April 06, 2015

Who Will Give the PPA a Hand?

In an interesting and unintentional homage to the "throwback Thursday" (#TBT) social media meme, the Poker Players Alliance (PPA) last week launched an online petition asking the White House to "pledge to veto RAWA [the Restoration of America's Wire Act bill]." As reported by Steve Ruddock at Online Poker Report: "If the petition can collect 100,000 signatures in 30 days it would compel the White House to address Jason Chaffetz's 2015 Restoration of America’s Wire Act bill that seeks to ban several forms of online gambling including online poker."

The PPA petition created a sense of déjà vu because the PPA had previously filed another petition to the White House in the fall of 2011, asking the Obama Administration to endorse the legalization and regulation of online poker. When the Administration issued a response in 2012, my view was:
"[T]he statement is pretty much a standard political puff piece, a souped up version of a polite blow-off letter from a legislator to a constituent on an issue the legislator doesn't care about. The statement basically restates the current status of the law—federal law bans sports betting, states can authorize iPoker and other forms of iGaming, and violations of state iGaming laws may also be a violation of federal law. The statement then placates any social conservatives or law and order types by ticking off the usual laundry list of concerns—addictions, minors, fraud, and money laundering.


In short, I think this statement is utterly inconsequential, and was intended to be so. Of course, the poker world will seize on it to support their collective delusion that iPoker legalization is a major political issue."
To be blunt, the 2011 PPA petition was politically pointless and an utter waste of time. The 2015 PPA petition is equally irrelevant.

Why the PPA's 2011 Petition Was a Failure

Not surprisingly, the PPA views its 2011 petition as a "success". And, some in the poker community take the view that the 2011 petition was a political win for online poker advocates. This view, as summarized by Steve Ruddock, is essentially that the White House response in 2012 signaled a supportive view of legalized online poker / online gaming (emphasis added):
"President Obama hasn’t made it clear where he stands on gambling (particularly online gaming) issues, but a careful reading of the 2012 response shows the White House strongly leaning towards online gambling regulation being up to the individual states."
Yet nothing in the 2012 White House response supports this conclusion. The White House response merely restated, in lay terms, the substance of the Office of Legal Counsel's (OLC) opinion that the Wire Act applied only to sports gambling, and that state law otherwise generally regulated gambling. In other words, the White House response merely regurgitated the OLC's view as to the current status of the law; it was a statement of legal analysis.

Notably absent from the 2012 White House response was any statement of what the White House believed the law should be with respect to online gaming. In other words, there was no indication of the White House's policy position with respect to online gaming.

So if the 2012 White House response does not provide the Obama Administration's official online gaming policy position. where do poker advocates get the curious view that the current Administration is in favor of online gaming? Certainly not from the Administration's OLC Wire Act opinion, which carried this title:
Though it appears to be forgotten in poker circles, the entirety of the OLC Wire Act opinion was directed to the legality of online lottery sales. Also noteworthy is that the two states mentioned in the OLC opinion—New York and Illinois—are Democratic strongholds, with President Obama and several of his key Administration officials hailing from or otherwise strongly connected to Illinois (including notably former Obama Chief of Staff and current Chicago Mayor Rahm Emanuel). To the extent politics entered the equation, the OLC opinion was a sop to the lottery industry.

So, the idea that the OLC Wire Act opinion is a statement of the Obama Administration's policy position on online poker is unsupported by the language of the OLC opinion, because it is utterly silent on the poker question. Now the OLC's analysis clearly supports a legal conclusion that online poker does not violate the Wire Act for the same reasons that online lotteries do not violate the Wire Act. Nonetheless, the OLC opinion remains merely a statement of what the law is (analysis), not what the law should be (policy).

As I noted back in 2012, the Obama Administration "does not give a flying pig about internet poker or gambling." Nothing that has happened in the subsequent three years changes my view. In fact, the lack of any Administration policy statement regarding online gaming at any point in the past six-plus years only grows more ominous when one considers that the federal online gaming debate has shifted against the pro-legalization movement. At the time of the 2011 PPA petition and the 2012 White House response, Congress was considering an online gaming legalization bill championed by Representatives Barney Frank and Joe Barton in the House, and later that year considered a similar bill sponsored by Senators Harry Reid and John Kyl in the Senate. Now, three years later, Representative Frank and Senator Kyl have retired, the House just held a sub-committee hearing on a bill (RAWA) to ban all online gaming (with notable carveouts for lotteries and horse racing), and Senator Reid has gone on record supporting an online gaming ban. The federal online gaming environment has gone from temperate to downright frigid.

It would not be fair to blame the PPA's 2011 petition for the disintegration of the federal online gaming legalization effort; RAWA is the noxious by-product of a broader set of toxic political forces. Yet, in evaluating the PPA's 2011 petition against its modest goal of advancing the position of online gaming by obtaining a supportive policy statement from the Obama Administration, the 2011 petition was, charitably speaking, somewhere between "inneffective" and "irrelevant". In any event, given the lack of any policy statement, it is foolish to pretend to know how the Administration views online gaming, and it is foolhardy to speculate that the Administration either supports online gaming legalization or is opposed to RAWA.

Why the New PPA Petition Is Pointless

So, if the Obama Administration's policy views on online gaming are unknown, won't the new PPA petition force the Administration to take sides in the debate once and for all? Hardly.

