If you have a question about a specific topic, who are you best to ask: a recognized expert or John/ Jane Q. Public? Well, if you have a question about what’s going to happen next in the wild world of derivatives, you may get more accurate predictions by asking a group of ordinary people than from an economist, analyst or even the CEO of Goldman Sachs. The idea that the masses can make surprisingly more accurate collective judgements than expert individuals, is nothing new.
Power in Numbers
James Surowiecki’s 2005 book “The Wisdom of Crowds” compellingly illustrated how crowd wisdom works. Let’s travel back to 1906, when Charles Darwin’s cousin Francis Galton, a Victorian polymath, was the first to note the wisdom of the crowds at a livestock fair. In one event, fairgoers were given the opportunity to guess the weight of an ox. The person with the closest guess to the actual weight would win a prize. Galton pointed out that the average of all the entries in a ‘Guess the Weight of the Ox’ competition at a country fair was amazingly accurate – beating not only most of the individual guesses but also those of alleged cattle experts. This is the essence of the wisdom of crowds – their average judgement converges on the right solution.
Derivatives: Titan of Prediction Markets
Now let’s look at derivative trading, an area that stands to benefit greatly from crowd wisdom and which, to date, has been largely dominated by an elite few advisors and investors. A derivative is a financial security with a value that is reliant upon, or derived from,
an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Trading a derivative is essentially the act of committing funds to a prediction and derivative markets are prediction platforms. Analytical predictions are the professional backbone of the analysts and stockbrokers in the market.
While the derivatives industry is not a simple one, historically it has suited this small community to obfuscate what is essentially the titan of prediction markets. Many people are daunted by derivative trading, but predicting is ubiquitous in our daily lives. We are a tribe of, what I like to call, “homo-predicens”, The concept of “homo-predictions” refers to how humans predict in everything we do. Predictions are the basis for our most trivial expectations such as me expecting the words to appear on the screen as I type them. Analytical predictions are the professional backbone of analysts and brokers in the stock markets. However, what separates predicting from guessing is knowledge.
“Large groups of people are smarter than an elite few” according to Surowiecki, and when it comes to daily problem solving and predicting the future, this can be said for the derivatives market too.
Disparity of information
The typical derivative contract takes place on an exchange market or in an Over-The-Counter (OTC) contract where a market maker orchestrates the trade. These market conditions are where the asymmetry of crowd wisdom is fully felt. Two parties make the trade, but just one is privy to crowd wisdom. Much like the livestock fair Surowiecki examined, the farmers purchasing the oxen, like ordinary investors, make predictions in isolation, without access to information about their counterparts’ predictions. Let’s explore this a little more.
The derivatives market is, in a word, gigantic – often estimated at more than $1.2 quadrillion on the high end. Some market analysts even place the size of the market at more than 10 times that of the total world gross domestic product (GDP). It is one of the world’s most important and influential economic markets, yet the least understood. Unless you are a licensed professional or otherwise possess the technical acumen, you will have little to no visibility of the mechanism driving the market. The status quo mandates that investments can only be made through centralized organisations that can profit from an asymmetry of information.
Currently, all data on who is selling and buying what, and when, is held by the derivative brokers and market makers, and them alone. This represents a distinct asymmetry of information. These centralised providers overlay the information from historic volatility prediction models, and augment it with crowd wisdom. Each new derivative contract signed is factored into the pricing of the next derivative contract. However, the traders themselves don’t have this key information on how others are predicting. Without access to the same information and analytic tools, the individual trader remains at a disadvantage, relying on their own siloed resources. This information blackout also enables institutions to market certain products to offset their potential losses by pricing them attractively, another way in which they use their advantage over the investor to create unfavourable market conditions for them.
Now, let’s go back to that livestock fair in 1906. It should be clear by now that, as with any trade where only one party knows exactly what everyone else is estimating, the advantage lies solely with that party. In collectively guessing the weight of the ox, all the participants gain an advantage. Surely, there is something we can learn from this and apply to the largest financial market in the world? In a market worth $1.2 quadrillion, it’s clear that there is enough money to go around. It is time to take the ox by the horns and employ crowd wisdom to allow everyone to tap into the global derivatives market and bring about a fairer and more equal distribution of wealth.