Money Stuff: Bilateral OTC Goat Hedge

Programming note: Money Stuff will be off on vacation next week, back on August 24. 

We have talked a number of times around here about businesses hedging real-world risk on prediction markets. Some business faces some risk from some real-world event: “If Zohran Mamdani is elected mayor, my business of selling Manhattan pied-à-terres will dry up,” or “if Cardi B doesn’t perform at the Super Bowl, I will sell less Cardi B-themed merch,” or, overwhelmingly, “if my local sports team does not make the playoffs my bar will not sell enough beer to pay the rent.” Prediction markets like Kalshi offer bets on those events, with real-time prices that seem to efficiently reflect their actual probabilities.

So you can go to Kalshi and buy, effectively, insurance. If you will make $100,000 selling beer if your team makes the playoffs, and $0 if it doesn’t, and Kalshi’s odds show that it has an 80% chance of making the playoffs, you can buy $100,000 of “No” contracts for $20,000 (20%). If the team makes the playoffs, you lose your $20,000 but make $100,000 on beer; if it doesn’t, you sell no beer but make an $80,000 profit on the hedge. Either way, you get $80,000: You’re hedged.

Two points about this. First, prediction markets are mostly for sports gambling, so many of these stories are about businesses hedging real-world sports risk. If you’ve got a European soccer club that might get relegated, that’s perfect for prediction-market hedging. But prediction markets are very invested in demonstrating that they are not purely sportsbooks, so when Kalshi helps a business hedge a non-sports risk I get a lot of emails.

Second, I have been imagining that you “go to Kalshi” and buy a big chunk of contracts to hedge your business risk. In practice, the actual exchange-traded liquidity in many of these contracts is limited: If you want to hedge your US presidential election risk, you can probably buy a lot of size without moving prices much, but the actual volume for even soccer relegation contracts is pretty small relative to the economic impact  of relegation. If you went to buy millions of dollars of those contracts, you would move the price against yourself so much that the insurance wouldn’t be worth it.

And so often the way these hedges work is as block trades, or, if you prefer, over-the-counter insurance contracts. That is:

• A business wants to hedge some event.
• Kalshi lists a contract on the event implying that its probability is 20% or whatever.
• You could not go buy $10 million of that contract on Kalshi, at 20 cents on the dollar or maybe at all.
• But you can go buy $10 million of that contract from Susquehanna International Group, the big proprietary trading firm that has made a push into sports and prediction markets. (Or perhaps some other big prop trading firm, but so far mostly Susquehanna.)
• Some broker will set you up with Susquehanna, who will sell you the contract.
• The pricing of the contract will be more or less the result of bilateral negotiation between you and Susquehanna, but it will probably be based on the Kalshi pricing. Susquehanna makes markets on Kalshi, it uses Kalshi market prices as an indicator of probability, and it will probably base its over-the-counter trading prices on those public market prices. (Here is an Odd Lots episode with Susquehanna’s head of prediction markets, who makes this point: Susquehanna will trade large blocks using the exchange pricing as an anchor.)

You could imagine a future in which prediction markets are so deep and liquid that it would be no problem to just log into Kalshi and buy $10 million of insurance against random events by clicking a button. But that would be weird. Who would be providing millions of dollars of resting liquidity, at low bid/ask spreads, on all sorts of weird events? If you are just bopping around trading a few hundred dollars’ worth of “Ipswich Town is relegated from the Premier League,” and then all of a sudden someone wants to buy $10 million worth, surely you are getting adversely selected. The far more sensible thing is for most prediction markets to keep working like this: A public market trading relatively low dollar amounts but with pretty efficient pricing, and then bilaterally negotiated over-the-counter contracts for businesses that want to hedge in big size. [1]

What about a public market with a zero dollar amount? That is: What if you had some event risk that you wanted to hedge, but that wasn’t covered by a contract on Kalshi? (What if your bar will sell $1 million of beer if the local Little League team wins the county playoff, and $0 if it won’t?) You might call up Susquehanna anyway. “Hey Susquehanna,” you could say, “I want to buy insurance against this weird niche risk. Could you price it for me?” Susquehanna is very much in the business of pricing and holding weird niche risk. Often Kalshi market prices are an input to its pricing, but maybe that’s not strictly necessary. Susquehanna could go research the underlying event, figure out the probability of it happening, add some spread for itself, and quote you a price. You could pay Susquehanna a $100,000 premium for a contract that pays you $1 million if the event occurs and $0 if it doesn’t. It’s a pure over-the-counter bilateral prediction market, just you against Susquehanna.