Here's the thing. The Administration clearly has no skin in the game either way. Online gaming is simply not a priority for the Administration, either pro or con. So, even if forced to respond to the PPA petition (which appears a dubious longshot), the Administration is almost certain to put out yet another non-responsive response, taking neither side of the debate. In other words, at best we will get a rehash of the Administration's non-committal response to the 2011 PPA petition.

From the Administration's perspective, there is no political advantage to taking sides in the debate at present. Taking sides now when RAWA or other online gaming legislation appear unlikely to advance simply creates unnecessary enemies, while distracting from the Administration's priority legislative goals. If and when RAWA or other online gaming legislation passes out of one of the Congressional chambers, the Administration will have plenty of time to weigh the most politically advantageous response. The Administration might support a RAWA-style online gaming ban as a reward to Democratic Senate leader Harry Reid, who has done yeoman's work in advancing the Administration's agenda the past six years. Or, the Administration could threaten to veto a RAWA-style online gaming ban as a bargaining chip to extract concessions on issues where the Administration has a stronger interest. The Administration could even agree to sign RAWA into law in exchange for something—say, passage of a bill or approval of a judicial nominee—the Administration truly values, or as part of a compromise package of "must-pass" legislation.

The 2015 PPA petition also is unlikely to gain a supportive reply from the Obama Administration because of a key ideological issue—"states' rights". The PPA petition declares: "Regardless of personal opinions on wagering, the Tenth Amendment directs that states decide such matters, not Congress." The trouble with this language is that it is ideologically charged. In constitutional jurisprudence, "state sovereignty" and the Tenth Amendment have historically been invoked by conservatives seeking to invalidate liberal/progressive economic and social policies. From the Great Depression to present, Democrats' major policy initiatives—e.g., Social Security and other New Deal legislation; the Civil Rights Act; various anti-discrimination laws; wage/hour, and other employee protection legislation; the Affordable Care Act—have been achieved via federal action, generally pursuant to a broad reading of the Commerce Clause. Republicans, by contrast, have tended to resist these laws by asserting those issues were reserved to the determination of individual states. Asking a Democratic President—particularly one whose signature policy initiative (the Affordable Care Act) was nearly invalidated on a Tenth Amendment challenge—to endorse a "state's rights" argument limiting the role of Congress in regulating economic activity such as online gaming is like asking a North Carolina fan to root for Duke in the national title game just because they belong to the same conference. It might happen, but don't hold your breath. [FN1].

The 2011 PPA online poker petition did nothing to clarify the Obama Administration's policy views related to online gaming. There is no reason to expect the 2015 PPA petition to succeed where its 2011 petition failed.

Why the New PPA Petition Is (Probably) Harmless

Now, for the same reasons why the PPA's current petition is destined to fail in its quest to gain support for online gaming from the Obama Administration, the PPA's petition is also unlikely to harm the online gaming cause, either. Essentially, the Administration has an equal incentive to avoid committing to an anti-online gaming position as it does a pro-online gaming position. Again, the most likely—probably inevitable—Administration policy position is a mealy-mouthed non-committal response which allows it to take any position it finds convenient in the unlikely event online gaming legislation (pro or con) ever makes its way out of Congress.

Still, the PPA's petition could backfire in terms of public-relations. Remember, the PPA needs to gin up 100,000 signatures in one month in order to force a response from the Administration. Right now, the petition has just over 3,000 signatures. Yet, in 2011, months after Black Friday destroyed the online poker economy in the United States, when the poker community was presumably most united and most motivated, it took the PPA nearly six months to gather a mere 10,000 signatures for its first petition.

If the PPA falls short of its goal in its current petition campaign, it will walk away with a lot of egg on its face. The PPA likes to brag about its "more than one million members", a membership level it has touted since at least 2008 (and during its 2011 White House petition campaign). The potential problem with the current PPA petition is that failure to generate 100,000 signatures in a month undermines the PPA's narrative of broad public support for its position. Worse, failure to garner the requisite signatures would tarnish the PPA's credibility as an advocacy group. If the PPA fails to deliver signatures for what it considers an important initiative, outsiders will be left to wonder about the cause of the failure: Are there substantially fewer active PPA members than advertised? Are PPA members unmotivated? Is there a disconnect between the PPA's leadership and its members?

Why Poker Players Should Sign the PPA's Petition

There are many political issues which are beyond the influence of individuals or even organized advocacy groups. Many political activities—circulating and signing petitions, attending board meetings, sitting through legislative hearings, contributing to political action committees, volunteering for political campaigns, even the act of voting—are irrational to dispassionate observers who can see that these activities will have no discernible effect on the outcome of the political debate in question. Yet, for some individuals, the mere act of participating in the political process, even if that participation is pointless, provides the salutory effect of making these individuals feel a part of the civic process. For these folks, meaningless action is superior to measured inaction. Raging impotently against the machine is more existential war cry than rational argument.

So it goes for the PPA's latest petition, despite its certain destiny with the trash heap of historical irrelevancy. Signing the PPA petition provides an opportunity for online poker players worked up over RAWA to release some frustration and feel good about themselves, quickly and free from risk, without any long-term commitment. In other words, it's political masturbation.

If signing the PPA's petition makes you feel good, by all means shoot off a signature.

* * * * *

[FN1].  The appeal to a states' rights argument in the fight against RAWA is a smart decision on a tactical level. Because Republicans tend to favor state regulation over federal regulation (particularly with respect to economic issues), invoking the states' rights rhetoric divides the Republicans into the socially conservative anti-gambling (pro-RAWA) faction and the anti-federal regulation (anti-RAWA) faction (though many Republican legislators fit comfortably into both camps). Of course, the states' rights rhetoric may become detrimental in the long-term if federal legislation authorizing online gaming once again becomes more politically palatable. But in the short term, a significant division in the Republican ranks over the proper forum for legislating about online gaming is a major stumbling block for the pro-RAWA forces, and online gaming advocates are wise to fan the flames of that division ("the enemy of my enemy is my ally").

