Where’s the world going?

Here’s a viable scenario for the future: An expanding frontier of unpredictable climate shocks precipitates regional economic collapses. Hot spots of food and shelter insecurity stress governance structures even more than the pandemic did, as economic refugees surge. Many, many of the routine functional components of our society shatter or change greatly. Jobs lost; prices rising as supply chains fail; national economies regionalized into areas of the devastated and the fortunate; mobility constrained; insurance markets collapsed; mistrust flourishing… and, of course, the demons of our political partisanship bellowing on social media.

The way humans organize themselves politically is simply not geared to an optimal response to this threat. We can see it coming but we can do little about it[1].

Can you protect your capital?

How do you protect your capital in these situations? How do you take new opportunities? Think about it for a moment and you’ll quickly realize that conventional markets offer you very few tools for this changed world. Wealth-destroying risks are going to come at you from angles you can’t defend against through the stock market.

"Special situations" is a term that hedge funds and other big market players use to describe their positioning in risks and opportunities outside the arena of the stock and bond markets. Big players can benefit from foreign currency carry trades, operate in foreign stock & bond markets, acquire non-listed companies, buy and sell portions of lawsuits, swap risk derivatives.

But retail investors simply have not had access to such channels for opportunity participation and risk management. You can long or short the S&P, or bury your money in the backyard. 

Event contracts

Event contracts can perform two essential functions in this changing world.

• First, they offer a hedging mechanism for atypical risks at the level of the individual.
• Second, they provide a crowd-sourced prediction of how those risks are going to play out.

Hedging

For an example of the first, look no further than the homeowners insurance market in Florida, which has already effectively been broken by hurricanes. In West Palm Beach insurance rates are so high, homeowners are selling up to avoid it. Read our previous coverage of this here.

Insurance companies are gigantic, traditional, slow-moving and confined by regulation – it’s not surprising they struggle to adapt to rapid climate change. But individuals at risk have no other way of protecting their assets.

Event contracts help with that. If you’re in a climate-vulnerable area and there is an open market on the likelihood of a destructive event in that area, you have a way of hedging. The risk distribution on the other side of the contract is much wider (not confined to Florida-registered insurance companies), which aids price efficiency. Insurance is ripe for disintermediation, and event contracts are ideal for matching capital with needs in this sphere.

Predicting

You’re sick of hearing about the wisdom of crowds, right? And haven’t political opinion polls been way off the mark recently? Yes and yes. But that’s partly a story about outdated polling methods and partly because “opinions” have a high emotional quotient and are prone to misreporting. Prediction markets are quite different, simply because the predictors have “skin in the game” – their prediction is a considered risk in which they can take a loss. This largely purges prediction markets of the main biases in opinion polls – wishful thinking, manipulation, poor question framing, etc. Nicholas Nassim Taleb unpacks this, and the value of skin in the game in his book with that title. 

Think of the wisdom of crowds not as an average of guesses, but as an aggregation of local reporting – like individual weather station sensors sending back data which, only when collated together, draws a useful picture.  This is particularly valid in situations where experience is geographically distributed and varied (as in national elections). 

In a rapidly changing world, the usefulness of traditional information sources declines. News of what’s actually happening on the ground in a fragmented world is hard to get. Prediction markets are a way of collecting that distributed information in one place. Participants in prediction markets are relaying into the market what they see and feel in the world around them and in so doing they are acting as sensors spread out across the vast and diverse landscape of US experience.

…and the upswing

The good news? We need this. If you don’t think capitalism is ripe for overhaul, you’re one of the privileged who has to look away from the consequences of that privilege. Volatile politics around the world are already telling us that there’s pent-up rejection of how we live, of anxiety and distrust, even in prosperous nations like the US.

This is how humans operate: first we break it, then we fix it. We have a shot at transforming the way we use energy and protect our environmental capital.  

Catastrophe is also a moment of rebirth. Stale conventions are swept away, new ideas flourish. Chaos explodes exhausted institutions, clearing the ground for new ones.

Things are going to look very different, and the way we store and conserve individual wealth is going to be very different. 

At a rather unusual gathering of forecasters held recently in Berkeley, California, Eliezer Yudkowsky, an A.I. safety researcher, said this: “Prediction market prices are the means by which a high-functioning civilization knows what it knows.” He was wearing a glittering gold hat when he said it, but still. It’s a view worth considering.

To prepare for this world, I have two book recommendations:

* Chaos Kings, by Scott Patterson, just published June 2023

* The Shockwave Rider, a sci-fi book from 1968, which foresees with uncanny accuracy a disrupted world, the internet… and a public trading exchange of event contracts.

[1] We are trapped in structures based on competition between nations, so we have no way of coordinating a response. The climate crisis comes at a time when the United Nations is at its weakest, western democracies are preoccupied with populist concerns, and non-democracies are led by risible strongmen whose entire model of power depends on them not seeing this particular problem. 

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