Did Intrade Do an MF Global?

By Rajiv Sethi, Professor of Economics, Barnard College, Columbia University. Cross posted from his blog

The peer-to-peer prediction market Intrade ceased operations yesterday and closed out all open positions without notice. Visitors to the site were greeted with the following mysterious message (emphasis added):

With sincere regret we must inform you that due to circumstances recently discovered we must immediately cease trading activity on www.intrade.com.

These circumstances require immediate further investigation, and may include financial irregularities which in accordance with Irish law oblige the directors to take the following actions:

• Cease exchange trading on the website immediately.

• Settle all open positions and calculate the settled account value of all Member accounts immediately.

Cease all banking transactions for all existing Company accounts immediately.

During the upcoming weeks, we will investigate these circumstances further and determine the necessary course of action.

To mitigate any further risk to members’ accounts, we have closed and settled all open contracts at fair market value as of the close of business on March 10, 2013, in accordance with the Terms and Conditions of our customers’ use of the website. You may view your account details and settled account balances by logging into the website.

At this time and until further notice, it is not possible to make any payments to members in accordance with their settled account balance until the investigations have concluded.

Translation: all open contracts have been closed out at current prices, account balances now reflect only cash positions, and no withdrawals can be made until further notice. Not a penny will be paid out to any member for the time being, no matter how large their cash balance may be.

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.

All this was made clear in the exchange’s so-called Trust and Security Statement:

Segregated Funds: Your funds are held in segregated accounts with banks in Ireland, and are segregated from Intrade’s own corporate funds.

Safer by Design: If the Dow Jones crashes, the New York Stock Exchange doesn’t go bankrupt. In the same way, intrade doesn’t lose money when an unusual result arises. Whenever you trade, intrade will ‘freeze’ sufficient money in your account to cover your potential losses. If you lose, we simply transfer the already frozen money from your account to a winning customer account. If you win, we pay your winnings from a losing customer account.

While this design is safe in theory, there was no mechanism in place to ensure that these commitments would, in fact, be met. When Intrade closed its doors to US residents in November, it did so in response to an action by the CFTC. I wondered at the time whether there was regulatory concern about the segregation of funds:

Even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

Similar concerns were raised in an exchange with Dave Pennock on twitter. I thought at the time that the biggest risk came from failures in the Irish banking system, and discounted the possibility that trader margin could be deliberately co-mingled with company funds, invested in risky securities, or simply embezzled. This may have been too optimistic a view, especially given the precedent of MF Global.

If some funds have been diverted or lost, then traders face the prospect of receiving less than par on their cash balances when withdrawals eventually resume. And even if they do not suffer eventual losses, the fact that their funds are frozen for an extended period itself imposes an opportunity cost. If there’s a lesson in all this, it is that markets cannot exist without trust, and trust cannot be sustained indefinitely without some sort of oversight and regulation. Reputational effects alone are simply not enough.

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  1. jake chase

    This doesn’t sound good, but I wish the writer had bothered to tell us what Intrade is, or perhaps I should say what Intrade was. It sounds like some kind of futures exchange in Ireland. What do they trade, potatoes? Is this regulatory arbitrage? Why are people trading anything tied to the Irish banking system, death wish?

    1. MacCruiskeen

      They were bookies. They allowed people to gamble on the outcome of events rather than the value of things.

      1. ambrit

        That’s sort of how the futures market operates, eh? Enough rain in the Ukraine and wheat futures fall. A bridge in the Congo gets the ax and egg futures are scrambled. Let’s not even get into Colombian Cannabis futures…

    2. Furzy Mouse

      As a former, mostly, futures broker, I am sad to see InTrade evaporate…a fun market!..during the last Pres election, it was quite accurate picking the winner, based on “crowd-sourced” volunteer voters/players making small, off-setting bets,,These were like futures contracts, having a settlement date, and an open interest of longs and shorts…Saw many trading possibilities, the per “contract” or margin quite reasonable..

  2. RueTheDay

    Jake – Intrade was a “prediction market” exchange. It allowed people to place bets on all sorts of non-sporting events, from the outcome of elections, to the weather, to legal case decisions and everything in between.

    It seems their auditors discovered that their late CEO and founder was embezzling money along with other “financial irregularities”.

    I was never a big fan of the concept. It seemed like yet another case of market fundamentalists trying to overextend their metaphor yet again.

    1. ambrit

      In other words, they got greedy and were caught “skimming.” Just like “real” gambling operations. (That’s one reason why Uncle Fidel threw the Mob out of Cuba.)

  3. Clive

    True story: My grandfather who died before I was born was, by all accounts a real wrong ‘un. I suspect that’s where I inherited my innate ability to play the system from, which is not really a trait to be proud of (but perhaps it’s a latter-day survival skill… anyhow, I digress).

    He was what was known as a bookies’ runner. In England at the time, off-course betting was illegal. So an early art of regulatory arbitrage emerged (there really is nothing new in the world, folks) whereby punters wanting to bet on the gee gees would hand over their cash to the bookies’ runner who would then, theoretically, go to the track and lay the best, legally, on course.

    The nefarious amongst you can spot the eminently scam-able potential here. If the bookie’s runner didn’t lay on the bet but instead kept the cash for himself, he could pocket the money as pure profit. Most bets are losing bets so the risk was in the runner’s favour.

    The snag was, what happened if the horse won ? Then, the runner would have to pay the person who had placed the bet. If he had sufficient “capital” (i.e. ill gotten gains from scamming the other punters) he could make good the loss. But of course, being in that line of business, he was more likely to have spent his “earnings” on booze and ladies of dubious reputation — or even the nags on the track too.

    The “recourse” for my grandfather’s unwitting “investors” was a sound beating up in a dark alley (don’t let anyone convince you that the North of England in the 1950’s was like a Downton Abbey with coal mines, oh no, it wasn’t like that at all, let me you).

    Well, those were the stories about my granddad. Little did I realise it, but there was Intrade’s business model. Grampy had beat them to it 60 years ago. Of course, he was an ill educated guy from the wrong side of the tracks and no better than he ought to be. They wear $2000 suits, have the whitest shoe law firms covering their backs and a nice wodge of hard assets in their wives’ names… As Christine Lagarde would no doubt say if she travelled in my sorts of circles, c’est la vie…

  4. steelhead23

    Hmm. Let’s see, the founder and CEO, one John Delany died trying to climb Mt. Everest back in 2011 and is reportedly still up there. Chances are, as a dead guy, he didn’t rip his customers off. My guess? Intrade suffered some losses for poorly worded contracts and absent we crazy Yanks, was short on the vig needed to keep the operation going. No problemo – grab some customer money to ride out the “low spots” and a bump in cash flow killed it. We Yanks need to thank our CFTC for running this outfit out of town. Let’s hear it for the regulators… YAAaaayyy. Actually, this is laudable only because it is so damned rare.

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