March 25, 2015

Drawing the Line Between Gambling and Finance:
Part V—Hedgers and the Law

Note:  This is the fifth article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article.

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Having looked at some of the more common aleatory contractsinsurance, reinsurance, and derivatives—and found strong parallels between those legally accepted contracts and various forms of gambling, it is time to return to the original question: Why are contracts like insurance and derivatives legal if they are fundamentally identical to gambling?

The short answer is that the law regarding aleatory contracts has long reflected a struggle to resolve the tension between the economic benefits of risk hedging on the one hand, and the moral and economic dangers of unbridled speculation on the other hand. This legal tension has spanned several centuries and been addressed across many cultures. The American legal system has traditionally taken a conservative approach to aleatory contracts, permitting those which show clear economic utility while being slow to permit or enforce contracts which resembled traditional wagers. But, as the American economy has evolved into a leader in the modern sophisticated global financial markets, the American legal system has likewise evolved to accommodate a broader array aleatory contracts.

The Historical Utility of Insurance
"This [New York City] has only been made possible by the insurers. They are the ones who really built this city. With no insurance there would be no skyscrapers. No investor would finance a building that one cigarette butt could burn to the ground."

~ Henry Ford
Insurance is the oldest form of legal aleatory contract, with some forms of economic risk pooling dating back to at least the ancient Babylonian empire; the Code of Hammurabi recognized a form of insurance protecting merchants' goods transported by ship or caravan against loss by storm or theft.

With the rise of the British Empire, insurance became an important and increasingly sophisticated part of international commerce as reflected in the founding of the famed Lloyd's of London underwriting syndicate. Interestingly, the close relationship between insurance and gambling was never far from the surface. As maritime insurance revenues fell, the Lloyd's underwriters turned to other lines of insurance, some of which—death by gin drinking, say—might raise a modern regulatory eyebrow. And the Lloyd's underwriters also turned to other, more traditional forms of aleatory contracts:
"Lloyd’s coffee house soon became notorious as a gambling den. An extract from the London Chronicle of the time [1768] stated: ‘The amazing progress of illicit gambling at Lloyd’s coffee-house is a powerful and very melancholy proof of the degeneracy of the times.’"
American insurance law, as might be expected, derives heavily from English common law. The American insurance industry was slow to develop in colonial times, mostly because the high risks of loss in the New World were deemed uninsurable by established British insurers. But, following the Revolutionary War, numerous American insurance companies were founded. Despite some moral opposition from conservative churches, the American insurance industry was doing robust business by the early 1800s; ironically, one of the first insurance corporations was organized by the Presbyterian Synod of Philadelphia to protect its ministers and their dependents.

The Economic Utility of Risk Hedging

The legal acceptance of insurance contracts is based on their economic utility; insurance is legal because it is economically important. The economic benefits of insuring against catastrophic loss are readily apparent. But insurance offers other, less obvious, economic benefits. For example, two of the largest expenses most people will routinely encounter are purchases of a house or vehicle. Generally, these purchases are made on credit, via a home mortgage or an auto loan or lease. Without insurance to protect their collateral, banks would be reluctant to offer credit on as favorable of terms. Instead, banks would require larger down payments (to limit the extent of possible losses) and would charge higher interest rates (to compensate for their higher risk of loss). In other words, insurance not only protects against large scale losses to homes and vehicles, but in many cases, insurance makes the purchase itself possible.

Similar principles apply in the commercial context. Without insurance, businesses would be reluctant to make large-scale capital investments in, say, buildings or machinery, if those investments were subject to loss because of fire or storm. To the extent businesses face uninsured risks of any kind—whether from fire, storm, theft, cyber-attack, lawsuit, or other cause—prudent financial planning will result in the maintenance of substantial capital reserves to cover those uninsured risks. Insurance, then, is not just a risk mitigation tool, but a method by which businesses can free up capital for investment into business operations.

Insurable Interests and Moral Hazards

Insurance, then, derives its legal status from its obvious economic utility. The ability of individuals and businesses to hedge against catastrophic risks not only protects those purchasing insurance, but also serves to lubricate the general economic machinery. But the law is careful to limit insurance to a hedging function through a concept known as insurable interest.

The insurable interest doctrine requires a party purchasing insurance to possess some legal interest in the object of the insurance policy. For example, an individual can insure his own life, but cannot insure his unrelated neighbor's life. Similarly, a business can insure its warehouse against fire, but cannot insure the warehouse of a competitor. Although the underlying insurance contracts in each case might look the same, the purpose of the contracts is fundamentally different. When insuring a life or property in which a person or business has a direct legal interest, the purpose of the insurance is hedging against risk of loss. When insuring life or property in which a person or business has no direct legal interest, the purpose of the insurance shifts to one of pure speculation. As the U.S. Supreme Court stated:
A contract of insurance upon a life in which the insured has no interest is a pure wager that gives the insured a sinister counter-interest in having the life come to an end. And although that counter-interest always exists, as early was emphasized for England in the famous case of Wainewright (Janus Weathercock), the chance that in some cases it may prove a sufficient motive for crime is greatly enhanced if the whole world of the unscrupulous are free to bet on what life they choose. The very meaning of an insurable interest is an interest in having the life continue, and so one that is opposed to crime. And, what perhaps is more important, the existence of such an interest makes a roughly selected class of persons who, by their general relations with the person whose life is insured, are less likely than criminals at large to attempt to compass his death.

