Is The Geopolitical Risk Futures Market Concept Dead?  Don’t Bet on It.

One day it’s a news item: DARPA (Defense Advanced Research Projects Agency- part of the US Department of Defense) seeks several million dollars of congressional funding to launch a trial Geopolitical Risk Futures Market in conjunction with two commercial partners, Net Exchange and the Economist Intelligence Unit.  The next day, a political firestorm sweeps the US Senate, and the project, or at least DARPA’s involvement in it, dies.

But is it dead?  Good ideas- especially those based on a legitimate need- have a way of re-emerging and being implemented sooner or later. And we think a Geopolitical Risk Futures Market is a good idea.

In our opinion, the concept died primarily because of “moral outrage” expressed by politicians seeking the next sound bite on the evening news. And on the surface, the Geopolitical Risk Futures Market concept was an easy political target.  In the sixty-second coverage most news stories receive these days, who could defend a new financial market (funded in part by US taxpayer money) that would permit traders to speculate and profit on adverse moves in a country’s geopolitical risk index caused by war, civil strife, famine, government coups and other events that often result in human suffering and death?

What the news stories missed was the fundamental driving force- the legitimate need, if you will- that makes this concept not only a good one but a compelling one, too.  Futures markets emerge and thrive whenever an old order or system for controlling (or negating) risk fails.  The currency futures markets are a direct result of the failure in the early 1970’s of the Bretton Woods Agreement, crafted by the Allies in the final year of World War II to maintain stable exchange rates in a post-war global economy.  The development of energy futures markets reflected the “de-integration” of the global oil industry through the mid-20th century as oil-rich nations appropriated production assets, nationalized reserves and created an oil cartel.  The “Seven Sisters” of that era (Esso, BP, etc.), who no longer dominated production or controlled supply, were forced to move from transfer prices to market prices for their oil requirements.  The oil futures markets allowed them and other market participants to manage these new price risks.

For Geopolitical Risk Futures, the legitimate need is a dramatically changed geopolitical order since the decline and collapse of the Soviet Union beginning in the late 1980’s. The bipolar world that preceded its collapse (along with the Cold War) created a number of adverse and perverse effects.  The worst of these being that, in exchange for some global order, we all sat on the edge of Armageddon and tolerated lengthy and bloody proxy wars in some of the poorest nations on earth. But for 45 years, it was a workable system for controlling many elements of global geopolitical risk in a nuclear age.   In the wake of the Soviet Union’s demise, it initially appeared that a unipolar world order would emerge, with the US (directly, or under the guise of NATO) as the world’s hyperpower. And events during and immediately following the first Gulf War seemed to confirm this model.

In contrast, events of the past several years have demonstrated that a unipolar model is probably not viable.  The recent Iraq war demonstrated that many of America’s traditional Cold War allies- as well as major non-aligned nations- prefer the risks of a multi-polar world order to the risks of domination by a hyperpower.  If this analysis is correct, a market in geopolitical futures is as logical as the development of currency or energy futures markets in response to the failure of their old risk management systems.

Some argue that there is no real need for a market in Geopolitical Risk Futures given the existence of other futures markets, such as energy and currency futures, where prices should incorporate and reflect country-specific geopolitical risk. But the former fails to capture most aspects of country-specific risk; and the latter, while reflecting a specific country, suffers from other shortcomings in terms of capturing true geopolitical risk. 

What shortcomings?  Basis risk is probably the biggest: Currency rates are leading indicators of national economic health in terms of balance of trade, current account balances, export earnings, foreign exchange reserves, inflation and real interest rates, and so on.  But they are poor leading indicators of important non-economic factors such as the stability of and internal support for established political regimes, or a country’s commitment to the rule of law and establishing institutions to punish corruption. In addition, some of the riskiest countries prohibit or severely restrict the convertibility of their currencies.

In hindsight, DARPA’s funding of a Geopolitical Risk Futures Market test was a mistake. It created the opportunity for a hot news story including reports that this futures market would allow traders to take direct bets on likely assassinations of leaders in Middle East countries (and this, during the intensive manhunt for Saddam Hussein and the killing of his two sons).  In fact, the parties involved in the development of this concept had worked hard to create a political stability composite index for each country based on a number of objective, measurable and transparent metrics. And to DARPA’s credit, they recognized the important role that financial markets play in assimilating and processing (on an instantaneous basis) the views, opinions and latest information of all participants.  To the extent this could provide a leading indicator of potential geopolitical trouble, it can be an important risk management tool- especially in a multi-polar world where the old rules for geopolitical risk management no longer apply or work.

Jim Finnegan

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