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Betting on unknown future events may be the next big thing in hedging your investments

By Gordon Gottsegen

New exchanges allow people to trade event contracts, adding credibility to a relatively new - and risky - financial instrument

There's no denying that the latest reading of the consumer-price index or a change in the fed-funds target rate can move markets. However, unless you have insider access to the U.S. government's economic data or the mind of Jerome Powell, it may be hard to position your investments so you're prepared for whatever the outcome is.

Now, retail traders are gaining easier access to a burgeoning financial instrument that lets them hedge positions against future events - whether that's unemployment numbers, a Fed announcement or even the weather. However, the speculative nature of these instruments means that regulators are keeping a close eye on them.

Interactive Brokers Group Inc. (IBKR) recently announced ForecastEx, a subsidiary that acts as an exchange for trading forecast contracts. The exchange was unveiled at the end of June and was originally set to launch Monday - though Interactive Brokers has pushed back its debut to a undetermined date later this summer, with a company spokesperson citing unspecified "administrative issues." When it does launch, Interactive Brokers told MarketWatch that it would be open to allowing other brokerages to trade on the ForecastEx exchange, in order to provide more liquidity.

What, exactly, is a forecast contract? Also known as event contracts or event futures, forecast contracts are a somewhat new financial product that allow investors to place a bet that something will or won't happen. These contracts are binary, so investors can either buy a "yes" contract or a "no" contract. Contract prices typically range from $0.02 to $0.99, and provide a $1 payout if the event outcome is predicted correctly - or $0 if incorrectly.

Depending on how confident an investor is in their prediction, they can buy dozens, hundreds, thousands or more of these contracts to maximize their return on investment, but there's always the chance of losing all that money if the prediction is wrong.

Placing a wager on an unknown future event - isn't that just gambling? Critics of these contracts, like investor advocacy group Better Markets, have made the comparison. But proponents say that all speculative investing and derivatives involve gambling to an extent - and those are regulated and legal.

"I think of it as a form of insurance," Steve Sanders, Interactive Brokers' executive vice president of marketing and product development, told MarketWatch.

Sanders gives the following example: Let's say someone buys a home on a coastline that is eroding due to the effects of sea-level rise and climate change. Some home insurers would be nervous to insure the house, or offer a plan with high premiums. Instead, that person may opt to buy event contracts based on certain climate-change events. That way, they would get a payout if the worst outcome were to occur.

Event contracts are regulated by the Commodity Futures Trading Commission, the same government agency that regulates things like grain futures contracts, stock-index futures and other derivatives.

Also read: Retail traders are beating big firms in guessing where U.S. interest rates will go next

Kalshi, a fintech startup that was founded in 2018, was one of the pioneers in getting these contracts regulated - and thus legitimized - by the CFTC.

"When we first started, it wasn't regulated - it wasn't really allowed," Tarek Mansour, chief executive and co-founder of Kalshi, told MarketWatch. "We spent more than three years with the CFTC to figure out the model to get this thing regulated, and we did succeed at doing that,"

Before Kalshi, Mansour and his co-founder Luana Lopes Lara both worked in finance at places like Citadel LLC and Goldman Sachs Group Inc. (GS) They noticed that trading activity usually stemmed from someone's opinion on a future event and either positioning their investments to benefit from that future event or hedging to protect their investments from a certain outcome.

"So the question was, what if we just created a marketplace or exchange where people could just trade directly on the outcome of events?" Mansour said. "Things they relate to and understand, like economics, politics, finance, COVID or really anything that's relevant and has economic and social value."

However, while Kalshi would like to allow anyone to trade on any future events they believe are relevant - whether that's the number of Fed rate cuts, the price of bitcoin by the end of the year or the Rotten Tomatoes score of "Despicable Me 4" - CFTC regulators are less keen. The CFTC specifically believes that event contracts involving political contests should be considered "gaming" and thus prohibited. Kalshi is actively suing the CFTC in an effort to overturn this decision.

Cantrell Dumas, the director of derivatives policy at Better Markets, believes this CFTC pushback on political event contracts is important.

"The CFTC's proposal is an important step to address the substantial and multifaceted threats that political event contracts pose to our democratic processes, financial-market integrity, public trust and the CFTC's important mission of serving the American people," Dumas told MarketWatch in an email.

Dumas cited the ongoing U.K. election-betting scandal as an example of how political event contracts could incentivize misconduct. In the U.K. scandal, candidates, their aides and people in the political orbit were allegedly betting on the outcomes of the elections they were preparing for - opening the door to potential inference in a public government election for financial gain. If this sort of political betting were to continue, if could incentivize bad actors to try to step in and disrupt future elections. Dumas stressed the importance that the CFTC ensures these contracts only trade for events that are financially relevant.

"The Commission's regulations are designed to ensure that event contracts serve a legitimate economic purpose, such as hedging or price discovery, and gaming contracts involving the winner of a track meet, basketball game or the Emmys do not meet these criteria," he said.

While Kalshi casts a wide net to include all sorts of future events, ForecastEx is limited to just economic and climate events. This includes things like the fed-funds target rate, U.S. consumer sentiment, U.S. unemployment rate, global temperatures and atmospheric carbon dioxide. That's because ForecastEx and Interactive Brokers contend that these types of events are material to investor portfolios.

Although Kalshi and ForecastEx both offer exchanges for event contacts, they appeal to different types of investors. While Kalshi has found success catering to a broad retail-investor audience, Interactive Brokers appeals to more active professional traders - and that's who the company thinks will use ForecastEx the most.

When asked about ForecastEx's launch, Mansour said it was "super encouraging" because it adds more credibility to the instruments. Other players are also involved, including futures-exchange juggernaut CME Group Inc. (CME) Event futures are similar to the weather derivatives offered by CME, especially when they're tied to climate events. In both cases, people can use the financial products to hedge against future ecological outcomes.

A handful of brokers are also beginning to allow some form of event-contract trading, including Tradovate, Edge Clear, Blue Line Futures and Ironbeam. Each new entrant to the space may help investors get more comfortable putting money into this burgeoning financial product.

But should individual investors start buying these contracts? It all depends on their conviction and risk tolerance. If an investor is an expert in climate-related events and feels like they know for certain how a future event will unfold, they might see opportunity in event contracts.

But they should keep in mind that if they guess incorrectly, the money wagered will disappear.

-Gordon Gottsegen

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

 

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07-08-24 1312ET

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