Influence Of Information Markets Spreading In Finance By Spencer Jakab Of DOW JONES NEWSWIRES 1095 words 8 April 2005 01:17 PM Dow Jones International News NEW YORK (Dow Jones)--Investment professionals often warn us about the madness of crowds, but they've recently begun to give them newfound respect. The spreading influence of information markets, in which participants with any degree of expertise can make a monetary bet on the outcome of a quantifiable event such as a data release, has given forecasters a wake up call and has become a growing profit center for a pioneering group of brokers. "We're strongly resisting the temptation to grow this too quickly," said Bill Cassano, a vice president in Goldman Sachs Group's (GS) economic derivatives group. Goldman, along with Deutsche Bank AG (DB) and, in the energy field, ICAP PLC (IAP.LN), have now rolled out derivatives for seven leading economic indicators and two major data points for U.S. energy markets. In the economic field, the auctions now cover payrolls, the ISM survey, retail sales, advance GDP, the trade gap and jobless claims. Cassano said that derivatives covering the consumer price index will be launched soon. In the energy field, an auction was launched last summer covering the outcome of the federal Energy Information Administration's weekly natural gas storage report, followed later in the year by an auction on the EIA's petroleum inventories report. "There's many axes for this to grow on," said Cassano, who surmised that the burgeoning appetite to hedge specific event risk could eventually extend to areas like individual company earnings announcements. As the popularity of economic derivatives spreads, Cassano predicts that early movers such as Goldman, Deutsche and ICAP will be able to retain a healthy share of a much larger market. "We believe that this will eventually turn into an over the counter market, and when that happens, the people that were involved first will be in a great position," he said. Escaping The Ivory Tower Information markets are behind the parimutuel nature of betting on many sporting events, creating a virtual market in which gamblers influence the perceived odds through their own bets and also finance the payouts of winning participants. This lets gamblers have an idea of the probabilities while taking financing risk away from the facilitator of the bets. Academics and gamblers have long been interested in such markets, but the investment community was initially slow to catch on. "Everybody's skeptical at first - it's new, it's different - but people quickly get excited about it," said Cassano. Even for many traders who don't participate yet, the auctions are now seen as a better measure of market consensus than traditional opinion surveys. An accurate measure of the consensus ahead of a report has value, as it allows traders to judge the likely reaction to a surprise outcome. "It's attained critical mass as a source of market sentiment," said Patrick Morgan, who administers the natural gas and crude inventory auctions for ICAP Energy. A September Goldman Sachs study showed, for example, that the standard deviation of implied ISM expectations from their auction was just 1.56 versus 1.95 for a consensus survey of dozens of leading economists and an even higher 2.19 for Goldman's individual forecasts. A similar pattern is evident for payrolls auctions, according to the same research. Energy traders have also concluded that the weekly auction for natural gas futures is unusually accurate, beating individual forecasts and surveys such as those conducted by Dow Jones Newswires. The longest-running experiment illustrating the accuracy of information markets versus straight consensus estimates is the Iowa Electronic Marketplace, which has beaten nationwide polls in predicting the outcome of presidential elections. "We've found that our markets tend to predict election outcomes better than polls," said Joyce Berg, an associate professor at the Tippie College of Business at the University of Iowa and a director of the program. "In surveys and polls, people don't have an explicit requirement to be accurate and honest," she explained. "In a market, people express strength of belief." There Are Limits Free enterprise advocates see huge promise in extending decision markets into the policy arena and more broadly into the business world. Robert Hahn, a resident scholar at the American Enterprise Institute, wrote in a recent paper that "information markets combined with pay-for-performance contracts have the potential to revolutionize the way the government, the nonprofit world, and the private sector do business." He gives as an example an information market to predict the number of HIV-infected people in Africa in 2010 to determine how to best allocate development aid today. But some applications of information markets have run into resistance. For example, the proposed Policy Analysis Market touted by a group within the Pentagon to more accurately predict geopolitical risks by creating a financial futures market in events such as political turmoil or terrorist attacks was quickly shot down on public relations grounds. With financial applications expanding, the predictive abilities of economic derivatives may have limits depending on what kind of data are being analyzed. In the energy field for example, the natural gas auction has been far more accurate than the crude oil inventory auction. "The gas auctions have done a good job of being predictive of the storage levels," Cassano said. "I don't think that every auction is the definitive view of oil yet." When it comes to oil, the auction can miss the actual inventory number by a large margin. That's because the auctions, while a better measure of consensus than surveys, still rely on the ability of auction participants to correctly forecast the number at issue. "What we find - and we find this in everything - is the auction tends to be directionally very good (but) it tends to be gravitationally pulled toward the survey," Cassano explains. Data points with more moving parts like oil are just harder for individuals to guess than gas, ICAP's Morgan said. Goldman's economists point out the same difficulty for typically volatile jobless claims. Finance professionals don't claim to have invented a crystal ball, but they've succeeded in creating a product that shields investors from specific events. Given the seemingly endless flow of data that buffets financial markets on a daily or even hourly basis, the auctions introduced so far may well just be the tip of the iceberg. "The question may be what won't be covered," Morgan said. -By Spencer Jakab, Dow Jones Newswires; 201-938-4377; spencer.jakab@dowjones.com