Or almost. Here’s this:

Up until now, there was no way to directly cover the risk that a state law might shutter your goat herding business. Prediction markets changed that. 

Northern California rancher Tim Arrowsmith owns a company called Western Grazers. The business provides targeted grazing to reduce wildfire risk by clearing dry brush in hard-to-reach areas. Arrowsmith has over 4,000 grazing goats and employs eight herders who work around the clock to manage the goats. 

A recent legislative interpretation eliminated California’s longstanding wage framework for goat herders, which had been designed for the realities of around-the-clock livestock care. (Interestingly, sheep herders were spared from this interpretation of the law). If California doesn’t re-examine this law by the end of August, Arrowsmith’s labor costs could rise by roughly four times, putting his business, the jobs of his longtime herders, and an important wildfire prevention service at risk.

Arrowsmith turned to Castle, a startup that leverages financial products to mitigate risk for businesses. Castle worked with Susquehanna, one of the world’s largest proprietary trading firms, to create a hedge: they translated a highly specific regulatory exposure into a tradable market by defining objective settlement criteria and structuring the contract. Castle provided the coverage, used Kalshi, the largest federally regulated prediction market in the US, to list the market, and transferred the risk to Susquehanna, which priced the contract and provided the liquidity for the trade. …

The contract pays up to $500,000 if California does not fix the goat-herder wage rules by the end of September 2026. Arrowsmith paid a fixed premium for the protection. If lawmakers restore the previous rules or pass a similar solution, the contract expires with no payout. That is the outcome Tim is hoping for. ...

“Businesses face risks that traditional insurance often can't cover,” said Lucas Cavalieri, CEO of Castle. “A rancher should be able to hedge a bill just like a farmer hedges wheat.”

“Prediction markets are becoming a practical risk management tool, not just for institutions but also for small businesses facing real-world uncertainty,” said Eric Passmore, Senior Trader, Prediction Markets, at Susquehanna. 

“Before Kalshi, there was no practical way to hedge against a specific legislative outcome like this,” said Nicolas Hull, Director of Business Development at Kalshi. “We hope businesses of every size and industry can use Kalshi to manage risk. This is just the beginning.”

That’s the Kalshi press release. Here is a good CNBC story with more of the background. Basically goat herders are on the job 24 hours a day, and now you have to pay them at least minimum wage for that whole time, which makes them expensive.

Here is the actual Kalshi goat herding contract. I want to make a few points about it. First, it was listed last week, purely for this trade. This is not a case where Kalshi had an active market in California goat herding legislation probabilities. This is a bilateral trade between the goat guy and Susquehanna, which was then listed on Kalshi. CNBC explains the pricing:

Led by Susquehanna senior trader Eric Passmore, the firm established pricing and the contract terms on Kalshi. Constructing those provisions came after deep research on California’s goat herding business, speaking with industry professionals and connecting with Arrowsmith, Passmore said. 

The contract has a $500,000 payout that Arrowsmith paid a 10% premium or $50,000 on.

Second, as of about noon today, Kalshi showed a volume of about $500,476 on this contract. It was listed purely for the one guy’s over-the-counter trade, but now it is listed, so if you want to bet on California goat legislation now you can. Intriguingly, the contract has traded (in tiny size) at lower probabilities than 90%, meaning that arguably Susquehanna significantly underpriced this risk. The goat herder put one over on Susquehanna!

