Jason Ruspini went overboard on BBN TV, claiming his tax futures markets will become InTrade’-s most popular ones in 2009, but he managed to control well his descent to Earth:
[Y]es they have lost a lot of steam and that statement seems overconfident at this point, – or has always [been] for that matter. There was no real follow-through to the apparent trend of the first week or so. Lack of news flow is the main culprit. […]
The mainstream media continue to show interest for Jason Ruspini’-s tax futures markets.
Previously: Video.
The “->-34″- contracts are being offered at 96. If you discount the possibility of the marginal tax rate for that year being below 34%, this is an annual yield of about 1.5%, after transaction fees. The 2010 “->-34″-s are paying around 1.35% and the 2011s, 1.2%. Buying any of those allows you to sell higher contracts on the ladder at reduced margin, as described before.
A possible trade that stands out on the board is to sell the 2010 “->-36″-s in the high 70s and buy the 2010 “->-38″-s for 50. I don’-t see how a spread of 30 is warranted there, as any legislation that accelerates the Bush tax cuts sunset will likely put the highest marginal rate at 39.6%, higher than 38% at least. That is, I think the market’-s implied probability of the rate ending-up in the 36-38 bin is too high. This trade would make roughly a 39% return on frozen margin, which could be improved to 50% by additionally buying the “->-34″-s at 95. (unannualized)
For years now, a criticism of Intrade has been its lack of a positive carry in long-term markets. In contrast to regulated futures exchanges, Intrade does not pay out interest on deposits to most traders. While understandable, this discourages liquidity and can skew prices near extremes as future winnings are discounted, exaggerating any favorite/longshot bias.
If carry can be seen as a type of liquidity subsidy, it need not be provided by the exchange. It could be paid by other traders, or passed-on by traders that happen to have interest-bearing accounts. Consider a contract that is set to expire at 100 with certainty at a future date. Offers below 100 then represent a carry payment, and prices in such a market imply something like a discount rate. This is not a true interest payment or discount rate because no funds are being loaned, but in some situations the buyer will gain the benefit of reduced margins on subsequent trades in addition to “-interest”-.
Take the new “-tax futures”-, which are structured as a “-ladder”- of binary options. Currently the lowest rung expires at 100 if the highest marginal tax rate is equal to or greater than 34% and zero if it is less than 34%. The next highest rung pays when the highest marginal rate >-= 36%, and so on. Say we add a new rung that pays-off if the rate is greater than 0% and has no transaction fees. This would seem to be a relative certainty, and an offer below 100 represents carry. Furthermore, the buyer of this contract can then sell short higher rungs at reduced margin.
For example, with the 2011 maturity contracts, the current bid/ask on the “->-38″- rung is 85/87.5. If a “->-0″- rung existed and someone sold it for 95, the buyer can then go out and short “->-38%”- at 85 with 10 margin (corresponding to his worst-case scenario of negative tax rates: 85-95!) instead of the usual 15 margin frozen, plus collect the carry of 5 in the “->-0″- contract by maturity. In absolute terms, the margin is only reduced by the unannualized carry of 5, but if the trader is right, he will capture a return on frozen margin of 900% ((85+5)/10-1) instead of 467% (85/15-1).
Likewise, an “-impossible”- contract would subsidize buyers. The 2009 contracts are currently 35 ask for “->-38″-. If a “->-100″- rung existed and someone bought it for 2, the seller could then buy the “->-38″- with 33 margin frozen – a subsidized 203% vs. a regular 186% profit in this case. (The “-sponsor”- is not interested in profiting directly on that trade and so the fact that the government would be owed all winnings if they are a US citizen doesn’-t matter.)
