Comment Text:
September 25, 2022
I am writing to suggest that a prediction election market that encourages hedging is contrary to the public interest.
According to a document published by Kalshi ("Kalshi Compliance Informational Document & FAQ for Finance Professionals"):
Rather, they [event contracts] allow Traders to make predictions on the likelihood of certain
events occurring, hedge their exposure to the negative ramifications of these events, and
provide society at large a valuable price-signal based probability estimate of various events
occurring.
It is well recognized that prediction markets have been a highly reliable predictor of event outcomes. However, as far as I am aware, previously existing prediction markets, such as Predictit, have not suggested that their contracts can be used for hedging. Hedging is a risk-mitigation strategy; a hedger would buy contracts that provide a payoff for an outcome that would have a negative impact on the hedger. A hedger may or may not believe that the outcome of a purchased contract is the most likely to occur. In fact, a hedger may buy a contract for an outcome that they think highly unlikely, if that outcome would negatively impact the hedger.
Clearly, hedging will diminish the predictive accuracy of the election market. To the extent that hedgers wish to protect against financially significant negative events, they may buy orders of magnitude more contracts than non-hedgers and thereby significantly degrade the predictive accuracy.
The Commission asks whether the contracts serve a hedging function [Question 6]. The better question is whether the contracts can be both predictive and usable for hedging. In my opinion, the two uses are not compatible. Since few, if any, commenters have discussed this conflict, I will elaborate.
As Kalshi has indicated [see above], there is a societal benefit to providing an accurate price-
signal based probability estimate of various outcomes. If traders buy contracts for a price less
than their personal probability estimate and sell contracts for a price more than their personal
probability estimate, then the market price of the contract would tend to approximate the
consensus probability estimate.
On the other hand, a hedger will buy contracts to offset their potential losses due to a specific
outcome. Hedgers might be willing to overpay to buy contracts with unlikely outcomes, if
those outcomes would have a negative impact on the hedger. In the opposite case, a hedger
might be willing to sell contracts at a lower price, if those outcomes would have a positive
impact on the hedger. Furthermore, I would expect that a non-hedger might buy hundreds of
contracts, whereas a hedger might buy thousands or millions of contracts.
It's very likely that hedging would result in price distortions, compared to a market without hedging.
In today's environment, society at large is very concerned about the fairness and accuracy of elections. If election results should be inconsistent with expectations, societal unrest may occur. Therefore, any instrument that states or implies that it is predictive, but has degraded predictive accuracy, is not in the public interest.
The fact that Kalshi presents its contract as both hedging and predictive, as do most commenters, indicates that marketing of the contracts is likely to be based on misconceptions and mistaken expectations. That aspect would also be contrary to public interest.
My suggestions are the following:
A market should not be presented as both predictive and hedging. The sponsor should
choose one of those characteristics and not pretend to be both.
A predictive market should limit the amount investable by an individual in any one contract
and the total amount invested in all contracts. A contract maximum of $1000 would seem
reasonable.
A hedging market would not need to have investment limits.
A hedging market would not be allowed to state that their prices are predictive.
Thank you for the opportunity to comment on this issue.
Richard Q. Wendt, CFA, FSA(Ret)