Third, the contract specification is long. The essential point of the contract is that it “Resolves Yes if California authorizes an alternative wage or provides qualifying relief from goat herder wage and overtime obligations before Oct 1, 2026,” and there are any number of ways in which that could happen. There could be a new statute, or a new state regulation, or a court order, or “an executive order or proclamation issued by the Governor of California.” Whatever it is must reduce the monthly cost of employing goat herders to no more than the cost of employing sheep herders.

This is not a simple yes/no question about whether a law will pass; this is a quite detailed contract specification designed to insure this guy’s actual risk. The goal is to have very little basis risk between the contract and the guy’s actual business. It is, as it were, loss-based insurance, not purely  parametric insurance.

That is a weird thing to trade, if you’re not a goat herder! If you’re just logging on to Kalshi to speculate, you might speculate on whether the California legislature will pass a law, but it’s a little weird to speculate on whether this guy’s goat herding costs will come down in any of a number of legal ways. This is not a product that Kalshi is listing because it thinks there will be a ton of retail investor demand. This is a product that Kalshi listed for the one trade, and that is optimized for that trade.

Fourth, why did Kalshi list it at all? If this is a bilateral trade between the goat herder and Susquehanna, why does it need to be publicly listed on Kalshi? (“Kalshi took a ‘backseat’ in facilitating the hedge,” notes CNBC.) Some possible answers:

1. Publicity. I was sent this press release three times. Kalshi wants to be seen to be in the business of hedging real world risk, and no one can resist a goat herding contract.
2. Neutrality. You could imagine Susquehanna and the goat herder negotiating the terms of the insurance contract, signing it, and then working in good faith to pay claims or not depending on how the event resolves. But that is a potentially complicated and adversarial process, and there’s a risk that (1) the goat herder’s costs don’t come down but (2) Susquehanna doesn’t pay anyway, because of some gap or dispute about the contract terms. But if you get Kalshi to write and list the contract and determine its resolution, maybe you trust Kalshi more: Kalshi is not on either side of the trade, and its incentive is to produce fair outcomes so that it can attract more business. Kalshi can serve as a neutral referee for bets like this.
3. Laying off. In theory, now that the event is listed on Kalshi, Susquehanna could lay off some of its risk by buying “No” contracts. Or Arrowsmith could take some immediate profit by selling his “No” contracts, which he bought at $0.10, for $0.20. In practice, the goat herder pay market is never going to be liquid enough for that to matter, but other contracts might be.
4. Regulation. Insurance is a highly regulated business, and Susquehanna can’t actually sell Arrowsmith something called “insurance” against his goat cost risk. It is selling him an event contract, which is a kind of “swap” under the US Commodity Exchange Act. That law says that “It shall be unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on” a registered exchange. (An “eligible contract participant” basically means a large institutional trader; the goat herder wouldn’t qualify.) That is, it’s actually illegal for Susquehanna to do this trade as a pure bilateral over-the-counter contract. But if you do it as a bilateral contract that prints on Kalshi, it’s fine.

That last answer is probably the most important. As I have noted before, the definition of a “swap” is quite broad, and if you take it literally you might conclude that every sort of bet has to be traded on a registered prediction market like Kalshi. Arguably, now, anyone who wants to offer a business a weird bespoke event hedge like this has to trade it on Kalshi. 

The way financial regulation works in the US is that a regulator proposes a new rule, and then the general public has the opportunity to submit comments. The comments might support the rule, or oppose it, or suggest changes. Then the regulatory agency has to consider the comments and come up with a final rule. The comments are not binding — if there are 100 comments in favor of the rule and 900 against, it’s not like the regulator has to withdraw the rule — but they have some effect on how the rule is perceived. “SEC Expected to Change Quarterly Earnings Rule Despite Public Backlash,” the Wall Street Journal reported last month: It can do that, sure, but it looks bad.

Many comments will naturally come from financial firms whose businesses will be affected by the new rule. They tend to submit informed, articulate, helpful comments written by expensive lawyers; they will naturally be  self-serving, but they will often make the rules better. But many rules are intended to protect ordinary investors, and so there is some desire to get feedback from ordinary investors. 