Grigsby v. Russell, 222 U.S. 149, 154-55 (1911) (emphasis added).
In other words, absent an insurable interest, an insurance policy is nothing more than rank gambling, a wager on misfortune befalling a third party. Worse, the lack of an insurable interest creates an acute risk of moral hazard—specifically, the risk that an insured will destroy property or kill a person insured in order to profit from the contract. Regardless of whether a moral hazard actually arises, this type of speculation on the misfortunes of others is generally regarded as morally repugnant. The law, therefore, has long refused to permit speculative insurance contracts, and regards as void any insurance contract in which an insurable interest is lacking.

Gambling With Insurance

Interestingly, the U.S. Supreme Court ultimately ruled in Grigsby that life insurance is a form of property that can be assigned (transferred) to another person, even a person lacking an insurable interest in the underlying policy. In other words, the insurable interest requirement is satisfied by the initial purchaser of the policy, who is then free to sell the policy and its benefits to anyone. This ruling eventually led to the explosion of viatical settlements in the 1980s and 1990s, as individuals with AIDS sought to extract enhanced cash value from their life insurance policies by selling them to speculators who would pay below the policy's death benefit but above the actual cash value of the policy (which might be zero in a term life policy, or relatively small compared to the death benefit in a whole life or universal life policy). The speculator would pay the policy premiums, and would profit if the insured died early enough such that the policy death benefit exceeded the purchase price plus additional premiums. Viatical settlements are also common with other acute diseases with limited treatment options and short life expectancies, such as certain types of neurological diseases and cancers.

Similar to viatical settlements are life settlements, where an individual may sell to a third-party a life insurance policy the individual no longer needs. As with viatical settlements, the purchaser is speculating that the policy will "pay off" with the insured dying early enough that the death benefit exceeds the purchase price plus subsequent premium payments. Life insurance policies purchased via viatical or life settlements are sometimes bundled and securitized as so-called death bonds (essentially turned into an asset-backed security, as discussed in Part IV of this series). Because of the potential for abuse and fraud, most states tightly regulate viatical and life settlements. Nonetheless, viatical and life settlements are the one area where the law permits insurance to be used for speculation—specifically, "gambling" on the life of a stranger.

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Next up, discussion of the law's view of speculation.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management

March 19, 2015

The Usual Brackets:
America's Curious Embrace of Sports Gambling

"The greatest trick the devil ever pulled was convincing the world he did not exist. And like that, poof. He is gone."

~ Roger "Verbal" Kint (Kevin Spacey), in The Usual Suspects (1995)

Today is the beginning of one of the great American sports holidays—the NCAA men's basketball tournament, a/k/a "March Madness", a/k/a "The Big Dance". Tens of millions of Americans who rarely if ever gamble will enter office pools, filling out brackets to pick the winners of 63 basketball games over the next three weeks, hoping to win a piece of prize pools which can range from enough to feed a family off the fast food value menu to thousands of dollars in some higher stakes contests.

My first time winning a bracket contest was my junior year of high school. I was in a pool with a handful of guys on the basketball team, along with our coach (who was also the principal). The stakes? The winner got a free soda (50 cent value in those days) from each of the losers. Keith Smart and "The Shot" kept me in quality caffeine for a week.

It was also my first big gambling win.

In the ensuing couple of decades, I have participated in and/or organized scores of NCAA basketball pools in numerous formats (all scrupulously conducted within the requirements of Iowa's social gaming statute, of course). There have been straight brackets, randomly drawn brackets, and brackets with upset bonuses (add the difference in seed to the points for each win). There have been "against the spread" brackets where players draft teams which play through the bracket with the Final Four teams getting the prize money; the catch is that the "winner" which advances is the team that beats the spread. There have been Calcuttas, where teams are auctioned off to the highest bidder, with a percentage of the overall pool awarded for each win. For years I operated a Sweet Sixteen second-chance "confidence pool" which required participants to rank the remaining teams in the tournament, with weighted points awarded for wins.

One of my favorite pools was one operated by a friend and (now former) law partner. His pool had five games; your standings in the overall pool were determined by your agregated standings from the individual games:
  • Game 1:  Standard straight bracket.
  • Game 2:  Rank the top ten potential champs. Winner is the person with the eventual champ ranked highest (first tiebreaker was highest ranked runner-up). A "go for broke" strategy would be to eliminate one team from your picks which is a popular championship pick among the rest of the participants (say, Duke, to pull an example from thin air). If that team doesn't win, you likely have a major edge in where you've ranked the actual champion. 
  • Game 3:  Pick all first round games against the spread. Picking all the dogs was usually a winning strategy. 
  • Game 4:  Pick one team from each seed level (i.e., pick one of the four 1-seeds, one of the four 2-seeds, etc. all the way to one of the four 16-seeds). Points are scored for each win, with points doubling each round. 
  • Game 5:  Pick any five teams. For each win, you get points worth the picked team's seed divided by the seed of the team they beat (i.e., if a 5-seed beats a 12-seed, you get 5/12 = .417 points, while a 12-seed beating a 5-seed would get 12/5 = 2.4 points). So, a 1-seed or 2-seed doesn't score many points until the late rounds, but is likely to go deeper, while a lower seed might score big points early, then fall out of the tourney. A good strategy was to pick seeds 2-6 likely to make deep runs, with maybe one flyer on a 10-12 seed likely to win a couple of games.
The best part of the pool was that participants and their guests would watch the championship game together in a sports bar. The kicker was that while the top 40% of participants split the prize pool, the bottom 40% had to split the tab for the party. You could always spot the locked-in winners—they were the ones drinking the top shelf booze. And with numerous tiebreakers in play, many participants were rooting for strange outcomes in order to make the money or miss the bar tab: "You need North Carolina to win by more than six in regulation, or you need two overtimes and total points scored under 166."

