Let's Talk About Binary Derivatives - Part Three

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Event Futures?
Although most event derivatives products these days are called event futures, that name is verymisleading. Since the term futures conjures up notions of unlimitedrisk in the minds of many investors, most purveyors of event derivatives have decided to limitthe risk of their products by making them binary derivatives.

Instead of depositing funds into a margin account and thendebiting or crediting that account according to market fluctuations,customers will only pay a premium for the futures at the outset of thetrade. If the market moves against them, the customerís loss will belimited to the premium that he paid for the contracts. The limited riskand binary payout of these instruments makes them more akin to optionsthan futures.

It also makes them perfectly suited for a wide arrayof potential trading and speculating opportunities. ìThe binary,yes/no, event driven contract is an idea that applies to a wide varietyof risks,î says Edward Chambliss, VP of Institutional BusinessDevelopment for event derivatives exchange Hedgestreet. ìWe can create a derivatives market forthings that really donít meet the typical standard for current exchangecontracts. For example, we offer contracts on regionalresidential real estate so that a prospective home buyer or seller canprotect against adverse market moves. These regional futures will bethe perfect hedge for someone who is selling a house in New York andbuying a house in Chicago.î

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PROBLEMS ON THE HORIZON
One of the primary stumbling blocks for these products is regulation.Economic indicator products such as CPI futures donít raise anyregulatory red flags. However, other potential products such ascorporate earnings futures, election futures, sporting event futuresand M&A futures raise the specter of clashes between the CFTC, SEC,professional athletic leagues, gaming commissions, Congress and a hostof other regulatory bodies. Another potential problem with these eventfutures/options has to do with their public perception. The PRnightmare that accompanied the announcement of the ìterrorism futuresexchangeî shows how unreceptive the public can be to products that pushthe boundaries of good taste. If these futures become widespread, thenit is only a matter of time before someone lists a product that raisesthe ire of the public, or even worse, the regulators.

It is easy to envision the leaders of Hedgestreet and the PHLX beingdragged before the SEC or a Congressional subcommittee to explainirregular trading activities in a terrorism contract, sporting eventfuture or other questionable product. Hedgestreetís Chambliss was quickto address these concerns. ìWe are not a casino, so we will not bewriting contracts on athletic events. We will also not be writingcontracts on terrorist events. We are not going to write contracts onindividual equities because that is outside the purview of ourregulator. In addition, we are not going to write contracts onindividual lives or properties, because thatís insurance and thatís notour business.î

THE FUTURE IS BRIGHT
Although these products face numerous hurdles, it is easy to see thepotential of such a product class. Their binary nature makes themperfect for both portfolio managers and traders who want to hedge therisks of specific events. It may someday be possible for traders,property owners and government bodies to hedge against naturaldisasters, market meltdowns, political elections and even full-scalewars. While the questionable nature of some of these products willundoubtedly spark a regulatory debate, itís exciting to see thederivatives markets expand their horizons. PHLX and Hedgestreet mayhave captured lightning in a bottle with these products. If these eventfutures take off, then it wonít be long before other major playersfollow suit, creating an exciting new front in the endless exchangewars.
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