, the in-the-money expiry fee costs the buyer of a longshot 0.5c per lot and the seller 9.5c per lot – quite a difference!  The ratio varies smoothly from splitting the juice for a 50/50 bet to having the seller pay almost all of it for a 99/1 bet, yet I don’t see any underlying mathematical reason why this should be the case.  Which means it will distort prices.

The same is true of point 3.  If the risk-free rate of return is 5%, and traders are earning 3% on their accounts, then any money locked up costs 2%/year.  For a contract with 100% margin requirements, which is currently the case for the markets on the presidential primaries, this means that staying in a contract for 3 months costs roughly 0.5% of interest.  The seller of a contract at 5 must lock up $9.50 / contract, while the buyer only has to lock up $.50.  Which means the seller pays 4.75c in foregone interest while the buyer pays 0.25c.

About the only good thing I can find to say about this fee structure is the consistency – both of these charge buyer and seller at exactly the same rate, namely in proportion to the odds (19:1 for a contract at 5).  Although from the exchange’s point of view, a fixed fee per lot has the benefit of making revenue predictable (as opposed to charging a percentage of winnings), and there are psychological benefits to charging the winner.

Any suggestions for alternate fee structures?

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  • My suggestion – no fees, but pay no interest on deposits. I think this would attract a lot more action and InTrade could earn their money by investing the deposits.

  • Alas I would prefer the opposite of Will – pay full interest on deposits, and set fees proportional to the actual transaction costs. This would allow more longer term claims.

  • I personally like the Betfair model… just a commission on profits made. It’s simple, which is perhaps more important when it comes to actually getting a wider population of people to trade.

    Admittedly, the lack of interest payment skews bets toward short-term turnover in this system, though, which won’t help you in the ’08 politics arena.

  • Haven’t had time to look at these markets closely recently since there’s no lack of more liquid and volatile ones out there, but selling longshots would be my preferred *Intrade* strategy. I mean, Gore was still at 5% for the nomination after announcing that he wouldn’t be running.

    Are you taking advantage of “advanced” margining, Patri? That is, among other things, being able to sell two 10% longshots for 80% margin (not 180%) because they’re mutually exclusive outcomes and your worst-case loss is 80%. I’m surprised that these opportunities are still in place given the existence of that option. Also, with the fee issue if you assume that this bias is already in the price, changing your two ratios, the EV is closer to flat.

    I agree with Robin on the interest question, although clearly that is potential revenue for exchanges and your typical punter is more interested in blasting 500 foot home runs than just making contact. It’s a short-term revenue vs. long-term liquidity trade-off. Simplicity is preferable, but I don’t think that not being paid interest really falls under “more simple”.

  • Patri Friedman

    Jed – I think that would avoid bias #2.

    Jason – Selling longshots is what I did last election, but these transaction costs really eat into your profits. Selling multiple exclusive longshots is a good idea. Sure, the price may incorporate this bias – but that’s a bad thing, because it means prices can no longer be directly interpreted as probabilities. The market provider should be trying to avoid adding bias.

    Sure, the exchange likes earning the float. But that drag cuts down on volume and liquidity. Hopefully in time, competition will reduce these transaction costs.

  • Rick Garcia

    Tradesports had the same deal then they went to 4% profit tax. Someone did analysis of how that altered the payouts depending on the trade price:

  • Agree with Jed as to the Betfair model of just charging winners. Simple and a real psychological advantage (even for people who ‘get’ that there is no free lunch, our behavioral biases are extremely hard to overcome and so it is easy to give into them in this case.)

    Re margining, etc. – what is really needed (to develop long term to expiry) markets is a prime brokerage model where you separate credit/intial & variation margin from the execution/transaction element. They are different businesses with different capital requirements and expected returns. Alternatively you need to have a CCH (Central Clearing House) mechanism.

    The problem here is – at least in the US – the underlying market needs to be seen as entirely legitimate/legal in order to justify the investments needed to develop either or both of these solutions.