Asymmetrical Information - Megan McArdle


What Happened At Intrade?

The prediction market suddenly shut down, with hints of possible improprieties yet to be revealed. Why?

The betting market shut down rather suddenly a few days ago, with a rather cryptic notice about "financial irregularities" and the requirements of Irish law that they cease trading at once.  Naturally, people have been wondering what, exactly, those financial irregularities might consist of.

Rajiv Sethi, a Columbia economics professor, suggests that they may have failed to properly segregate their trading accounts:

What on earth is going on? My best guess is that the margin posted by traders was not held, as it should be, in segregated accounts separate from company funds. When bets are made on this market, both parties must post margin equal to their worst-case loss, so that neither is subject to counterparty risk. In effect, each party is taking a position against the exchange, but these positions are exactly offsetting so the exchange bears no risk. To ensure that all promised payments can be made, these funds must be held in the form of cash, insured deposits, or safe dollar-denominated securities such as Treasury bills. They cannot be invested in risky assets, and cannot be used for the payment of salaries or expenses.

That would explain a lot.  It would also, of course, be exactly what happened at MF Global.  This is starting to look like some sort of epidemic.  Which is rather odd, if you think about it.  While I'm generally pretty pessimistic about the ability of regulators to keep ahead of financial innovators, this seems like the sort of thing that regulators should be pretty good at enforcing.  If we can't even ensure that trading firms segregate their clients' money from the firm funds, then the state of financial regulation is even worse than I thought.