A Prediction Market Mystery

The peer-to-peer prediction market Intrade ceased operations yesterday and closed out all open positions without notice. Visitors to the site were greeted with the following mysterious message (emphasis added):

With sincere regret we must inform you that due to circumstances recently discovered we must immediately cease trading activity on www.intrade.com. 

These circumstances require immediate further investigation, and may include financial irregularities which in accordance with Irish law oblige the directors to take the following actions:

• Cease exchange trading on the website immediately.

• Settle all open positions and calculate the settled account value of all Member accounts immediately.

• Cease all banking transactions for all existing Company accounts immediately.

During the upcoming weeks, we will investigate these circumstances further and determine the necessary course of action. 

To mitigate any further risk to members’ accounts, we have closed and settled all open contracts at fair market value as of the close of business on March 10, 2013, in accordance with the Terms and Conditions of our customers’ use of the website. You may view your account details and settled account balances by logging into the website. 

At this time and until further notice, it is not possible to make any payments to members in accordance with their settled account balance until the investigations have concluded.

Translation: all open contracts have been closed out at current prices, account balances now reflect only cash positions, and no withdrawals can be made until further notice. Not a penny will be paid out to any member for the time being, no matter how large their cash balance may be.

What on earth is going on? My best guess is that the margin posted by traders was not held, as it should be, in segregated accounts separate from company funds. When bets are made on this market, both parties must post margin equal to their worst-case loss, so that neither is subject to counterparty risk. In effect, each party is taking a position against the exchange, but these positions are exactly offsetting so the exchange bears no risk. To ensure that all promised payments can be made, these funds must be held in the form of cash, insured deposits, or safe dollar-denominated securities such as Treasury bills. They cannot be invested in risky assets, and cannot be used for the payment of salaries or expenses.

All this was made clear in the exchange's so-called Trust and Security Statement:

Segregated Funds: Your funds are held in segregated accounts with banks in Ireland, and are segregated from Intrade's own corporate funds. 

Safer by Design: If the Dow Jones crashes, the New York Stock Exchange doesn't go bankrupt. In the same way, intrade doesn't lose money when an unusual result arises. Whenever you trade, intrade will 'freeze' sufficient money in your account to cover your potential losses. If you lose, we simply transfer the already frozen money from your account to a winning customer account. If you win, we pay your winnings from a losing customer account.

While this design is safe in theory, there was no mechanism in place to ensure that these commitments would, in fact, be met. When Intrade closed its doors to US residents in November, it did so in response to an action by the CFTC. I wondered at the time whether there was regulatory concern about the segregation of funds:

Even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

Similar concerns were raised in an exchange with Dave Pennock on twitter. I thought at the time that the biggest risk came from failures in the Irish banking system, and discounted the possibility that trader margin could be deliberately co-mingled with company funds, invested in risky securities, or simply embezzled. This may have been too optimistic a view, especially given the precedent of MF Global.

If some funds have been diverted or lost, then traders face the prospect of receiving less than par on their cash balances when withdrawals eventually resume. And even if they do not suffer eventual losses, the fact that their funds are frozen for an extended period itself imposes an opportunity cost. If there's a lesson in all this, it is that markets cannot exist without trust, and trust cannot be sustained indefinitely without some sort of oversight and regulation. Reputational effects alone are simply not enough.