Close your eyes with me and imagine…
Imagine a hypothetical material, call it plusevium. Plusevium is an unwanted byproduct of every industrial and economic process in the world; in fact, of life itself. This byproduct is so undesirable that those who produce it will gladly pay to have it removed and destroyed.
Now, imagine that there’s a small tribe of freaks who absolutely LOVE plusevium. They crave it. Can’t get enough of it. They desire it so much that they will gladly pay someone to manufacture it for them.
That would create quite an opportunity, wouldn’t it? Plusevium has negative value to the producers and positive value to the freaks – and one could make quite a business for oneself taking it away from the former and delivering it to the latter. Instead of destroying it and separately manufacturing it, what if we could recycle it?
I’m sure you can see the punch line coming…I think Plusevium is real.
It’s called “risk”.
The “producers” are insurance buyers, commodity hedgers, currency hedgers, hedge funds – anyone who pays a price to reduce risk in some way.
The “freaks” (no offense intended, I’m a proud one myself!) are gamblers – anyone who pays a price to increase risk in some way.
Note that these are not two distinct groups of people – one can buy insurance and lottery tickets at the same time. This is covered extensively in the literature on behavioural economics and risk preference theory but is not important to this discussion. The same person can be a “producer” in one context and a “freak” in another- it doesn’t matter.
So the billion dollar question is…how can we facilitate this transfer of risk from hedgers to gamblers in a way that’s more efficient than how things work today? If it were easy, I’d be on an island somewhere right now. A few things we’ll need to consider…
First, what the gamblers demand is not as simple as pure risk. They want entertainment to go along with it. Casino players want the atmosphere of the gaming floor. Sports bettors want the thrill of watching the game with action on it. Lottery players…well, that’s as close as it gets to pure risk. Perhaps the anticipation of the draw and the ability to fantasize about winning a big jackpot checks the ‘entertainment’ box?
Second, the domain has to be “low-information”. It doesn’t make sense to ask a gambler to be a counterparty to my life insurance policy because they can’t tell how good of a bet they’re getting without a lot of information (my complete medical profile) and the expertise to analyze it. In other words, no underwriting. Look what happened in 2007 in a high-information domain (default risk on subprime mortgages) when the underwriting was outsourced to rating agencies and the world economy collapsed. The ultimate low-information domain is a coin flip or a lottery draw (these would be zero-information domains), but those tend not to exist in the real-world risks that the hedgers are hedging. Is there anything that’s close?
Third, we have to be replacing something that is relatively inefficient. Institutional money can hedge their currency risk for a small fraction of a penny on the dollar. The general public pays 2-3% to do the same at a retail bank. Insurance companies charge margins of 10-50% to cover expenses and profit. We want a transaction that is high-friction. Unfortunately, high-friction tends to correlate with high-information.
Is there anything that fits all of these criteria? I have a couple of half-baked ideas. One is a slot machine where the random number generator is replaced with some function of micro-level fluctuations in the market for a commodity, currency or financial security. Another is some kind of gamified platform for weather risk where outdoor businesses like ski resorts and golf courses could offload risk. Weather derivatives exist today but they’re not very widespread or accessible to the public. Smart contracts (not mainstream) and betting exchanges (too limited in scope) also are close but not quite it.
Any ideas to get this idea across the finish line? Hit me up on Twitter!
Plus EV Analytics 