How would a regulator get feedback from ordinary investors? One possibility is that an ordinary investor would learn about the rulemaking, go to the regulator’s website, read the proposed rule, have some thoughts, and submit a comment. This is not impossible, but it would be a little weird. Who does that? We talked in May about a good comment on the quarterly earnings rule submitted by “/r/wallstreetbets,” a Reddit retail investing community; in a sense they are ordinary investors, but they’re unusually dedicated and online. Ordinary ordinary investors are less likely to submit comments.

And so the normal way to get feedback from ordinary investors works something like this:

• Some financial firm, trade group, lobbying organization, etc. writes a comment letter reflecting what they think an ordinary investor might say. “This new rule will help me save more money for retirement,” or whatever.
• They go out and find some ordinary investors.
• They try to get the ordinary investors to submit the comment that they wrote. “This new rule will help you save more money for retirement, so you should submit a comment letter saying ‘this new rule will help me save more money for retirement,’ under your name,” they say.

This is to some extent a volume game: If you get 200,000 people to submit a comment opposing a rule, that makes it easier to argue that ordinary investors oppose the rule. Will most of those comments be form letters containing exactly the language that you wrote? Sure. Will that be embarrassing, undermining the perception that ordinary investors actually care? Oddly, no; everyone understands that this is the way the sausage is made.

Will some of those form letters be submitted by dead people, or otherwise attributed to people who did not actually submit them? Oh sure, sure, whatever. None of this is real. It’s not voting. The comments are not binding. The comments are valuable (1) to the extent they make convincing arguments and (2) otherwise as a sort of vague directional indicator of quantity. If only 199,000 of the 200,000 people who oppose a rule actually exist, that doesn’t change the analysis much.

Still it is embarrassing. We talked a few years ago about a proposed US Securities and Exchange Commission rule cracking down on proxy advisers, which was supported by heartfelt comments from ordinary investors, many of whom either didn’t actually submit the comments under their names, or allowed their names to be used without reading the comments. I wrote that, if you favor limiting the power of proxy advisers, you can just say that, but:

It’s better if you can find an 83-year-old Army veteran to say “how disgusted I am that my financial investments are being used as a political pawn,” or a retired Marine veteran” to say “I didn’t invest my money to have others make any kind of political statement. I invested my money to be able to leave something for my children and grandchildren in order to make their lives a little better,” or a hard-working single mother to say “Let the folks who work at proxy advisory firms bring about social change on their dime, not mine,” or a retiree to say “Call me naïve but I certainly didn’t sign up for groups with their own agenda voting my proxy!”

Obviously you can’t find people to say that, because no normal human actually pays attention to or cares about any of this. But if you work on one side of the issue, you can convince yourself that normal people should care about it, and then you can imagine what they might say if they did care, and then you can write it down, and then as a final, only-somewhat-fraudulent step, you can go find an ordinary person to sign the letter you wrote.

If they’re dead it’s harder, but not impossible. We have talked about proposed rules to allow more private assets (and crypto) in 401(k) retirement accounts, which is something that (1) the financial industry really really really really really really really really wants and (2) some ordinary investors might want, hey why not. So a lot of ordinary investors submitted comments supporting the rules, and some of them were fake or dead, Bloomberg’s Noah Buhayar and Jeff Kao report:

Heath Oderman was surprised to learn that a comment supporting a plan to get more Americans’ retirement plans invested in private equity and other “alternative” assets had been submitted to the federal government in May under his mother’s name.

She couldn’t have done it, he said, because she died in December.

“That’s not my mom,” he wrote in an email to Bloomberg News after being alerted to the comment, which was submitted to the US Department of Labor on May 3 under the name Danna Oderman. “The language is nothing she would ever have used while on this Earth.” …

The comment was one of nearly 12,000 showing signs that they may have been manufactured to resemble grassroots support for the controversial measure. … Bloomberg attempted to contact dozens of the people whose names were attached to the 12,000 comments and found five cases in which people said they — or their family members — did not submit them. 

So some fakes, but against a pretty low baseline of reality:

More than 92% of the submissions, both for and against the proposal, followed some sort of form letter.

