Recently the U.S. Commodity Futures Trading Commission issued a complaint against the online prediction market firm Intrade.
Intrade is based in Ireland, so the complaint does not shut down the company, but it does effectively lock out U.S. residents from participating in the market. The ostensive reason for the complaint is that Intrade has been offering off-exchange options, which seems to mean that it has been offering online gambling.
I wrote briefly about Intrade a few months ago in an article on forecasting the winner of the U.S. presidential election. (Prices of contracts for the two presidential candidates correctly predicted the outcome of the election, by the way.) The CFTC apparently thinks that access to Intrade exposes customers to unacceptable risk of fraud. Either that or they view prediction markets as a form of illegal gambling.
Regardless of the merits of the Intrade complaint, it does raise some interesting questions about the link between risk and gambling.
I am not much of a gambler. Several years ago I attended a professional conference in Lake Tahoe and wasted $2 on the nickel slot machines trying to understand their allure.
It took me 10 minutes to run out of nickels, and I got no return in terms of entertainment to compensate me for the loss of my two bucks.
Slot machines are clearly a form of gambling. They can also be viewed as a financial asset. Each time a player puts a coin in the slot he is purchasing ownership of a random return to be determined by the next spin of the wheel.
While I don't play the slots anymore, I do find myself frequently purchasing other types of risky assets with potential gains and losses that are many times larger than nickel slots.
This leaves me a bit uncertain and uncomfortable about what qualifies as gambling and what doesn't.
One possible definition of gambling is that it is the purchase of a risky asset. However, all sorts of purchases involve risk, and we don't think of them as gambling.
Every time I buy a meal at a restaurant there is a chance I will get food poisoning. Most people would not think of this as gambling. Some people might think the risk is high enough that they never eat out, but even they wouldn't really call it gambling.
Another possible definition is that gambling is the purchase of a risky asset with a payoff that is negative on average. This definition would include games of chance at a casino.
In order to cover operating costs and earn a profit, the casino must average offer payouts that are less than the bets placed. I don't like this definition because I buy insurance. I insure my automobiles and my home, among other things. These are risky assets. If I don't have a car accident in December, I will end up losing my non-trivial premium payments. If I am lucky enough to have a fender bender, the insurance company will give me a large cash payment. However, on average I end up paying more than the value of my accident claims because the insurance company must cover operating costs and earn a profit, just like the casino.
We don't think of insurance as gambling because the intent and average effect of insurance is actually to reduce our overall risk. Insurance pays off handsomely in cases where other assets (like a car) are paying very poorly. Most exotic financial derivatives that exist today are traded precisely for insurance reasons. They offer ways of making or receiving payments when precisely defined events occur.
Another problem with this definition is that it doesn't include purchase of lottery tickets if the jackpot is large enough. When lotteries fail to pay for one or more rounds in a row, the prize money is usually added to the next round's winnings. In this case the expected payoff from buying a lottery ticket exceeds the cost of the ticket. Despite this, most people would view this as gambling.1 comment on this story
So what is the difference between gambling and the purchase of risky financial assets? A colleague of mine often jokes that gambling involves blinking lights and bells, while financial investment does not. A slightly more accurate assessment might be that gambling is the assumption of unnecessary risk. But what is necessary and what is unnecessary is not something on which everyone will agree.
Is participating in Intrade a form of gambling? Is day trading of stocks? I don't know the answer. But banning either on that basis is bad policy.
Kerk Phillips is an associate professor of economics at BYU.