Thursday, December 08, 2005

Hacking the EBOT

In my last post, I puzzled over why a prediction exchange might want to qualify as an EBOT (exempt board of trade). The benefits: relatively light federal regulatory burdens and preemption of state laws. (On the latter point, which I ignored to make earlier, see CEAct, 7 U.S.C. § 7a-3(e).) The large cost: Narrow limits on who can trade; only a "eligible contract participant" can. I doubt that a prediction market open only to, say, multimillionaires or registered brokers would do very well at quantifying the current consensus about future events.

But maybe I dismissed the EBOT status too quickly. Look again at CEAct § 1a(12)(C). It defines an eligible contract participant as "any other person that the Commission determines to be eligible in light of the financial or other qualifications of the person," (emphasis added). That suggests two legal hacks.

First, I could get the CFTC to allow a market in science claims open only to a large group of presumptively qualified commentators. That group of "eligible contract participants" might, for instance, include all faculty of accredited institutions of higher learning. And maybe their students, too. And what about mere high school graduates? Would you really want to exclude the likes of Bill Gates? Well, anyhow, you get the idea: Use § 1a(12)(C) to set up a usefully open EBOT.

Second, I could get the CFTC to define "other qualifications" relative to the market itself. In other words, I'd have the CFTC say, "Any person is qualified to trade on an EBOT that deals only in claims fitting the following description: . . . ." (More likely, the CFTC's statement would refer to a supplementary document, as defining the proper sort of claim would prove tricky.)

That second hack stretches the law a bit. Recall that the relevant statutory language reads, "other qualifications of the person," (emphasis added). Does the nature of the market you play constitute one of your qualifications? Arguably not. It looks more like a qualification of the market.

At all events, I've written to the CFTC to see how it reads §1a(12)(C).


Jason Ruspini said...

My idea for the hack is a variation of the "agent" idea. At first I also thought the key would be CEAct § 1a(12)(C), but can't TEN create sufficiently-funded legal entities on-the-fly, as investment banks do with "special-purpose entities". A specific market on the TEN EBOT might then technically have two large counter-parties, and profits and losses could be distributed to actual traders in a pro-rata fashion. Still, I think regulators would balk at this structure if the goal was to allow for entertainment-oriented trading, but this scheme is more feasible than qualification by authority (which makes me uncomfortable). Meanwhile, it seems that play-money markets intended to reveal information per se are moving ahead of their own accord.

Jason Ruspini

Tom W. Bell said...

I like that idea, Jason! I'll have to look into the details of implementing, though, before I can assess its practicality. If memory serves, it is not easy to qualify to serve as an agent authorized to trade on an EBOT.

Jason Ruspini said...

I just received the release below.

My initial reactions:
1) Regarding weather & economic derivatives, this seems to be CME's turf. Sure, the contracts will work differently, but it seems like the CME might be less than pleased with this development.
2) The bit about "credit risk" is interesting. Bonds and credit derivatives of course already represent credit risk, but they may difficult to trade. Is Intrade going to have contracts directly tied to credit ratings? Likewise, on the equity side, how long before someone broaches the possibility of having contracts directly tied to earnings releases?
3) None of this *seems* to address the "eligible contract participant" restriction, but I find this John Delaney statement interesting: "We bring not only our proven exchange technology to the table but will also provide a central counterparty [clearing house] to every trade and that should make financial institutions comfortable trading these markets"

Hmmmmm.. "A central counterparty [clearing house]"

Jason Ruspini

For immediate release

December 13, 2005

Trade Exchange Network Limited Launches Exempt Board of Trade

Trading in weather, economic numbers & credit risk planned

Dublin, IRE - Trade Exchange Network Limited, parent company of &, has filed a notice with the US Commodity Futures Trading Commission to operate an Exempt Board of Trade - EBOT.

The company intends to offer trading in unique contracts that serve the needs of the professional trading community. "Financial institutions, insurance companies & hedge funds have asked us to help them manage risks by listing contracts not found among current exchanges. Weather, credit risk and macro economic events, to name a few, present risks to portfolios that can not be managed with the current exchange products - we intend to change that by offering unique contracts on these events", says John Delaney, CEO.

The Commodity Futures Modernization Act allows for the creation of Exempt Boards of Trade but these markets are open only to Eligible Contract Participants - banks, insurance companies, hedge funds, regulated entities and high net worth individuals that meet certain financial requirements. "An EBOT is a natural next step in our growth, over the last four years we've established a solid reputation as the leading marketplace for economic and current event risk in the world. We bring not only our proven exchange technology to the table but will also provide a central counterparty [clearing house] to every trade and that should make financial institutions comfortable trading these markets", says Delaney.

For more information on Trade Exchange Network and their Exempt Board of Trade contact Mike Knesevitch, Communications Director, ###-###-####.

An EBOT is a board of trade that limits trading to contracts for the future delivery of a commodity (or options on such contracts or on a commodity) for which the underlying commodity has: (A) a nearly inexhaustible deliverable supply; (B) a deliverable supply that is sufficiently large, and a cash market sufficiently liquid, to render any contract traded on the commodity highly unlikely to be susceptible to the threat of manipulations; (C) or no cash market. The contracts can be entered into only between persons that qualify as eligible contract participants. The CFTC has exclusive jurisdiction over any contract or transaction traded on an EBOT, however, an EBOT may not represent to any person that the EBOT is registered with, or designated, recognized, licensed or approved by the CFTC.