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Kevin Smith

Iowa Exchange Project Proves Valuable Research Too

12 August 2003

Long before officials in the Department of Defense were caught with egg on their face when news broke about a proposed plan to create a futures betting market centered on terrorist activity in the Middle East, a group of professors in Iowa created what could be the world's first Internet based P2P betting exchange.

In all started in 1988 when a group of University of Iowa business and economics professors were watching the election results come in from the Michigan primary during the Presidential election. To everyone's surprise, underdog candidate Jesse Jackson won the primary. That got the group of professors wondering.

"It just started off as intellectual curiosity. Could a market do better than polls?" said George Neumann. "We knew nothing about polls and learned a lot along the way, it has been fun."

The fun evolved into the Iowa Electronic Market, which Neumann helped create.

The IEM was developed as an Internet-based teaching and research tool. It allows students to invest real money, $5-$500, and to trade in a variety of contracts.

The original market, and still the backbone to the IEM, is the political markets. Students can trade "shares" of political candidates or parties and the payoff depends on the election results.

Students, which essentially become traders on the exchange, also have the opportunity to trade in contracts whose eventual payoff depends on a future event such as an economic indicator, a company's quarterly earnings, a corporation's stock price returns or a movie's box office receipts.

Since its inception the IEM has proven an uncanny ability to predict various outcomes with greater accuracy then polls or surveys.

The IEM is the only real-money exchange of its kind in the U.S. and is able to circumvent U.S. gambling laws and regulations because it is operated by a University for educational and research purposes.

A common scenario with a trader on the IEM would be a contract on the percentage of the popular vote a particular candidate would receive in an upcoming election.

Shares, or futures contracts, are traded among students and people look at the prices to determine if the outcome of the contract is likely to happen.

If the contact is at .45 cents for a candidate and a trader thinks the candidate is going to win the election in terms of the popular vote, they can buy the contract for .45 cents. If the candidate wins the election by garnering 51 percent of the vote, the trader will make six cents off the contract.

Researchers are studying the effectiveness of a futures market in predicting events compared to traditional surveys and polls. The belief is that if a voter is asked whom he or she thinks will win the election by a pollster, they will answer with whoever they are going to vote for. In a futures market traders are trading on the actual probability of the outcome and not on who they hope will win the election.

"It is a heart versus head kind of contrast," Neumann said. "We are there for the long haul, while polls are relatively expensive to run and are very volatile early on. If you compared it to four months before an election we would be like three times as accurate as the polls."

The IEM got some unwanted attention last month after officials with the Pentagon released plans to launch a similar type of futures exchange, only traders would buy and sell contracts related to possible outcomes of international events. Contracts were to range from if the U.S. Embassy in Pakistan would be the target of a terrorist attack or if the Monarchy in Jordan would be overthrown. Within a day of the project being announced it was scraped after numerous Congressional leaders expressed displeasure and disgust over the idea.

The project was the brainchild of the Defense Department's Advanced Research Projects Agency (DARPA).

Officials with the IEM were more than a little familiar with the DARPA project.

There were two DARPA contracts, one to Net Exchange and the other to NeoTech. Net Exchange was providing much of the backbone for the system. NeoTech is a partner with MarTech, which is made up of four people who are with the IEM including Neumann.

"We were involved with them but I would like to think we are a little more sensible than them," he said. "It is a serious issue and what happened was a major screw up in public relations."

Net Exchange is comprised of faculty members and former graduate students out of Cal-Tech and come out of designing markets for auctions dealing with railroad leases where you have to put several pieces of something together in order to create something of value.

"We come out of the traditional IM market when people are concerned about this being gambling so we tend to be a little more reserved and discreet," he said. "There is this tremendous public opinion that gambling is bad and investment is good. No one thinks that investment is just placing a bet on a particular series of events."

Neumann said the DARPA project could have worked if the exchange was open only to a set of traders that had specialized knowledge in the area and if the traders were willing to share this knowledge through the mechanism of trading.

If the market were open to the public, which had been proposed for the project, it would have opened the exchange up to traders who didn't have specialized knowledge of the Middle East and wouldn't have been a valuable tool for predicting future events.

While there may not be an immediate future for markets related to terrorist activity, Neumann is confident other areas could benefit from creating a futures market.

"We think these kinds of projects are fundamentally interesting," he said. "We have gotten a lot of inquiries from other groups in healthcare and insurance who think they could use stuff like this to get information aggregated.

"In a variety of cases we need more information like this," he said. "A lot of people believe there is a need for more markets like this. Companies need to forecast sales of their products, insurance companies need to forecast what their liabilities will be. I think you will see an effort to get regulatory relief so companies can operate these markets if they are in the nation's interest."

Although his campaign for President of the United States fell short in 1988 and he didn't even get the Democratic nomination, Jackson’s effort contributed more than he ever would have imagined to the futures market industry.

Iowa Exchange Project Proves Valuable Research Too is republished from
Kevin Smith
Kevin Smith