Regardless of structure, all NCAA pools are gambling, assuming there is an entry fee. Frankly, NCAA pools are nothing more than the bastard love child of sports betting and keno (though Wall Street could probably sell them as "sports derivatives"). Whether these pools are illegal depends on applicable state gambling laws; many states carve out small-stakes social gaming from their criminal gambling and bookmaking statutes. Of course, even where NCAA pools are technically illegal, law enforcement rarely pursues them unless they are high-stakes or there are complaints of cheating or theft.

Despite being blatant gambling, NCAA pools occupy something of a moral and legal blind spot in American culture. President Obama can broadcast his bracket picks every year without any criticism that he is promoting gambling. Celebrities like Kevin Jonas and Kati Couric can participate in "celebrity bracket challenges" without fear of damaging their wholesome public images. Sitting down to help their young children fill out brackets is part and parcel of being an All-American Dad these days; none of these parents would dream of playing casino-style games with their kids. In Congress, fifteen Representatives have signed on as co-sponsors of an expansion of the federal Wire Act which prohibits electronic transmission of sports betting information; if I were a betting man—and I am—I would wager most of those Representatives have staff, friends, and family using one of the mainstream online sites (CBS Sports, ESPN, Yahoo) to manage their brackets. Opponents of online gambling legalization often dramatically tout the dangers in "making every cell phone a casino"; how many of them have a bracket tracking app on their own cell phones or tablets?

Americans' embrace of NCAA pools is directly at odds with their general hostility toward gambling. Recent Iowa polls, for example, show strong majorities opposed to legalization of online gaming (71% opposed) and daily fantasy sports contests (63% opposed). So why do NCAA pools get a free pass from America's otherwise judgmental gaze?

Our collective cognitive dissonance on the status of our brackets undoubtedly arises from the wild popularity of college sports in general and March Madness in particular. Even the most casual of sports fan is drawn to the drama of the tournament, rooting for their favorite team(s) and cheering for David-versus-Goliath upsets. Filling out brackets augments the enjoyment of the experience by giving fans something to root for in every one of the 63 tournament games, and something to talk about with friends and co-workers.

NCAA pools are just an old-school version of social gaming, the sports equivalent of Farmville or Candy Crush. Sure, they might cost a few bucks, but filling out brackets for a fun contest with friends or coworkers is nothing like calling a bookie or going to a casino. So, with a wink and nod, Americans have collectively convinced themselves NCAA pools are entertainment, not gambling. Fiction though it may be, that's our story and we're sticking to it.

March 11, 2015

Drawing the Line Between Gambling and Finance:
Part IV—Derivatives and Daily Fantasy Sports

Note:  This is the fourth article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article (when available).

* * * * *

Overview of Derivatives

Moving from the world of insurance into the world of finance, another important set of aleatory contracts are the derivative contracts ("derivatives" in common shorthand). Although derivatives come in a myriad of variations, they all share one important feature—the contract derives its value by reference to an underlying value. As we will see, that underlying reference value can be something as simple as a stock price or interest rate, or something as complicated as a portfolio of mortgages, a stock index, or even the temperature in a particular city.

Some of the more common kinds of derivatives include:

Forwards and Futures: Forward contracts and futures contracts are related types of derivatives in which one party agrees to sell a set amount of an asset for a fixed price at a designated point in the future. The most significant difference between forwards and futures is that futures are standardized contracts while forwards are non-standard and can be tailored to the specific needs of the parties; thus, futures are generally “exchange traded” while forwards are sold “over the counter”. A classic example of this type of derivative are commodity futures which are used to trade a wide variety of commodities such as agricultural products (e.g., grain, pork bellies, coffee, and sugar), metals, and oil. The current price is reported using both the price and the date; “September Corn is at $4.04” means that a contract for standard-grade corn to be delivered in September carries a price of $4.04 per bushel. The plot of the classic comedy movie Trading Places starring Eddie Murphy and Dan Aykroyd revolved around an attempt to corner the market on frozen orange juice futures.

Options: Options contracts give one party (the buyer) the right, but not the obligation, to buy or sell an asset (typically shares of stock) at a set price on or before a specific future date in exchange for an up-front premium paid to the seller. An option to buy is referred to as a “call option”, while an option to sell is referred to as a “put option”. If the buyer exercises his option, the seller is obligated to sell or buy the asset at the agreed price, even if the market price is substantially higher or lower. If the buyer does not exercise his option, the contract expires. In either case, the seller keeps the premium.

Swaps: Swaps are contracts in which the parties exchange the cash flows of two financial instruments. Common versions of swaps include interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. Swaps permit parties to gain the benefits of the underlying alternative financial instrument without incurring the potential legal, tax, and other downsides of an actual transfer of ownership.