Now it’-s fair to ask why you couldn’-t accomplish the same subsidy by just consistently selling for slightly less than and buying for slightly more than what you judge to be fair value. Aside from the facts that this could widen the bid/ask spread and make prices less reliable, the more explicit carry of the system described above is psychologically reassuring and should lead to more trade. It is very hard to distinguish between a 65% and a 67% chance of the next president being a Democrat – for good reason. How can a trader practically determine if a 2% difference in price is a subsidy? At the same time, the sponsor’-s risk is more defined if they stick to contracts with near-certain payoffs. In many cases the sponsor will also be a market-maker, but this system allows those functions to be decoupled.
It could be argued that the risk-profile of the average Intrade trader is such that they are insensitive to these kinds of incentives because they are generally trying to grow small sums of money by orders of magnitude, as opposed to preserving larger sums. Even if this is an issue, the multiplier effect described above should mitigate it.
A more likely problem with this system is the danger of free-riders taking carry without providing liquidity to the sponsored market. The sponsor could deal with this by only extending small subsidies at any one time and ceasing to do so if he doesn’-t see reciprocation. The fact that frozen margin on the trade earning carry is unfrozen only when an offsetting trade is made on the same ladder also discourages free-riders. The system could somewhat easily unravel though, with the “-discount rate”- collapsing to relatively useless levels. This would not be surprising, especially in the “->-100″- contract, although subsidizing tax short-sellers with the “->-0″- contract is more important in this market.
Remember, this entire idea is meant to work within the technical and legal structures as they exist.
Except for that stupid smirk, not terrible for my first t.v. appearance.
It’-s 23:45 minutes in, here.
Afterwards, I met some of the guys from CNBC’-s Fast Money, who were great. I wouldn’-t mind doing it again.
Jason Ruspini, interviewed by Bloomberg:
Taxes “-are the largest class of risk people don’-t hedge,”- said Jason Ruspini, a New York hedge fund analyst who established the market, which began trading last week. “-Hopefully this year, with this election, there will be kind of an increased interest in this kind of thing.”- […] “-If Democrats are perceived as having a greater chance to get in the White House these tax contracts will go up,”- said Ruspini, who declined to identify his employer because the market he created isn’-t related to it. “-If McCain is elected they won’-t go up as much.”- […] Right now, the market exists only for the top marginal income tax rate. Ruspini said he plans to have secondary markets based on Social Security taxes and whether Congress can restrain the alternative minimum tax from raising levies on tens of millions of households. […] “-This is such a young field at this point,”- Ruspini said. “-Ten years from now, it’-s going to be a huge market. Whenever you have a contract where there’-s a lot of hedging utility, that tends to be a successful contract in the long run.”- […]
Congrats to Jason.
Go read the whole piece.
Previously: Tax Futures, “In Real Life” – by Jason Ruspini
I am very pleased to announce the world’-s first tax futures on Intrade. I thank John Delaney and everyone there for their help and enthusiasm in getting these off the ground.
The contracts will forecast the highest marginal single-filer federal tax rates for 2009, 2010 &- 2011. I expect trade to be concentrated in the 2011 contracts, as Bush’-s 2001 tax cuts are scheduled to expire that year, reverting the rate in question from 35% to 39.6%, while the lower bracket rates each increase by 3%. While it is less likely, Congress may also alter the Bush tax cuts for tax years before 2011, but such changes would probably impact 2011 as well.
If reasonable liquidity can be sustained in these markets, I hope that contracts will be added to predict corporate taxes, and other factors that contribute to individual effective tax rates, like the Alternative Minimum Tax and the social security cap. Given the tremendous hedging utility of such markets, maintaining a liquid two-way market might be tricky, although there are some obvious ways for any market-makers to hedge what might become a position more short of taxes than usual.
Please read the last post on “-Policy Event Derivatives”- for some background on the potential benefits of such markets. I should add that while I am confident in their long-term value of making better group decisions and sharing risk, I am sensitive to some foreseeable pathologies, and don’-t want to give the impression of being too cavalier at this point. There are potential problems and side-effects stemming from the use of such markets that will be addressed later.
[Cross-posted from Risk Markets And Politics]
Previous blog posts by Jason Ruspini: