The Commodity Futures Trading Commission appears to have little respect for the power of markets, going by their proposal to ban futures contracts on electoral outcomes.
Elections have enormous financial consequences affecting future tax rates, trade policy, regulation and government spending. But instruments such as forward contracts, insurance policies or bets don’t provide effective ways of hedging these risks. Each election affects so many things, and in such complex ways, that — despite the passionate conviction of partisans — they likely have expected present values that net out pretty close to zero for most individuals and companies. This is precisely the kind of exposure that requires futures markets.
Unfortunately, proponents of election futures have marshaled only weak arguments. One is that the instruments would allow hedging of election exposures. But for the reasons above, we’ve seen very little demand for these hedges, and if anyone did want them, they could negotiate forward contracts or insurance policies for that job.
The other argument is that the contracts would give valuable information. The objection to this is markets give only “market-implied” probabilities, which differ significantly and systematically from actual probabilities. Moreover, as Fischer Black famously pointed out, efficient markets get prices within a factor of 2 about 90% of the time (I had advised him to say, “half the time,” and he considered it). If a futures contract gave Donald Trump a 50% chance of winning the 2024 election, we’d be 90% sure his chance was between 25% and 100%, and we know more than that already.
The co-conceiver of the Black-Scholes theory of options pricing argued that the point of markets was not to get prices precisely right — that’s impossible to even define — but to coordinate economic activity. If oil refiners are planning based on an assumption of high oil prices and airlines are selling tickets based on low assumed oil prices, there will be inefficiencies and deadweight losses.
Although a company may have no predictable directional exposure to election outcomes, it will have thousands of specific decisions that would change based on election probabilities: how it structures an acquisition for tax purposes, whether it settles a regulatory dispute or fights, what long-term contract terms it offers or where it builds a new facility. If different individuals within the same company, or different companies, are making decisions based on inconsistent probabilities, the economy will run less efficiently than it should.
Do not underestimate the power of futures markets to supercharge economic efficiency. When they were invented in the mid-19th century, they turned a sparsely populated backwater into the global center of the second Industrial Revolution. A century-and-a-quarter later when futures were extended to financial factors, they supported the greatest wealth-creation event in human history and gave birth to the modern global derivatives economy.
Would election futures provide a similar boost? I have no idea, but they might. It would have to begin with fundamental traders — people who can estimate actual probabilities — causing the futures prices to be accepted by economic decision makers. They wouldn’t necessarily have to be better than expert opinions or prediction markets; financial actors are predisposed to trust futures prices over those alternatives. But the prices would have to be accurate enough to be taken seriously.
If financial decision makers started looking at the election futures prices to refine decisions, correlations would emerge between election futures and other prices. These correlations could never be observed without futures markets. Prediction markets and insurance prices are too crude — not updated every second — and are disconnected from economic decisions. Only if economic decisions depend on the listed price is there any chance of estimating correlations.
Next Black’s noise traders come to market. These are traders with no fundamental information about election probabilities but who make money exploiting patterns like trends and correlations. Other noise traders bring tiny scraps of information — too small to influence a directional bet on the election outcome, but large enough to have a predictable short-term effect on prices. These people have no more idea than anyone else who will win the election, but they might know one small thing that, when it comes out, will predictably move the futures price a small amount.
It is the noise traders who make the futures price consistent with all other prices, meaning economic activity is optimally coordinated. Once this happens there may well be hedging demand from fundamental traders — not directional bets on the election but spread trades of election probabilities versus, say, interest rates or currency values, or more complex macro trades involving multiple markets.
You might think that if election futures were so valuable there would be more demand for them. But history argues that it’s very hard to predict which futures contracts will take off and stimulate economic growth, and which ones will not. Exchanges misguess this as often as Hollywood studios make unpopular movies. A successful futures contract requires a series of steps by different types of people, and you can’t know what one group will do until you show it the results of previous group contributions.
Still, economic theory suggests that it’s possible election futures would add significantly to global economic efficiency and growth, so it’s a highly consequential decision for the CFTC to ban them without a trial run. CFTC Chair Rostin Behnam grumbled that he didn’t want the regulator to be an election cop. This is like the Food and Drug Administration commissioner banning a promising new medical technology because he didn’t want the FDA to be a DNA cop. I sympathize with people who don’t want to be cops, but then why take a job as a top cop?
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