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Markets for the Digital Generation

As reported by Andrew Orlowski in The Register (thanks to Chris for the pointer), it seems that the Commons Culture, Media and Sport Committee’s Second Report on Ticket Touting (published last week) while tepidly accepting that a secondary market in tickets is a good thing (or at least not unambiguously the spawn of demons) - has at the same time recommended a secondary market tax in favor of primary market incumbents:

British MPs who oversee the Department for Culture, Media and Sport are a sensible bunch, with a keen eye for special pleading. But they’ve erred badly today. In a report on online ticket touting, the MPs have today given a strong recommendation for a levy on the resale of tickets for live events. (Report here.)

Resellers - and therefore punters - will be forced to pay this levy, and a levy collection agency would need to be established to distribute the tax. There’s no recommendation that the levy is returned to performers, as the MMF (Music Managers’ Forum) has proposed. As it stands, the levy will merely oil the machinery of the primary market: the promoters and their agents. This is a quite amazing stunt to pull off - and should serve as a wake-up call to everyone…

…there’s a very healthy after-market for tickets, sold through auction sites such as eBay and bulletin boards such as Gumtree and Craigslist. This is exactly what the internet is supposed to be good at: eliminating wrinkles caused by consumers having a lack of information. And it works very well.

Yet the major promoters have very nearly succeeded in banning this market outright. Instead they’ve won themselves a “right” not enjoyed by book authors, songwriters or composers - or even the RIAA! (Authors, publishers and record companies don’t get a cent from the second-hand sales of books and records.) …

The Committee said it wants the secondary market to continue, and declared itself reluctant to intervene. But it did so anyway, giving credence to a long laundry list of grievances raised by the mega-promoters, including Harvey Goldsmith. Goldsmith wants to extend his huge market power in the primary market by banning the secondary market, and does so by conflating issues such as fraud with touting. Of course, there’s already legislation in place to deal with fraud. But the ticketopolists want to fight fraud the cheap way: getting us to pay a tax, rather than using better technology or employing a few more people to check against abuse. And in this case, they’ve won an improbable victory.

I’ve only had the chance so far to read the summary or the report (but have printed out the whole c. 200 page pdf to read later) but I can’t for the life of me figure out how they managed to reach their final recommendations, which seem to contradict their own findings (!):

While the superficially obvious solution—of increasing ticket prices to whatever level the market will bear—might keep all the potential profit within the industry and effectively eliminate the secondary market, it would run counter to the industries’ pricing policies which aim to make tickets affordable by their grass roots and genuine fans upon whose continuing interest and attendance the long term wellbeing of the industries depends. [Give me a break!!! There are so many holes in this argument I don’t know where to start…] We did not receive any evidence from the grass roots or fan bases complaining that they were unable to obtain or afford tickets for their chosen events…

…We also believe that the existing situation whereby large profits can be made on the secondary market with no benefit to the organisers or owners of the primary rights is unfair and must be addressed. [Why????? Change the primary market price if you think it is wrong!!!!] …

…We welcome the initiative of the Music Managers Forum to seek agreement for a voluntary scheme under which sellers of tickets in the secondary market would pay a proportion of the profit to the original organisers to be distributed in the same way as the original amount paid. In return, the organisers would recognise the legitimacy of the secondary seller and not seek to invalidate the ticket being sold. [So the secondary market participants pay the primary underwriters for their inability to correctly price and risk manage their inventory…wow. Wow! All I can say is I wish we had that kind of mechanism when I was underwriting bonds for a living!] Such a scheme would recognise the right of those in the entertainment and sports industries to a share in the profit made by others out of the events for which they are responsible in the same way that creators of artist works now benefit from sales of their works through resale royalties. We believe that a scheme of this kind offers the best chance of meeting the concerns of event organisers while still allowing the secondary market to operate unfettered and we strongly encourage all those involved to consider it seriously.

May I suggest an alternative model? A simple one. Liberalize and regulate the secondary market. Full stop. Fraud and manipulative and abusive trading is proscribed with both criminal and civil penalties depending on the situation (analogous to securities markets.) And the market decides. I guarantee you the world will not come to an end. Events will continue to be underwritten. Artists and performers will end up being fairly paid (sometimes a lot more, sometimes a bit less but closer to “fair market value” in all cases), consumers will be happier, and underwriters and distributors will make a decent living and innovation will thrive.

