Copyright RISK, Vol. 8, No. 11, Nov. 1995, pp.11,12.

Idea futures invade Net

A burgeoning market trading on the World Wide Web may hold the key to one of the most common and least tractable of all market risks: the threat of competition.

An ill-informed strategic decision can scupper a companv just as effectively as a poor financial one. But by joining the 1,500 traders using "play money" on the Web market, a company could trade "idea futures" on a controversial topic. The pay-off depends on the topic's resolution as gauged by expert opinion, market share, election result or poll.

Recent underlyings have included the speed of next-generation PC processors and the popularity of cable versus telephone connections to the Internet.

Idea futures were first proposed in the early 1990s by Robin Hanson now a doctoral student at the California Institute of Technology, who suggested that unorthodox scientific or technological ideas which failed to attract conventional funding could be paid for from bets placed on their future viability.

"Such betting markets," he wrote, "would become idea futures markets - like corn futures markets except you'd bet on the future settlement of a scientific controversy instead of the future price of corn."

Assets whose appeal derive from an underlying idea are nothing new. Richard Sandor, chairman and chief executive of New York-based Centre Financial Products and founding father of Chicago's financial derivatives markets draws a link between the junk bond market and the entrepreneurial businesses it has financed. "Basically, CNN was an idea future: the thought 15 years ago that you could have a network over the [entire] planet was unheard of and the bonds and money that [Ted Turner] borrowed in the junk market were essentially idea futures."

One recent example was the initial public equity offering by Netscape Communications, a manufacturer of Internet browsing software, which opened at $28 but rocketed to $71 the next day, despite having few fundamentals to recommend it.

But, as Hanson points out, a Netscape investor is buying into a number of individual premises: that the Internet is important, that browsing software is the way ahead and that Netscape will con- tinue to dominate the market. He believes a dedicated idea futures market could refine the available choices.

Sandor agrees: "This really is a wonderful way to divide information into sensible categories so that people can make economic decisions."

Ideas can be used to hedge as well as speculate. For example, a video-cassette manufacturer tied to the defunct Betamax home video format for contractual or strategic reasons could have hedged with idea futures in the now ubiquitous VHS.

Useful though they may prove, a real-world implementation of idea futures will not be simple. The main difficulty is that in their current form they only loosely fit the usual definition of a derivative: an instrument whose value is linked to that of some underlying asset. For an idea future, the underlying "asset" may be poorly defined and its value still less so.

Assuming standardisation is possible, the market must develop a freely tradeable instrument. One possibility is to structure a note with an embedded option which generates a cash payout if the idea proves successful.

Another is to offer investors participation in the company's equity via stock options which kick in as the idea takes off.

At the moment, the Web market does not trade in real money. While this gets round US gambling laws, it also ensures the market remains little more than an interesting model. The stress created by putting hard cash at stake is likely to be significant.

Mr. Sumit Paul-Choudhury

The idea futures market can be found at