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May 26, 2005

The Outcome of Events: HedgeStreet and Philly Take a Lead in Strange New World

By Mark Longo

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  • The Outcome of Events: HedgeStreet and Philly Take a Lead in Strange New World

Is this sick or what? Who wants to make a profit from the human plague called war? One such sleazy scheme failed last year. It was the U.S. Terrorism Futures Exchange, which would have traded jaw-dropping derivatives products. These were instruments based on the outcomes, for example, of enemy attack on American soil. The exchange was conceived and financed by a Pentagon unit.

Sure, many people thought it was gross. It got short shrift then, but ghoulish investors persisted. So it's possible that these futures products are about to sneak in through the back door. Are planned new instruments - trading on the possible outcomes of events - the precursor of sinister terrorism derivatives?

Not quite. For now, at least, the gambles will be on events based on more conventional measures - such as the risk factors in real estate. There are also rumblings about other event futures based on corporate earnings, agriculture, elections and sports.

However, advocates of worst-case scenarios seemed to have put limitations on the original idea. "We are not a casino, so we will not be writing contracts on athletic events," says Edward Chambliss, vice president of institutional business development for futures market HedgeStreet. "We will not be writing contracts on terrorist events. We are not going to write contracts on individual equities." Players in the latest event futures also include the Philadelphia Stock Exchange, the Clearing Corporation and Susquehanna International Group.

The bottom line is that these event futures are different than ordinary oil, natural gas and other futures. That's because they have a binary payout. Regular futures do not. You deposit some funds with regular futures into a margin account. Then those funds are debited or credited according to market fluctuations. Binary futures are more like options because you buy them outright at the beginning of the trade instead of depositing margin funds. Until now, trading in event-driven futures was done over-the-counter between trading parties such as hedge funds and others.

Event futures are structured around a single event, including the earnings of a single company. They can be purchased for one upfront, or premium, price, just like options. In fact, they will also perform like options. These gain or lose in price as the probability of their payout increases or decreases. Several people have been referring to these products as binary options. However, they will be regulated by the Commodity Futures Trading Commission and not the Securities and Exchange Commission. Also, the listing firms are referring to these products as event futures, so I will refer to them as that.

The idea of speculating on the outcome of events is old. Gamblers do it for Super Bowl Sunday. Traders take a position in a stock or bond. But, what if there was a way to bypass these investment types and trade the actually underlying events, such as the CPI index? It has already started.