For example, one common swap—the interest rate swap—permits two parties who each have loans with different interest rates to swap or exchange the interest payments on the loans. For example, assume two companies have issued corporate bonds, one party at a fixed rate, the other party at a floating rate (e.g., a rate tied to LIBOR or U.S. treasury rates). The party whose bonds have a floating interest rate might want to be able to lock in a fixed rate on the assumption that rates will rise. The counterparty might like to move to a floating interest rate loan, on the assumption rates would fall. By using a swap, the parties gain the benefit of a different interest rate without needing to redeem and reissue their bonds, a process that would be both expensive and difficult. Also, note that individuals holding these companies’ bonds could also enter into an interest rate swap, although their expectations would be the opposite of the expectations of the underlying companies—i.e., a bondholder with a fixed rate bond would swap with a floating rate bondholder expecting interest rates to rise, not fall.

Interest Rate Caps, Floors, and Collars:  Closely related to interest rate swaps are interest rate caps, floors, and collars. These derivatives are contracts in which the buyer pays a commission in exchange for a guarantee of payment if interest rates rise or fall below a predetermined point. These derivatives are commonly used as a form of insurance on bonds or other debts which have a floating interest rate. These derivatives are also useful for companies which have a business model highly sensitive to changes in interest rates, even if the interest rate derivative is not purchased to hedge a particular debt instrument.

Asset Backed Securities and Collateralized Debt Obligations: Asset backed securities (ABS) and collateralized debt obligations (CDO) are derivatives which are created by pooling underlying assets, typically various loan and debt obligations, then paying the loan proceeds (interest and principal) to the contract holders as they become due. ABS/CDO can be created from a wide range of underlying debt obligations, including mortgages, student loans, credit card debt, and auto loans. A CDO differs from a vanilla ABS in that the debt proceeds are divided into slices ("tranches") which prioritize the order of repayment. This process allows the earlier tranches to be given higher credit ratings as they are much less likely to suffer a loss in the event of unexpected default rates in the portfolio of loans underlying the CDO. The 2008 recession was precipitated in large part by a real estate bubble market created in part by the packaging of subprime residential mortgages into mortgage-backed securities (MBS) and real estate CDOs which then experienced unexpectedly high default rates (partially due to shoddy or fraudulent mortgage underwriting practices).

Credit Default Swaps: Another derivative, credit default swaps (CDS), also played a key role in precipitating the 2008 recession and stock market crash. Although nominally a swap contract, CDS function as insurance against default on a debt obligation (e.g., bond or ABS). For example, a CDS buyer might hold a large number of corporate bonds issued by one company, or a block of similar ABS (say a portfolio of RMBS), thereby exposing the buyer to risk if the issuing company or the underlying industry sector suffer adverse financial results. For a fee or commission, the CDS seller agrees to pay off the underlying debt instrument in the event of a default or other negative credit event. In 2008, insurance giant AIG became insolvent as the result of collateral calls on billions of dollars of CDS it issued in connection with RMBS, as those RMBS became financially impaired in the wake of the real estate market bubble collapse. With many institutional investors exposed to financial risk if AIG collapsed, the federal government stepped in with an $85 billion bailout.

Derivatives: More Than Financial Risk Insurance

Because derivatives are aleatory contracts, they necessarily contain an element of risk (or chance, if you prefer). Thus, like insurance and reinsurance, derivatives are an excellent tool for financial risk and volatility management. In a sense, derivatives can be understood as a form of financial insurance. Investors can hedge the risk of a falling stock market through options. Futures allow producers of raw materials to hedge against falling market prices, while manufacturers can hedge the risk of rising raw material costs. Many businesses and investors can be adversely affected by fluctuations in interest rates; derivatives can offer protection against these fluctuations tailored to the purchaser's specific need. As with insurance, there is always a premium, commission, or fee associated with the derivative contract, but the purchaser deems that cost acceptable in exchange for reduction in financial risk and volatility.

Derivatives, however, go beyond acting as financial insurance in two respects. First, derivatives such as CDO and ABS also provide the benefit of transforming a relatively illiquid assete.g., a bundle of mortgages or credit card accountsinto a security which can offer a less risky stream of income payments than the individual underlying loans. In essence, the process of securitization spreads the risk of any one individual loan defaulting across the full pool of loans aggregated for the CDO or ABS. So, CDO and ABS offer banks and other debt writers a way to market their debt-based assets, while investors have a method of participating in the debt market via less risky and more liquid securities.

Derivatives also go beyond the financial insurance function by creating ways to monetize non-financial risks. A classic example are so-called weather derivatives, which base payment on how much temperatures or precipitation levels fall above or below certain points over a set period of time. So, a business adversely affected by unusually hot or cold weather, or by unusually high or low precipitation levels, can purchase protection against this type of risk, and receive a monetary payoff if extreme weather conditions occur. And, unlike insurance, the weather derivative pays off without any need for the purchaser to quantify any weather-related losses.

Taking matters yet another step, reinsurers have entered the weather derivative market with insurance-linked securities (ILS), which essentially are derivatives based off an underlying reinsurance pool. For example, a reinsurer with a large block of property insurance policies on the books in an area at high risk for hurricanes, tornadoes, or earthquakes might issue catastrophe bonds (or "cat bonds") in which outside investors pay a premium in exchange for a payment of money if a defined catastrophic weather event does not occur, or based on the value of an index of natural catastrophe events.

Fantasy Sports League Or Sports Derivative Investment Fund?

Which brings us to fantasy sports. Fantasy sports started out as an effort by hardcore baseball fans to essentially play general manager and put together a better team than their opponentsusually friends or work colleagues—in a friendly league. Because these fantasy teams obviously do not exist in real life, they cannot play actual games. Instead, the players on each fantasy team roster are awarded points tied to the performance of the players in real life games.

