Wednesday, June 23, 2010

Defending Derivatives and Responsible Financial Innovation

I'm a big fan of making bets on opening weekend box office grosses - that's the raison d'etre of my other blog, TEQP-HSX. I've used real money on Intrade, although not for a while. So I was very excited about Cantor Exchange, the real-money spin-off of the Hollywood Stock Exchange. Cantor works just like HSX, except that the stocks have a shorter lifespan, and there is real money involved. The securities on Cantor are technically derivatives, and, as such, trading them has to be approved by the Commodities and Futures Trading Commission. A great explanation of the potential benefits from Richard Jaycobs, president of Cantor, can be found here.

Most of the debate around trading in futures based on box-office receipts has revolved around technical questions, such as whether or not such contracts could be manipulated, how they would work, etc. There hasn't been much examination of the philosophical issues. That's what I am going to look into.

The core issue is innovation. Trading in box office receipts represents financial innovation. I'm not surprised that the major studios are opposed to it; this is the same industry that fought the VCR all the way to the Supreme Court. They were worried that machines that gave people the ability to watch movies at home would cut into their revenue; those machines are now a major source of that revenue. I can understand their initial opposition to VCRs - at the time, the idea that videotapes would generate lots of money for the studios seemed absurd. The lesson is that we don't know what the future holds, but that it's a usually a good idea to err on the side of more innovation, rather than less.

There's a saying in the movie business that movies are a great art form, but a terrible business. Consider: every movie is effectively a completely new product, almost a new company. Studios invest millions of dollars in products that can technically last forever, but really have a shelf life of a couple of months. Every product has to be completely different from, and yet very similar to, every other iteration of the product that has come before it.

Movie studios and movie theaters have come up with many different ways to control the chaos and hedge against the uncertainty of this wonderful and maddening business. Studios take out insurance against various kinds of calamity. They look for franchises, so they can make several movies that are fairly similar, and therefore likely to generate predictable returns. They use famous stars and directors who can dependably "open" a movie. They follow trends and jump on bandwagons. They test-market potential audiences. They scour film festivals for undiscovered gems that they can buy cheap, hoping for a hit. Theater chains build multiplexes, so that if one movie is not successful on a given weekend, they have others that are. They charge astronomical amounts for junk food.

All of these trends and business practices represent different instances of innovation, except sequels, which have been around since the Iliad and Odyssey. Each of these also has its downside; stars can be expensive, and many eventually lose their allure for audiences. Many sequels are not as good as the original. Many movies based on books or TV shows are not as good as the property they were based on. Trends burn out. Failure is inevitable with any widespread innovation. But learning from failure is part of what fosters further innovation.

I've read the statement by the MPAA before the CFTC on why they think these derivatives are a bad idea. I don't know whether or not all of the terrible consequences that they predict from trading in box office futures will come true. Nobody knows. That's the beauty of democracy: we experiment, and, if we're wrong, we change.

There is one aspect of this debate of which I am confident: this represents - and I realize that, given the current economic environment, this may sound almost like a contradiction in terms - responsible financial innovation. Our current economic crisis was brought about in large part because of irresponsible financial innovation. But box office derivatives are very different from exotic financial instruments like CDO's. First, CDO's are extremely opaque and obscure - most people had never heard of them before 2008, and even many sophisticated financial professionals have no idea how they work. Box office numbers, on the other hand, are public information; there are few pieces of financial information more widely available to the public. It's also very simple: that's why there are hundreds of thousands of players on HSX. There are some risks, but there are regulatory structures in place to deal with those risks that raise ethical or legal issues. Again, I don't know whether or not those structures will be adequate to address the risks and contain bad behavior. No one knows. What we do know is that those regulations, rules, and institutions can be adjusted and changed. Given the public nature of the information and the simplicity of the securities, I am confident the US government can handle the challenges of regulating these securities. The total value of the market will be a fraction of the market value of a single large company. It will not necessarily be easy to police this market, but it certainly won't be impossible.

At the end of the day, there is only one reliable way to make money in the movie business: make good movies. The problem, of course, is that no one - other than Pixar - has really figured out how to do that on a consistent basis. Some people are better at it than others - those are the ones that get to do it again. The market rewards those who make good movies. A market in box office futures will have the same effect: it will reward people who make and invest in good movies, and it will punish people who make and invest in bad movies. It will also have the opposite effect: it will punish people who bet against good movies, and it will punish people who invest in bad movies.

The movie studios have legitimate concerns, particularly about piracy and market manipulation. But the best defense against both of those is the same: make good movies. Seeing a movie at a movie theater is still a great entertainment value. Actually, I'd like to qualify that: seeing a good movie at a movie theater still is, and always will be, a great entertainment value. Markets in box office derivatives will be vulnerable to rumors. But so are all securities markets. The best defense against rumors is, once again, the same thing. Many, many very successful movies - from Jaws to Titanic and even the remake of The Karate Kid - have suffered from rumor, innuendo, and just bad analysis. The Karate Kid was a remake of an 80's movie at a time when the audience was supposed to be hungry for originality and tiring of remakes. It opened on the same weekend as The A-Team, which was also a remake of an 80's entertainment property. Both movies were predicted to open between $30 and $35 million. The A-Team opened at $26 million. The Karate Kid opened at $56 million. No one - not even the studio - had any idea it was going to do that well. But the optimists (I, unfortunately, was not among them) made a killing. The best way to manipulate this market is to make a good movie.

Trading in box office futures represents responsible financial innovation that rewards people who make and invest in good movies. For that reason, I think they should be approved.

3 comments:

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