You Better: Gambling & Risk Management

Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article first appeared as "You Better - Gambling and Risk Management", Journal of Risk Finance, The Michael Mainelli Column, Volume 6, Number 5, Emerald Group Publishing Limited (November 2005) pages 450-453.]

“I Call You On The Telephone” - Doubling With No Quits In Sight

Who would have bet, a few years ago, that the financial services and gambling sectors might converge? Gambling was, until recently, limited to a fairly restricted set of biased odds products (e.g. lotteries) or specific sporting events (e.g. horse racing). Today, gamblers can bet on rarer sporting events, financial markets, the weather or indeed anything in which they can interest other gamblers. The advent of on-line betting (be it internet, mobile phone or interactive television) and the growth of spread betting (as opposed to simple fixed odds betting) have transformed the sector. The risk and return profile of many betting products is often almost indistinguishable from equivalent financial products, but with greater flexibility and tax advantages. Insurers - beware. Derivatives merchants – watch out for opportunities. Risk managers – sit up and take notice.

The sums involved in online gambling are enormous. Enormous sports betting firms and financial betting firms continue to grow, while in 2005 we’ve seen multi-billion $ flotations of online poker companies. The world gambling industry turnover is estimated to be in excess of US$400 billion and rising rapidly. The hot growth sector is online betting, 30% of which is estimated to be located in the UK. The leading online betting exchange, Betfair, achieved an estimated IPO value of over 50% of the London Stock Exchange’s current market capitalisation of just over £1 billion in just five years. The beneficial tax treatment for gambling encourages betting products that emulate the results of financial services products, for instance it can be better for some consumers, after tax, to have bet on the FTSE index rather than to buy it. Recent UK legislative activity makes gambling contracts enforceable. Banks, exchanges and insurance sector players need to watch this space carefully – anywhere there is a consumer interest in risk, there is a possible corporate hedge.

"I Know That I Been Wearing Crazy Clothes”

Robert Shiller writing in The Economist on 20 March 2003 said “information technology will allow us to produce large international markets for a complex array of aggregated risks that today are not traded at all”. This was hardly a prediction as these markets are already significant and growing rapidly; it’s just that people tend not to think of online gambling as “international markets for complex aggregated risk trading”. When discussing the possibility of “hedging property risk on the online betting markets” with a lawyer recently, he remarked, “that’s just a fancy expression for gambling”. A number of people classify betting as “frivolous” or for entertainment, while “investment” is socially enhancing. However, isn’t equity investment gambling - when you buy you’re betting against existing shareholders, and when you sell you’re betting against future shareholders? Is a racehorse an investment in the entertainment industry? If a racehorse is an investment, is betting to win on your own horse just leveraged finance? While there are definitely complicated ethical issues around the moral acceptability of gambling, it can be almost impossible to discern from the objective structure of a trade whether it is a “bet”, an “investment” or a “hedge”.

Actual contracts have been struck that hedge travel costs for national qualifying matches, e.g. have your hotel and flight costs back if England fail to qualify for the world cup. These hedges are pitched to consumers by commercial organisations as “flight insurance” or rebates, but the underlying hedge can be on online or other gaming markets. At a Centre for the Study of Financial Innovation conference in November 2003 and a subsequent roundtable in December 2004, a number of ideas were discussed showing the overlaps between betting and traditional risk transfer products, for instance:

• weather derivative markets might function better with consumers or SMEs taking the opposite side of wholesale contracts with utilities for outdoor events, weddings or utility bills;
• sports contingency insurance for relegation or players’ bonuses might be held directly by opposing fans’ bets;
• individual mortgage insurance based on indices of local house prices;
• film hedging based on bets of opening audience numbers or box office take.

“You Better Shove Me Back Into Line Now”

Since there is already demonstrable consumer interest and good liquidity in existing online betting markets such as football or golf, there already exist opportunities to hedge related corporate risk, e.g. football club takeovers, marketing campaigns, stadium attendance correlated with league status or relegation. In future, it is likely that financial firm might try to generate consumer interest in risk to create more market liquidity, e.g. promoting the house price gambling market in order to have adequate liquidity for the mortgage insurance idea above.