Over the past two decades, participation in fantasy sports has exploded. Much of this growth is tied to the rise of online sites which take care of much of the tedious record keeping and scoring functions, leaving players free to focus on evaluating players to draft or trade. More recently, fantasy sports have experienced another boom with the advent of daily fantasy sports (DFS) sites in which contests run not for a full season, but for only a day.

Although DFS is legal in most statesand legislative efforts are underway to clarify the legality of DFS in the other handful of statesthere has been a growing debate as to whether DFS has gone too far and approaches being a form of gambling. Although whether DFS is "gambling" requires something of a value judgment, there is little question DFS is an aleatory contract, and more specifically, a type of derivativea sports derivative, if you will.

DFS contests clearly involve an element of risk or chancespecifically, the uncertain nature of any player's performance on a given day. There is a fee associated with the contests. The financial results of DFS contests derive from the performance of all of the players drafted in their underlying real life games, much like derivatives can be tied to the performance of outside stock or commodity prices, securities indexes, interest rates, or even weather events. And, much like weather derivatives, DFS contests act as sports derivatives by awarding financial payoffs based on a non-financial performance.

The DFS industry assiduously eschews any connection to gambling, instead marketing DFS as a "skill game". Top DFS players tout their analytical chops in winning hundreds of thousands of dollars a year, enough to even lure some to quit their Wall Street trading jobs for a regular DFS grind. Yet, there is a fairly strong public sentiment that DFS at least borders on being gambling. In New Jersey's ongoing legal battle to legalize traditional sports gambling, the state has asserted that DFS is akin to sports betting. And as prominent sports bettor Haralobos Voulgaris tweeted, "Newsflash to the NBA—DFS is actually gambling."

The question then becomes: Why is the legal system—and for that matter, the general public—comfortable that stock options, commodity futures, and even weather derivatives are not gambling, but concerned that a DFS contest—a de facto sports derivativemight be gambling? As we will see, the answer to that question is complicated.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management

March 09, 2015

Drawing the Line Between Gambling and Finance:
Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Note:  This is the third article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to other articles in the series can be found at the conclusion of this article (when available).

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Purpose of Reinsurance

In the last article in this series, we looked at insurance contracts and how they function. Although insurance companies are in the business of assessing and accepting risks, there are situations where insurers look to limit their risk exposure. The primary tool for insurance risk management is through reinsurance. Reinsurance treaties (as such contracts are traditionally denominated) are complex and high-dollar business arrangements by which insurance companies achieve certain financial goals—risk reduction, volatility reduction, and capital management.

With respect to risk reduction, an insurance company might review its block of business and note that it is vulnerable to a particular risk. For example, a property insurer might note that it has a high volume of insured properties in areas at risk for hurricanes or tornadoes. Or perhaps an insurer notes it has insured multiple office buildings in a single block or fire station district, making it vulnerable to heavy losses in a large-scale fire. In many cases, an insurer might want to write policies with large benefits (e.g., a $5 million life insurance policy or a $2 million dollar homeowners policy), but be uncomfortable being at risk for the full policy amount, particularly where the insurer writes a decent volume of such policies. And sometimes an insurer will write a special endorsement or surplus lines policy to accommodate an insured's special risk needs, but the insurer will be uncertain it has properly underwritten the risk. In each of these situations, an insurer would seek out reinsurance in order to reduce its risk profile by laying off some portion of the excess risk.

Reinsurance assists insurance companies with volatility reduction by smoothing over differences in year-to-year loss experience. Reinsurance treaties tend to involve long-term, multi-year relationships between insurer and reinsurer. In a given decade, an insurer might have three years with massive underwriting losses which are offset by the other seven years of moderate to significant underwriting gains. Yet the years with large losses might interfere with the insurer’s long-term business plans. By sharing the risk with a reinsurance partner, the insurer is able to achieve smoother, more predictable cash flows, enabling it to maintain a longer term business perspective (e.g., holding premium levels steady rather than raising premiums—and losing market share—in an attempt to immediately recoup losses).

Finally, reinsurance is a key tool for capital management by insurance companies. Insurance companies are subject to strict regulations meant to ensure they will be able to meet their obligations to policyholders. The cornerstone of these solvency regulations is statutory accounting, which places greater emphasis on the balance sheet and liquidity than do the generally accepted accounting principles (GAAP) commonly used in most other industries. An insurance company can only write more new policies if it has sufficient surplus (positive working capital) to support the policy. Yet, under statutory accounting, when a new insurance policy is written, the full amount of the actuarial reserves and policy acquisition costs (e.g., commissions, expenses, and other overhead) must be immediately posted to the balance sheet as liabilities, rather than amortized over time. So, writing new business quickly erodes surplus, leading to surplus strain. In such a situation, an insurance company can find new capital, stop writing new business, or find surplus relief by laying off part of the policies (and their attendant reserves) on its books through reinsurance.

Reinsurance Structures

Reinsurance can be structured in a number of ways, but the basic forms are facultative and obligatory (a/k/a treaty) reinsurance (see SwissRe's "Essential Guide to Reinsurance", pp. 22-24). Facultative reinsurance is where a large individual risk or policy is ceded to the reinsurer; e.g., a multimillion dollar property policy on a commercial building or a multimillion dollar life insurance policy on a company’s CEO. Obligatory reinsurance, by contrast, allows a block (portfolio) of similar risks or policies to be ceded as a unit; e.g., a block of all automobile liability policies written by a company during 2014.

