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.
The early shots across the marketing bow came when the pros gathered at the Futures Industry Association conference in Boca Raton, Fla. At this conference, I listened as the Philadelphia Stock Exchange (PHLX) announced it was launching event futures. And why a potentially controversial product? One reason is because the exchange has been struggling. ArcaEx's purchase of the Pacific Coast Exchange, and its planned NYSE merger, have made the PHLX's situation more difficult. "We are looking to replicate the success we've had with our technology on the options side," says Daniel Carrigan, vice president of new product development at the PHLX. "We are going to change the way commodities trading advisers (CTAs) and hedge funds operate on futures exchanges." The exchange envisages listing futures on economic indicators, equities, interest rates and agriculture. Specialized futures products based on event-risk potential are currently offered by several Wall Street firms such as Goldman Sachs. However, Carrigan said the PHLX event-driven products – which will be electronically traded either from the PHLX trading floor or a remote location – will have more frequent terms of volatility than a consumer price index futures contract from the Chicago Mercantile Exchange.
'These event futures gain or lose in price as the probability of their payout increases or decreases. People refer to these products as binary options.'
HedgeStreet teamed up with Clearing Corp., giving the venture access to a stable of institutional customers. Clearing Corp.'s customers will be able to include event futures in existing cross-margin accounts without having to open additional accounts. "The binary, yes/no, event driven contract is an idea that applies to a wide variety of risks," says HedgeStreet's Chambliss. "We can create a derivatives market for things that really don't meet the typical standard for current exchange contracts. For example, we plan to offer contracts on regional residential real estate so that a prospective homebuyer or seller can protect against adverse market moves. These regional futures will be the perfect hedge for someone who is selling a house in New York and buying a house in Chicago." Unfortunately, the binary nature of these event futures is the only contract specification that had been revealed as I write my column. However, the PHLX did point out that Susquehanna will be the specialists in its products. "In addition to providing liquidity," says Carrigan, "Susquehanna will also bring other resources to the table such as a research team that is in constant contact with over 1,500 institutional customers." But how many clients will actually ante up for this strange type of investment? Although Philly and HedgeStreet are adamant their event futures will be fully available by the third quarter, there are still a number of problems. One is regulation. Economic indicator products such as CPI futures don't raise any regulatory red flags. But look at the plethora of potential products – corporate earnings futures, election futures, sporting event futures and M&A futures. This uneven mix raises the specter of clashes among the CFTC, SEC, professional athletic leagues, gaming commissions, Congress and a host of other regulatory bodies. Public Perception Another potential problem is public perception. The PR nightmare that accompanied the announcement of the "terrorism futures exchange" is not lost on trading pros. If these latest futures become widespread, then it could be only a matter of time before someone lists a product that raises the ire of the public or – even worse – the regulators. But it is easy to see the potential of event futures. They are perfect for portfolio managers and traders who want to hedge the risks of specific events. It may someday be possible for traders, property owners and government bodies to hedge against natural disasters, market meltdowns, political elections and yes, full-scale wars – even if that does not seem to be the present intention. Mark Longo is an options trader and a former member of the Chicago Board Options Exchange. E-mail: firstname.lastname@example.org