Mainelli and Dibb [2004] explored how lessons from financial services might apply to online gambling markets’ structure and competition. The report showed how one could arbitrage online gambling markets and make risk-free returns. As the markets mature, of course, such opportunities will become harder and harder to find or exploit, but they exist. The report highlighted the potential for money laundering in the lightly regulated world of traditional UK bookmakers, a group that is excluded from the UK Money Laundering Regulations 2003. Since publication, NCIS (National Criminal Intelligence Service) announced in January 2005 that it is investigating what to do about the money laundering gap of bookmakers. The report also highlighted the similarity of betting exchanges to traditional financial exchanges, e.g. stock exchanges, particularly with regard to the never-ending mutual ownership versus profit-making from membership. Again, since publication, at least one profit-making betting exchange announced that it is becoming a co-operative exchange. Finally, the report suggested that online gambling regulation was likely to emulate traditional financial services regulation, of particular interest as the UK Gambling Commission is seeking suggestions on regulatory structure for the industry.

“Those Feeble Minded Axes Overthrown”

The stakes are high for regulators and governments. Tax efficiency and the low cost of transactions will only attract substantial business if the betting offerings are secure and from trusted sources. Gambling is lightly regulated in comparison with financial services. Gambling markets are getting large enough to warrant a look at international consumer protection through increased regulation, although domestic regulatory systems often conflict with each other. The gambling markets may bear some comparison with the Euro-dollar markets, i.e. high USA regulatory restrictions creating a substantial overseas market opportunity, e.g. in London.

Likewise, online gambling is highly likely to affect traditional financial services. Anywhere there is reasonable depth of consumer interest in risk, there are going to be significant opportunities for financial services firms to develop products, e.g. hedging a global sponsorship programme for a large sports apparel manufacturer. Given current USA legislative moves, e.g. Senator Kyl of Arizona’s suggestions, US financial services firms may find themselves constrained from participating in these high-growth markets.

Consumer gambling markets may well transform wholesale finance as we know it by removing some of the venerable intermediary institutions in markets such as banking and insurance – allowing consumers to hedge directly other consumers’ risks. For instance, in the UK www.zopa.com allows investors to lend directly to groups of borrowers – in effect betting on their group default rate.

“We Could Make Some Book of Records”

Unlike The Who’s lyrics [“You Better, You Bet”, Face Dances, 1981], we don’t think we’ve “got it all down to a tee”, but we do believe that on line gambling markets will soon be quite analogous to financial markets and partially integrated with financial markets. Perhaps in the next 3 to 5 years:

For risk managers, gambling, particularly online betting, is an area to watch. Risk managers can already use betting markets as a source of some objective odds. For some risk mangers, e.g. those in sports-related companies, there already exist opportunities to manage corporate risks better using gambling products. New gambling markets will emerge and create further opportunities, e.g. for mortgage companies to hedge housing price falls for their clients or marketing departments to underwrite promotional tours for sports teams when they succeed. One sure bet is that a new class of risk management tool is emerging online.

References

Michael Mainelli and Sam Dibb, “Betting on the Future: Online Gambling Goes Mainstream Financial”, Centre for the Study of Financial Innovation, Number 68 (December 2004), ISBN: 0-9545208-5-8, 34 pages.

Thanks

I would like to thank Ian Harris of Z/Yen and Sam Dibb for their advice and assistance with this article.

Professor Michael Mainelli, PhD FCCA FCMC MBCS CITP MSI, originally did aerospace and computing research followed by seven years as a partner in a large international accountancy practice before a spell as Corporate Development Director of Europe’s largest R&D organisation, the UK’s Defence Evaluation and Research Agency, and becoming a director of Z/Yen (Michael_Mainelli@zyen.com). Z/Yen was awarded a DTI Smart Award 2003 for its risk/reward prediction engine, PropheZy, while Michael was awarded IT Director of the Year 2004/2005 by the British Computer Society for Z/Yen’s work on PropheZy. Michael is Mercers’ School Memorial Professor of Commerce at Gresham College.

Michael’s humorous risk/reward management novel, “Clean Business Cuisine: Now and Z/Yen”, written with Ian Harris, was published in 2000; it was a Sunday Times Book of the Week; Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.

Z/Yen Limited is a risk/reward management firm helping organisations make better choices. Z/Yen undertakes strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (www.zyen.com), such as developing an award-winning risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks.

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