Simply Efficient Markets and the Role of Regulation: Lessons from the Iowa Electronic Markets and the Hollywood Stock Exchange

I. INTRODUCTION The conventional view of the mechanisms of market efficiency focuses on large numbers of market participants, at least some of whom are well informed.1 But what if this seemingly obvious and simple mechanism, or requirement, is in fact unnecessary? My aim here is to suggest that efficient markets may in fact be much simpler than normally imagined. The real question, as we will see, is how our understanding of simple markets, with small stakes and modest numbers of players, affects our understanding and regulation of thicker and more complex markets. II. FANTASY MARKETS Consider, as a starting point, the Iowa Electronic Markets, or IEM, which may be familiar to many readers because of its presence in the news during U.S. Presidential election campaigns. IEM is a controlled environment, or experiment, operated by the University of Iowa Business School, which allows participants to invest modest amounts of (real) money in certain "decision markets. "2 An individual's investment is limited to five hundred dollars; imaginative players could, no doubt, use multiple personalities and credit cards to avoid this limit, but it is unlikely that many players do so. The IEM opened in 1988, and offered trading in but one thing, the expected fraction of the popular vote candidates would receive in the November U.S. Presidential election. The Exchange issued securities that promised to pay $2.50 multiplied by whatever share of the vote a specified candidate received on Election Day as reported by the Associated Press the following morning. Thus, if on the Wednesday following the election one held a share of Bush, and Bush received 54% of the vote, then the shareholder would have received . 54 x $2.50 = $1.35. (And, in fact, the last trades on the eve of the election were at $1.34). 3 As late as the day before the election, shares were bought and sold with respect to the expected vote share of Bush, Dukakis, Jackson and a fourth package, as it were, representing the combined share of the vote to be received by the minor candidates who formed the rest of the field. Under the terms of the originally issued shares, there was no payoff at all for shares of candidates who withdrew from the race, but of course these four packages each produced some payoff. The IEM itself made no money and took no position on candidates, nor has it become a profit-seeking enterprise in the subsequent fifteen years. IEM initiates markets by offering (an unlimited number of) bundles of all known alternatives. The price of the initial bundle is of no consequence, though the IEM quickly moved to bundles priced at $1.00. Buyers can of course unbundle the candidates and help form markets in individual candidates.4 For example, if the IEM makes a market in a political election with two known candidates, D and R, it offers, for $1.00, two pieces of paper, representing these two candidates. D plus R will of course garner 100% of the vote. Over time and up to the election, shares of D and R will sell separately, because the original buyer can separate them, and we can expect the price of one D and one R always to sum to $ 1.00-apart from some small discount to reflect the time value of money.5 IEM continues to issue and facilitate trading in shares of this kind, but it has also added more popular winner-take-all shares.6 Again, as the issuer, it offers shares in bundles priced at $1.00 each, but the new and far more popular promise is that each share associated with the winning candidate will be redeemed for $1.00 after the election, with all other shares regarded as worthless. Both sorts of bundles could contain all possible candidates, but in fact the trading is in shares of the two major party candidates, with the final vote extrapolated upward to reflect any third party vote. If Candidate D gets 55% of the votes that are cast for the two major candidates, then the "old," or market share, IEM pays $0.55 to holders of D paper, and the "new," or winner-take-all, IEM pays $1. …