Senate Cut Pentagon's New Anti-terrorism Scheme

Now Prediction Markets Use Same Idea to Attract Event Speculators

Aug 27, 2009

In summer of 2003, a routine budget request of $8 million by the Defense Advanced Research Projects Agency or DARPA created a furor in the US Senate.

The Pentagon request was to fund a policy analysis market, which was criticized and turned down by the Senate Armed Services Committee as "morally repugnant and grotesque."

Afterward, Chairman John W. Warner said he had discussed the matter with John M. Poindexter, program director, and they had mutually agreed the program should be terminated. This was reported by Carl Hulse, in the New York Times, July 29, 2003.

In a defense budget that topped $355 billion in fiscal 2003, the sum of $8 million for DARPA would seem a stipend. However, the negative reaction of the committee hearings was vehement, unusually strident for the august senators.

Senators Said Nay! But Prediction Market Idea Began Growing

The aborted program was to become a “prediction” or “decision market,” of a sort used today by organizations, companies and researchers to forecast future happenings, in which they have vested interests.

The format is patterned after conventional stock or commodities futures markets, except the values of the trading contracts are based on probabilities of events happening- elections, financial markets, wars, floods, etc. - rather than outcomes of business operations. Actually these event probabilities are derivatives, since their values depend on activities disconnected physically.

Pentagon Planned to Discover Terror Threats with Prediction Market

The Pentagon wanted to develop a prediction market to forecast terrorist activities. But the Senate found reprehensible the use of public market speculation for profits, on events that could lead to horrific and fatal consequences. Senators dubbed it a "terrorism market."

Joe Nocera, in a New York Times article of March 11, 2006, declared the granddaddy of prediction markets is the Iowa Electronic Market, which the University of Iowa runs. In the 2004 presidential election, it not only predicted a Bush victory, but came within 1.1 percentage point of the actual result.

How a Prediction Market Works

Russ Ray, PhD, explained how such a market works in the magazine “Risk Management” of April 2004.

According to Dr.Ray, a bettor enters an assertion, an opinion that something will happen, by a certain time. For example, in the Iowa Electronic Market, during the presidential election season of 2004, assertions could be bought or sold on who the Democratic nominee for President of the United States would be.

At the conclusion of the trading period, if an event does occur, the holder of a winning assertion receives a dollar from the exchange for each contract unit held, while the holder of a losing assertion receives nothing.

John Kerry Traded on the Predictive Iowa Electronic Market

In March 2004, the cost of an assertion on John Kerry winning the nomination was 89 cents. A bettor, who bought this, received one dollar when the nomination occurred. The contract had attained 100% percent probability then, and the profit was 11 cents.

The rationale justifying prediction markets is they are able to flush out information that otherwise would not be available. Individuals around the world have different tidbits of inside information, and they know that using such information can enable them to earn a profit. Proponents say prediction markets are able to quickly and successfully aggregate information as no other mechanism can.

Although not well known to investors, some of these markets or exchanges are quite sophisticated. They also strive to create efficient markets, where trading forums reflect information readily.

Intrade.com Provides Event Trading for Members

One such exchange is Intrade.com. After opening an account, a member can buy or sell units of listed trading probabilities; or create a new event probability; or just observe broad public opinion about likelihoods of many future events. Trading charts and maps are viewable. The exchange charges commissions only on matched or completed orders. In their opinion, they are the leading prediction market platform.

At this writing, trading on that exchange reflected an 88% probability of President Barack Obama being nominated for a second term, by the Democratic party in 2012. The contract was selling for 80 cents. If the event happens, an investor receives one dollar for each unit held, which represents a 20% return.

Seasoned Investors Understand that Markets Can Be Predictive

Veteran investors have always suspected efficient markets possess predictive characteristics. For example, in May 2001, the S&P 500 Stock Index averaged 1270.37. It dropped every ensuing month, until reaching 1044.64 - 12.2% lower - in September, the month of the attack on New York City by terrorists. Afterward, the market rose for the rest of the year. Did insiders know something?

In the instance of DARPA’s policy analysis market, what was an intriguing intelligence tool was unacceptable politically. Even so, prediction markets have grown in popularity. Advocates say only when a speculator “puts money where his or her mouth is” can that opinion be trusted.

The copyright of the article Senate Cut Pentagon's New Anti-terrorism Scheme in Derivatives Investing is owned by Howard Bryan Bonham. Permission to republish Senate Cut Pentagon's New Anti-terrorism Scheme in print or online must be granted by the author in writing.