The crowning irony is that folks like Mr. Goldsmith would probably continue to be very successful - and the Sharpe Ratio of their business vastly improved - in such a new world. After all they still have their relationships which in an efficient electronic market paradigm generally become even more valuable insofar as they cannot be industrialized and yet can be monetized against a much more efficient infrastructure. But fear and habit are powerful ghosts…and change is well, scary. Like the recorded music industry before them, rather than clinging for dear life to the status quo, major promoters should be leveraging their position of market knowledge and leadership to participate and profit from change: partnering with and investing in innovative new participants and business models. And not leave it until it is too late.

I just wish I had know about the report. I would have liked to submit my Tickets & Markets Part 1 and Part 2 as evidence…

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The emergence of the euphemistically labeled ’sovereign wealth funds’ as (the) major players in global capital markets was one of the stories of 2007, brought home in the latter part of the year by some massive investments in major global banks (such as Citigroup and UBS) who were looking to quickly shore up their capital bases following their widely reported asset write-downs. A story which is continuing into 2008 with both Citigroup and Merrill Lynch (and almost certainly others) in the process of finalizing additional capital injections (mainly) from these investors:

(from The Economist) The risk of a big bank going under has receded as $27 billion (and counting) of capital has flowed into the sector from sovereign wealth funds. Recipients include Merrill Lynch, Citigroup, Morgan Stanley and Switzerland’s UBS (or, as wags now call it, Union Bank of Singapore). These injections may have upset existing shareholders, who have seen their stakes diluted, but they have ensured that although big lenders have wobbled, none has toppled.

(from Times Online, link above) [Merrill Lynch] is however in talks to raise up to $4 billion of fresh capital, with the KIA understood to be one of the big investors in the latest consortium. The Middle East sovereign wealth fund is reportedly also prepared to invest up to $3 billion of the $15 billion of new investment Citigroup wants to raise under Vikram Pandit, its newly installed chief executive.

Chinese state-backed investment funds or banks are expected to stump up collectively another $9 billion for Citigroup, which ousted Chuck Prince as its chief executive late last year after having to take multibillion-dollar writedowns on its balance sheet. The remainder is expected to come from public market investors.

Last month Merrill agreed deals to raise up to $5.2 billion from Temasek, the Singapore government-owned fund, and $1.2 billion from Davis Selected Advisors, the US asset manager. In November the Abu Dhabi Investment Authority, the investment arm of Abu Dhabi, injected $7.5 billion into Citigroup, in return for a 4.9 per cent stake. Last month China Investment Corproration, agreed to inject $5 billion into Morgan Stanley in return for a 9.9 per cent stake.

So just for argument’s sake, let’s say these investors are going to invest c. $50 billion (give or take a few…billion) of capital into these financial institutions. It obviously begs the question: why? A cursory analysis I believe throws up a few possibilities:

• Because they expect to earn a good risk-adjusted return on these investments over the medium term.
• Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
• Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
• Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.

I figure that it is probably some combination of some or all of these factors. Let’s take them one at a time.

Because they expect to earn a good risk-adjusted return on these investments over the medium term.
This should - and probably is - the main reason. Classic distressed play: solid underlying business and franchise with one-off (solvable) problems creating a buying opportunity for investors with ‘patient capital’ - a medium to long term horizon (something that these funds ostensibly have.) I wouldn’t pretend to have done any sort of modeling (rigorous or otherwise) to have an opinion on the specific investments being made (and prices being paid) but wonder at a high level whether modern global (investment) banks are good long term investments (at any price.) I will come back to this point in a subsequent post. (Of course if these investors are looking to trade out of these positions over 12-36 months, my scepticism is much less relevant.)

Because they can: ie this is a rare opportunity to deploy substantial amount of capital without moving the market against you.
This may sound naive but is actually pretty important. Managing tens or hundreds of billions of funds may sound easy and fun (the world is your oyster) but as any good fund manager (hedge, sovereign or otherwise) knows, in many markets and instruments, size can be a curse on two counts: firstly, finding investments that are big enough to ‘move the needle’ - ie make a difference to the overall returns of the fund; and secondly, having identified such an opportunity, actually being able to execute without overwhelming the market and/or incurring such high transaction costs that the returns effectively disappear. In this sense, beggars can’t be chosers works both ways: you take what’s on offer (at least whatever seems at least somewhat reasonable.)

