Monday, 6 June 2016

Binary outcomes and Brexit bookies

The two ‘shocks’ of the last couple of days have been the Non Farm Payrolls kicking Fed expectation into longer grass and a swing in expectation back toward LEAVE in the UK EU referendum. I put the word ‘shock' in parenthesis because it wasn’t really shock shock, more an expected shock, as my last post focused solely on this occurring. . Fading swings in expectation appears to be the winning strategy this year but there are big differences to playing the Fed and Brexit.

Economic data is about tuning underlying views. There is a steady enough flow of it to think of it as the view out of your car's windscreen. A constant stream of little bits of information prompting you to tweak the wheel left or right to keep your car on the road. Every now and again we hit a bigger lump of data, such as the NFPs, which can act more like a moose in the road, demanding sharp avoidance action, but on the whole there is rarely a single piece of data big enough to cause half the cars on the road to crash.

But when it comes to politics things are different. Binary events are the market’s worst nightmare as they can cause instant death to positions. There is no room for avoidance. This loathing of binary outcomes is why the market tries to smooth the path to the outcome by gleaning as much information it can beforehand to make it effectively less binary. In other words to get the inside track on what the outcome will be.

Hence with the EU referendum in the UK, market participants are doing there damnedest to read the minds of the UK populace ahead of the vote with, we understand, fund managers commissioning their own pollsters to compile reports that they hope will give them the inside edge. Here one has to ask how, in such a tightly regulated market, the authorities manage that razor edge of a divide between insider trading and the application of ones own research. In many ways commissioning your own poll is no different from any institution doing its own economic research and hedging its risks based on that research. But in extremis, could an individual be accused of market manipulation for shorting GBP and then voting to exit the EU? No? If there were only 1 voter would you be so generous with your leniency? What if a group of voters realised that they could hedge out the financial risks of Brexit leaving just exposure to political gains? Or realised they could make much more in betting on an EU exit than they would lose economically over exiting? Or the whole of the UK LLC (the financial UK as a whole) pretend they are staying, bet against the rest of the world who are pricing a stay on what they are told, and then vote out? How can the rest of the world afford to take a bet when it's the bookie that chooses the outcome? That would be as nuts as taking out a LIBOR based loan without checking who sets LIBOR.

If Peaky Blinders were real and based in the present I am sure they would be making a killing rigging the Brexit market. Which reminds me of Barney Curley, a real life character who has been a master of playing and adapting the odds. A genius, as exampled in the case of Yellow Sam, where he monopolised the only telephone at the race course preventing on and off track betting prices from being smoothed.

And don’t forget that the bookies also have the final say on whether they pay out, even if you do win. In the case of Brexit I would be very surprised if any vote of less than 55% to Leave actually results in a leave. The ruling bodies, who are pro-Remain, will most likely invoke a masterly ‘We will not enforce such a momentous change on such a marginal majority’. This is now being mooted here -

With everyone so desperate for clues, it is easy to see feedback loops of information spiral away from reality like eddies from an oar. Who is watching whom. Opinion polls matter but market reaction and price moves are equally provoking. Instead of watching the underlying, people are watching the derivative in a belief that it drives the underlying. A very common mistake and example of the correlation/causality error. Just as a CDS does not define the actual probability of default, rather the market price of implied probability, where the bookies have the price of Brexit only reflects their opinion swayed by an average of all the bets placed with them. The financial markets are a larger example of the same, but with much greater liquidity. Differences in liquidity in markets that track each other is prime hunting ground for market manipulation. For example Mr Big Fund buys large amounts GBP puts, then goes to the bookies and places bets to Exit until the price has moved substantially (though of course actual outcome probability has not), the rest of the market see this as an indicator of actual outcome and sells GBP giving the fund a larger profit in FX than the cost of moving the bookie’s price.

The only way to really work out what is going on is to do your own groundwork. Don’t look at bookie prices, nor financial markets, but talk to your friends and family. Even though they may express biases the interesting juncture is picking up how their voting intentions are changing. It’s the feel of the fluctuation that is most telling.

If you need a living examples of the Prisoners' Dilemma and many other behavioural theories then the EU referendum encapsulates the lot.

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