On Monday, the U.S. Commodity Futures Trading Commission issued an order prohibiting the marketing of a new set of derivatives that would have enabled traders to bet on the winners of national elections. While these “political events contracts”—the latest development in the world of prediction markets—have their partisans, the CFTC’s order was based on fundamentally sound logic that should be applied more broadly. Financial instruments that serve primarily as a means of speculation rather than hedging should be banned, just as gambling is illegal in most contexts.
A simple, common-sense principle guides this distinction. Imagine two different scenarios. In the first, an oil producer faces the risk that oil prices will fall while a consumer faces the risk that they will rise. The producer and the consumer might use a futures contract to hedge this risk by contracting to transact in the future at a price fixed today, thereby effectively purchasing insurance against the risks they both face. The consumer no longer worries that a price increase will interfere with his daily commute, while the producer no longer fears that a price decline will force him to lay off his workforce. This insurance reduces the unpredictability of the individuals’ incomes, smoothing them out across different contingencies. Such transactions embody the valuable spreading of risk for which financial markets are justly praised.
Now consider an alternative scenario. Suppose that two individuals, neither of whom uses or produces oil, harbor different opinions about the future price of oil and decide to wager on it. Both parties willingly participate, because they think they’re each getting the best of their confused counterparty. Clearly, both of them cannot gain from this transaction, and the wager itself creates rather than reduces risk. While each party thinks it is getting the better of the other, both agree that on average both of them will be worse off because on average they will win and lose on the same number of bets, and both of their incomes will be less smooth and predictable on account of their wagering. As a consequence, this sort of speculation is socially harmful. That’s why gambling and wagers are heavily regulated or banned outright in nearly every country.
Read more at Slate