Because there are additional ’strategic’ and /or ‘political’ benefits (over and above the expected financial returns.)
Perhaps. I’m not really qualified to say, although I suspect that if the above two conditions are met, this is probably the icing on the cake (as opposed to the driving consideration.) As the sovereign wealth funds quickly grew in size, number and ambition (in particular straying out of bond markets into public and private equity) over the past few years, much of the political and business establishment in the developed world was growing increasingly anxious about what they saw as the potential of their economies and national corporate champions being unduly influenced by foreign governments. (Without I might add seeing the irony…) These funds as a result face(d) a real risk of being shut out of many potential (large) investment markets. Taking into account the challenges they already faced with respect to their size (see above) this would be disastrous. Bailing out key major financial institutions should in principle be a great way of keeping the door open and building political goodwill.

Because they are major customers of these firms and they want to build even closer relationships and share in the upside of their own custom.
The Victor Kiam gambit: “I liked it so much, I bought the company!” Maybe. Although the basis risk is huge and the potential for conflicts of interest enormous.

So if you had $50bn burning a hole in your pocket, would you do the same trade(s)? While based on my framework above, I can see what might be driving these investors, I’m not sure I’d do the same. Even if the goal is only to take a short term (1-3 year) “trading” view on valuations, there are probably better (ie more liquid, less risky) ways to express such a view even for the size. Some background on my view in Part 2.

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For those of you who aren’t prediction market enthusiasts, there is a vibrant community that has developed - much of it manifested online - over the past few years. Like many such emergent communities, there is much passion amongst the members for there chosen area of focus. Generally this is a good thing but is not immune to excess from time to time as some of this passion occasionally splills over into what might fairly be described as zealotry. I guess I would consider myself to be a member of this community, probably somewhere towards the middle or the back of the room: trying to follow the main plots, absorbing quite a bit of information and occasionally asking a question or making an observation. So in this micro-context, on the spectrum from zealot to reactionary sceptic, I’d probably be halfway between the middle and sceptic; however if you choose the general population as your sample, I’d be close to the zealot camp. Everything is relative.

But - much as I entertain a similar passion for the potential power of markets in “predictions” as many of the leaders of this movement, I have to chuckle when I run across some of the more - shall we say “emotional” discussions within this community. Again while this is a common characteristic of most new ‘movements’, and in no way unique to passionate prediction market proponents, it is still funny to see this community’s People’s Judean Front and the Judean People’s Front equivalents bash it out on the airwaves so to speak.

And of course there is a small fringe that is keen to control the terms of engagement - the quintessential ‘rule-writers’, often obsessing about semantics and making sure that everybody innovates but only in the ‘right’ way. Another irony - from my point of view - is that many (perhaps most?) of the most active, eloquent and committed members are American (or more relevantly based in America), where of course the wise people in Washington, DC make it as hard as possible to run said prediction markets without risking 2-5 years… Actually, when you stop to think about it this is actually less surprising than at first glance: repression is a great catalyst to passion. (Thank goodness!)

Anyhow, last week’s Clinton victory in the New Hampshire primary has thrown this community into a tizzy…sort of like kicking an anthill…many many column inches have been written defending, deriding and analyzing the fact that the ‘(prediction) market(s)’ got it WRONG! ie Didn’t accurately predict the outcome - indeed they were no better than the POLLS! Oh the shame…

Well - and I suspect many others have already made the same observation so I make no claims to any original insight - this line of reasoning misses the point entirely in my opinion. The ‘failure’ of New Hampshire was the result of primarily two factors:

1. It wasn’t a failure. No market is always right. More importantly markets reflect the information available to and the interests of their participants. Basically markets are very efficient mechanisms (I would claim the most efficient) for processing information. No more, no less.
2. In this particular instance, the probability of the market producing an erroneous forecast was high due to the lack of liquidity. This is a problem of all political markets in the US. Show me a market on the New Hampshire primaries with tens of thousands of participants and millions of dollars traded and I will show you a market that creates more valuable information. BUT it would still on occasion be ’surprised.’

Basically I guess what I’m trying to say is the expectations seem to be set all wrong by many inside the community. I think “prediction markets” - creating markets in information and outcomes is a wonderfully important and valuable thing to do. Equally however I think that anyone that represents such markets as being able to predict the future is a charlatan. What they can do is collect and synthesize powerfully and efficiently all the dispersed available information - using money as the relevance filter. This is very valuable in its own right and is defensible. Promoting prediction markets to true sceptics (ie mainstream American politicians) on the basis that they are a Delphic Oracle is surely a path to certain tears and ultimately is almost guaranteed to fail.

Markets don’t compute unknown unknowns. That doesn’t mean they are useless, just that they have to be understood in context.

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