OFR advocates prediction markets to help identify systemic risk issues old-school monitoring might miss

Nov. 19, 2020 — The Office of Financial Research is telling the U.S. Congress that the development and use of information markets as a tool for anticipating and managing financial systemic risk would be a valuable complement to the current surveillance system.

In light of the fact that two and a-half dozen high-profile financial stability reviews 2019 failed to recognize a potential pandemic as a threat, conventional monitoring can come up short, according to the OFR, an arm of the U.S. Treasury Department.

“The pandemic illustrated the difficulty for conventional financial stability monitoring to identify true vulnerabilities,” the OFR’s annual report stated.

An information or “prediction” market for systemic risk, where participants who have superior information are rewarded financially while weaker-sourced individuals who wager lose could help reveal hidden information that might forecast or contribute to financial risk, the OFR suggests.

This information might otherwise be costly to ferret out or retrieve, the report’s authors say.

Information or prediction markets are a type of informed wagering with trading done between and among parties looking to make money off the outcome of the way an event breaks or what happens in the future to any number of scenarios. Major U.S. corporations have used them but regulatory barriers remain for wider use, apparently.

“Information markets might facilitate a more suitable allocation of those risks, and thus reduce the chance for systemic crises to emerge,” the paper states. They may also make a market more resilient, as well, according to the thinking, based on some renowned economists’ theories.

Such markets can help to produce forecasts of event outcomes with a lower prediction error than conventional forecasting methods and have been shown capable of producing more accurate and timely signals of weakening financial stability,” argue academic articles, as quoted by OFR. Other citations follow with the same general thesis.

The OFR, which was created under the Dodd-Frank Act a decade ago with a charge to give a report annually to the federal legislators that created it, also noted the obvious — that COVID-19 pandemic has affected all systemic risk categories and increased overall market uncertainty.

The categories the OFR deems high risk now are macroeconomic risk, with potential inflation caused by government intervention and credit risk from highly leveraged corporations, with the potential for defaults and bankruptcies.

Market risk is elevated, but not high, with help from the Federal Reserve, but that could change if valuations rise for not-so-healthy assets, the paper warned.

On the moderate risk scale are liquidity and funding, also helped, along it the markets, by the Federal Reserve’s stabilization efforts, according to the OFR. This also could change.

However, codependence between large providers and users of short-term funding remains a key vulnerability.

On the low end of the risk assessment scale is leverage in the financial system itself, while insolvency and octagon risks “appear contained,” the OFR said. Fortunately, leverage in the U.S. financial system has been restrained since the last financial crisis.

For insurers and banks, the capital buffers now in place “appear to provide an adequate cushion for unexpected losses” in the short term, at least.

The risk posed by cybersecurity threats, natural disasters, Brexit and the transition this fall to alternative reference rates from the old LIBOR system are also potential vulnerabilities are for financial stability overall, the OFZR notes.

The paper also mentions the development of quantum computing presents a longer-term risk.

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