Risk allocation under a reinsurance treaty can also be structured in several ways (see SwissRe's "Essential Guide to Reinsurance", pp. 25-30). In quota share reinsurance, the insurer and reinsurer(s) each receive a proportional amount of the premiums and pay proportional amounts of losses, with the primary insurer being paid a commission by the reinsurer for the costs of selling and administering the policies. For example, a primary insurer might keep 25% of the premium (plus its administrative commission) and cede the remaining 75% to one or more reinsurers (it is common for multiple reinsurers to take from 5% to 50% stakes in the ceded risk). When losses become payable, the insurer pays the claims and then is reimbursed by each reinsurer for their share of the losses.

Other kinds of reinsurance risk allocation methods operate by permitting the primary insurer to retain the first full layer of risk and associated premiums (the retention) with all risk and premiums/losses above that amount allocated in various fashions to one or more reinsurers (again, the primary insurer is paid a commission by the reinsurer for the costs of selling and administering the policies). Such arrangements include surplus share, excess of loss, and stop loss agreements which are tied to particular blocks of policies, as well as catastrophe and aggregate agreements which are tied to losses caused by a single large-exposure event (e.g., a hurricane, thunderstorm cell, or large fire) or by a series of large-exposure events (e.g., multiple hurricanes or storms), respectively. For example, a reinsurance treaty might provide that the primary insurer will retain the first $500,000 of risk per policy, and reinsurers will assume and share responsibility for losses above $500,000 per policy. Or, a primary insurer with high storm loss exposure could enter into a combined “catastrophe aggregate” reinsurance treaty in which the primary insurer would retain the risk for losses of $10 million per storm and $100 million per year, with reinsurers sharing losses above those retentions.

Reinsurance v. Bookmaking

Despite its complexity, reinsurance shares some traits in common with simpler and more common gambling world concepts. Consider, for example, a typical local or retail sports book operator. The bookmaker’s business model is essentially a specialized form of insurance—attempt to take roughly even bets on each side of a given game or wager, pay the winners with the wagers of the losers, and keep his commission (“vig”).

However, the bookmaker faces two financial risks. First, betting may fall unusually heavily on one side of a wager; if that side wins, the bookmaker will need to pay the winners out of his own pocket. Second, a bookmaker might face an unexpectedly large individual wager or a high volume of wagers (perhaps on the NCAA tournament or the Super Bowl). Here, the bookmaker faces a financial risk if there is a notable default rate by losing bettors. The solution? In both cases, the bookmaker retains the amount of wagers he is comfortable with keeping in light of his risk appetite and working capital. The bookmaker then passes along (“lays off”) those wagers he is not willing to risk—along with the accompanying risks and profits—to a larger bookmaker, online sports book, or even a legitimate sports book. In other words, the bookmaker is limiting his risk exposure through use of what are essentially stop loss, catastrophe, and aggregate reinsurance principles.

Reinsurance v. Poker Staking

Reinsurance also bears strong resemblance to the practice of poker staking. In general, poker staking is an arrangement where a poker player receives some percentage of the buy-in to an individual or series of tournaments or cash game sessions in exchange for a roughly commensurate share of any profits. The staking agreement can have one or more backers, and each backer may have a different share in the agreement. Typically, the player will retain a piece of the action, and will be paid a premium (“markup”) in compensation for the investment opportunity and the player’s efforts in actually playing in the tournaments or cash game sessions. Essentially, poker staking is analogous to a specialized version of quota share reinsurance—facultative if only for certain high-stakes tournaments or cash games, obligatory if for a set series of tournaments or period of time, with markup playing the role of the commission paid by the reinsurer to the insurer for administrative costs.

Poker players seek staking arrangements for the same three reasons insurers seek out reinsurance—bankroll (capital) management, risk reduction, and volatility reduction. Bankroll management is essentially a working capital issue. A poker player might have a positive expected value advantage in, say, the World Series of Poker or a cash game session with some wealthy whales in Bobby’s Room at Bellagio. But the player might not have enough money to buy in to the tournaments or cash games without putting too large a percentage of their liquid working capital at risk. Staking gives the player the ability to take advantage of these potentially profitable games while maintaining prudent bankroll reserves. Similarly, even if a player can comfortably afford to buy in to the tournaments or cash games, poker results can show high volatility, creating a financial risk for even the best player. A staking arrangement, particularly for a single high cost tournament (e.g., the WSOP Main Event or a high roller event) or an expensive series of tournaments (e.g., the full WSOP tournament slate), can both reduce financial risk and smooth out the inherent volatility of poker results. This reduction in risk and volatility, of course, comes at the price of reduced profits from successful tournaments and cash game sessions subject to the staking arrangement.

Even more interesting is the alignment in interests between reinsurers and those who stake poker players. Reinsurers are seeking out high rates of return from specialized investments; so are poker stakers. Reinsurers want to be able to participate in an insurance market without the hassle and expense of getting licensed and dealing with regulators, not to mention designing, selling, and administering a block of insurance policies. Likewise, poker stakers want to participate in the opportunity to make money in poker tournaments or cash games, but without the hassle of actually playing. Reinsurers tend to bring highly sophisticated risk analysis to bear in evaluating potential deals; though this skill is not necessary for successful poker staking, the best poker stakers demonstrate a keen evaluation of poker playing skill when choosing players to stake.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part II—Insurance: Gambling on Catastrophe

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management