Vernon Smith sees an age of people creating derivatives markets on public policy outcomes.

Question: How do derivatives markets help businesses manage risks and how do they help the common man?

Vernon Smith:  They’re a form of hedging risk and they’re essentially what in experimental economics what we call an information market and you know our colleagues at the University of Iowa innovated information markets back in the 1980s.  They introduced the kind of market where people could make for example trade shares on the outcomes of political elections and that created a market in which the price of the traded shares gave you a market estimate of the chances that a particular candidate would win a political election. It was call the Iowa Electronic Market and the first one actually was a presidential market and it was the 1988 election and that started then a movement toward creating markets on all kinds of political and economic events and in particular it provides you see a form of market that can make a forecast or a market indication of what the chances are of a particular event happening like a default on bonds, default on mortgages, default on the for example the sovereign bonds.  You have now markets that, derivatives markets that give you an idea of the chances that the Spanish government will default on its bonds or the UK government of the U.S. government and it seems to me these entirely legitimate forms of markets, but they ought to be collateralized.  And I think that’s the most important lesson we’ve learned from the housing market debacle. 

Question: What do you believe might be the next application of derivatives and how might this change the way we live?

Vernon Smith:  So far as new applications of derivatives markets I think one possibility is we may see more people making, creating derivatives markets, betting markets on policy, public policy outcomes.  We’ve already seen that with regard to the Federal Reserve.  There is a market now in which people are able to make, take positions on the likelihood of a change in the Federal Reserve Bank policy at their next meeting of the Federal Open Market Committee, so and these markets are concerned with the question of what the Federal Reserve Bank rate will be set at.  So I think we may very well see more of these kinds of markets and this could very well provide some indication of how the participants in these markets evaluate some of the policy proposals that governments are making. 

Recorded on December 17, 2009