Why Expiration Dates are Harmful

Setting expiration dates on decision or prediction contracts is problematic. Dates are often arbitrary in the first place, and the contract language and stated conditions are both open to interpretation. In order for the expiration date to be meaningful, some person or panel needs to pass judgement on their own interpretation of the contract conditions and close out the contracts as of that date. Setting accurate closing prices is itself subject to manipulation, individual error, corruption, and dispute.

The entire premise of a decision market is that an open market is smarter than a handful of experts -- why, then, would we want to have a handful of experts second-guess the market's decisions, and pick the winners and losers?

Picking a "good" underlying instrument is not a dependable solution. Even the most transparent, regulated, and publicized underlying events can continue to provide conflicting signals well after their originally published maturity date. And the most interesting services are those that are hardest to describe or commoditize. They are at best a FuzzyUnderlying, and can't be depended on to provide clear signals at all.

Finally, the maturity date of underlying service events and the expiration date of derivative contracts can be difficult to keep synchronized -- natural disasters, good will, and crime can all conspire to manipulate underlying dates in ways that prospectus authors can never forsee. The best contingency plans are just that; plans, which can never be fully tested, particularly in the case of low-volume or one-shot events.

If we were to base a commercial or even semi-public exchange on a model which included fixed expiration dates and arbitrary judging of outcomes, we would invite disputes, legal proceedings, and external regulation. Open-ended contracts, with no expiration date, not only need to be supported, but appear to be what we'd prefer in most cases.

Why Expiration Dates are Redundant

We don't need fixed expiration dates. We can instead allow the market to detect and act on the maturity of the underlying event, no matter when it takes place.

If we use contracts similar to IEM's Unit Portfolio contracts, then expiration dates on derivatives are completely redundant. (Some of the IEM folks may have figured this redundancy out already, but I haven't looked through their published papers to find out.)

If we simply fail to expire derivative contracts, then the market itself ensures that traders realize their gains or losses after the underlying event matures, and the market itself decides when maturity is reached. Here's why:

• There is no short selling when trading unit portfolios. This means traders "go in the hole" when they enter the market, and must unwind their positions to net a profit even when they are on the upside of a trade.
• The exchange will always buy or sell a unit portfolio bundle for exactly $1. This provides an outlet for unwinds.

In a unit portfolio market, related contracts are grouped in a bundle which is worth exactly $1 -- the exchange itself will always buy or sell a bundle for that amount. This establishes a "par value" for the aggregate market, ensuring that a store of value exists in the bundle. It is up to the market participants to negotiate how that value is allocated to each contract in the bundle as underlying conditions change. See IEM's literature for more details of how unit portfolios work.

How to Avoid Expiration Dates

In order to avoid having to set, administer, judge, and defend judgements based on expiration dates, simply use Unit Portfolio contracts.

When using unit portfolios, traders must always spend money to enter the market, and their net income from trading is maximized by a complete exit, no matter how far the market has moved either for or against them. There is little incentive to hang onto a position after the underlying event has clearly matured; in fact, liquidity drops, and prices get worse for either counterparty, as time elapses after maturity. There is incentive for each participant to negotiate an exit, unwinding all positions, as early as they themselves perceive that maturity has been reached.

The attached spreadsheet (ExpirationRedundant.gnumeric) shows an example of how this works; the entries can be tweaked to play with other scenarios. An HTML rendition of the spreadsheet is shown at the bottom of this page.

In order to unwind their positions, winners and losers negotiate prices in order to accumulate unit bundles which can be sold back to the exchange, recouping their $1/bundle investment and accepting gains and losses in the process. Those traders -- both winners and losers -- who exit their positions earliest will get the best final prices. Those who wait may not be able to exit their positions at all, as they are paired with obstinate counterparties who refuse to cut their losses and trade. This provides a powerful incentive for all participants to act quickly in determining and trading on the actual maturity date.

These final trade prices describe the market's best evaluation of the outcome. These prices will always be less than $1 and greater than $0, reflecting the real ambiguity that exists in the Big Blue Room.

As shown in the spreadsheet, a market finally closes when all bundles have been repurchased by the exchange.

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