Maybe We Should Give Rummy's Job to Bill Bennett

In Las Vegas race and sports books, you can place bets on sporting events, but you can't bet on politics. The Department of Defense wants to change this.

The Pentagon's Defense Advance Research Projects Agency (DARPA) — the people who brought us the Internet — is collaborating with the Economist Intelligence Group and a firm called Net Exchange to put together the Policy Analysis Market, a market in futures contracts that deal with "underlying fundamentals" of the Middle East:

Analysts often use prices from various markets as indicators of potential events. The use of petroleum futures contract prices by analysts of the Middle East is a classic example. The Policy Analysis Market (PAM) refines this approach by trading futures contracts that deal with underlying fundamentals of relevance to the Middle East. Initially, PAM will focus on the economic, civil, and military futures of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria, and Turkey and the impact of U.S. involvement with each.

The contracts traded on PAM will be based on objective data and observable events. These contracts will be valuable because traders who are registered with PAM will use their money to acquire contracts. A PAM trader who believes that the price of a specific futures contract under-predicts the future status of the issue on which it is based can attempt to profit from his belief by buying the contract. The converse holds for a trader who believes the price is an over-prediction – she can be a seller of the contract. This price discovery process, with the prospect of profit and at pain of loss, is at the core of a market’s predictive power.

The issues represented by PAM contracts may be interrelated; for example, the economic health of a country may affect civil stability in the country and the disposition of one country’s military may affect the disposition of another country’s military. The trading process at the heart of PAM allows traders to structure combinations of futures contracts. Such combinations represent predictions about interrelated issues that the trader has knowledge of and thus may be able to make money on through PAM. Trading these trader-structured derivatives results in a substantial refinement in predictive power.

The PAM trading interface presents A Market in the Future of the Middle East. Trading on PAM is placed in the context of the region using a trading language designed for the fields of policy, security, and risk analysis. PAM will be active and accessible 24/7 and should prove as engaging as it is informative.

In an example of how futures contracts might be structured, PAM's Web site provides an example of combining contracts on the (now historical) duration of conflict in Iraq with those on the likelihood of the overthrow of the Jordanian monarchy, to show a way that, if someone who doesn't particularly know the likelihood of the duration of the conflict but with a sense that, should it last, a neighboring state is likely to be unstable, that person can hedge a prediction. (I.e. "If the war lasts longer than 1 month, then the Jordanian government is likely to fall.")

Registration of futures contract traders is slated to begin on August 1, with trading scheduled to open on October 1.

If this system is implemented as planned, it will be possible to gamble on the outcome of middle-eastern political and economic events. The system's business model resembles more the Chicago Board of Trade than it does the sports book at Caesar's Palace; but gambling it is.

As you might imagine, not everyone is happy with this prospect. Two Democratic senators have requested that the Pentagon kill the project before registration of traders begins on August 1. An Associated Press report quotes Sen. Ron Wyden (D-Ore.) as saying, "The idea of a federal betting parlor on atrocities and terrorism is ridiculous and it's grotesque," at a news conference held jointly with Sen. Byron Dorgan (D-N.D.)

Sen. Dorgan described the Policy Analysis Market as useless, offensive, and "unbelievably stupid." "Can you imagine," he said, "if another country set up a betting parlor so that people could go in ... and bet on the assassination of an American political figure, or the overthrow of this institution or that institution?" (One wonders whether Dorgan has ever been to the UK, and, if he has, whether he ever set foot inside a Ladbrokes shop.)

FutureMAP, the program which manages DARPA's participation in the project, has this to say about the market's utility and application:

There is potential for application of market-based methods to analyses of interest to the DoD. These may include analysis of political stability in regions of the world, prediction of the timing and impact on national security of emerging technologies, analysis of the outcomes of advanced technology programs, or other future events of interest to the DoD. In addition, the rapid reaction of markets to knowledge held by only a few participants may provide an early warning system to avoid surprise.

As a gambler, I have no a priori objection to the Policy Analysis Market. If policymakers can use market activity as a warning sign of sudden changes, more power to them.

I see difficulties with this system. No one in their right mind would trade these futures contracts unless they had some reason to believe that they had insight into the occurrences which underly those contracts.[1]

Punters — err, investors who trade these contracts are going to be at risk of losing their shirts, unless they have some kind of edge. There's a saying about commodity futures trading: The way to make a small fortune in futures is by starting with a large one. How can you evaluate whether a contract is trading at a fair price unless you have a sense of the odds?

The market will respond usefully to the activities of a knowledgeable few if and only if it is sufficiently liquid, that is, if there is sufficient interest in buying (or selling) contracts when someone suddenly wants to sell (or buy). Are the market-makers prepared to take the kind of short-term risks that are needed to provide that liquidity? How large a spread between bid and asking prices will be needed to tempt them into taking that risk?

And the experience of the existing financial markets is that with such liquidity goes volatility. They respond when an informed buyer starts buying in quantity ... but they also respond to unsubstantiated rumors, to irrational exuberance and bleak pessimism, to the manipulations of crooked traders. A sudden flurry of activity in contracts predicting the assasination of Syria's Bashar Assad might reflect the knowledge of someone close to Muslim Brotherhood cells working in Syria, or it might reflect the need of a trading firm to create a climate of rumors in which it can profitably dump contracts it had bought earlier.

In his autobiography Jimmy the Greek, by himself, Jimmy "the Greek" Snyder described the lengths he had to go in the days he ran an illegal sports book in Ohio to gather intelligence about college football teams in order to get a leg up on the gambling public. And as such things go, football teams are relatively well-defined and clear. Al Qaeda is not going to publish its DL for the benefit of punters. In order to gather the information needed to consistently come out ahead in this market, a punter would need intelligence that was good and consistent enough to rival (if not outperform) the secret services and intelligence agencies active in the region. Everyone else is going to lose their shirts, on average, to the market makers' spreads.

(via Talking Points Memo)

[1] This is gambling, though. Abdul Jalib's First Law of Gambling is "People are stupid," and his Second Law of Gambling is, "When people are stupid, there's money to be made."