The most popular of these was a petition that urged the government to scrap the proposal, arguing it would expose people to “expensive fees and dangerous levels of risk.” That message was sent more than 30,000 times, representing about two-thirds of all submissions.

Ninety-nine percent of these commenters included an email address and location in their submission, and many had personalized messages or signatures at the end of the form letter. Bloomberg attempted to contact three dozen of them. Most didn’t respond. But Judith Bergson, a social worker in Massachusetts, confirmed that she sent the comment and would be “terribly upset” if private investments were put into her retirement plans. “I’m definitely a person,” she added in an interview.

The advocacy group Americans for Financial Reform drafted the form letter that Bergson signed and worked with partner groups to disseminate it, said Ericka Taylor, the organization’s co-executive director. 

Incidentally, I have some firsthand experience with having financial regulatory comments submitted under my name! The SEC is considering new rules about sports gambling exchange-traded funds. I have written about this, because it is wild. At the end of one column on the topic, I wrote:

A couple of weeks ago, we discussed the US Securities and Exchange Commission’s “request for public comment on exchange-traded funds (ETFs) seeking to invest in innovative asset classes or engage in novel investment strategies” (sports gambling). You can submit comments here. I suppose this is my submission.

Here are the comments that have been submitted on that proposal.  One is from me. It used to contain the text of that column, though now it reads “Copyrighted material redacted” with a link to my column. I did not actually submit it, and I am not entirely sure how it ended up on the SEC’s website. I can’t really complain: I did write it, and I said “I suppose this is my submission,” so someone submitted it as a comment. And I like to think that the SEC will take it into consideration in writing rules about sports gambling ETFs. But the point is that there’s a comment on an SEC rule submitted under my name but that I did not submit. Could happen to anyone, really.

I have, a couple of times, espoused a tidy theory that hedge funds can smooth out lockup expiries for big initial public offerings. The theory is:

• When a company is added to an index, there is quite predictable demand for the stock, on a fixed date, from index funds. There is a big business, done mostly by multistrategy hedge funds, of smoothing out this demand. Basically the hedge funds buy the stock before the index rebalancing date, and then sell it to the index funds right on the rebalancing date. Therefore the stock shouldn’t go up too sharply when it joins the index; the hedge funds effectively average it in.
• When a newly public company has a lockup expiry, there is predictable supply: A bunch of early investors are finally allowed to sell, so more shares are available than were before. This also happens at a fixed date, and hedge funds can similarly smooth out the supply. Basically they can sell short the stock before the lockup release date, and then buy it from the insiders on the lockup release date. Therefore the stock shouldn’t go down too sharply when the lockup expires; the hedge funds can average it in.

This is only a loose analogy. For one thing, it is relatively easy to buy stock ahead of an index rebalancing; it is harder to short stock ahead of a lockup release. Shorting stock requires you to borrow it and pay a fee to your stock lenders, and when a company is newly public, with only a limited float, it is often hard to borrow. If there aren’t a lot of shares available to borrow, or if the fees are high, hedge funds will not be able to pre-sell all of the locked-up stock.

For another thing, index demand is quite mechanical: You can more or less count how many shares the index funds will need to buy, and then buy those shares to sell to them. The index funds are rules-based and price-insensitive, and there is a lot of data (from previous index adds, from quarterly rebalancings) about how they behave. Lockup-release supply is much less mechanical: You can count how many shares will be released from the lockup, but it is hard to guess how many shares will actually be sold. Lots of early investors are true believers and won’t sell when their lockups expire; others are price-sensitive and will sell at high prices but not low ones; others plan to dump all their stock but are on vacation on the lockup release day and only get around to it next week. You can sort of guess “well, when the lockup expires, some shares will come up for sale,” but it is hard to quantify precisely.

SpaceX had its first post-IPO lockup release on Aug. 7, and on Aug. 6 I wrote:

Really the expected price of SpaceX stock tomorrow, after the first phase of the lockup is released, should equal the closing price of the stock today: This is a well-anticipated event, and all of those short sellers have essentially been selling tomorrow’s shares today. That said, the variance around tomorrow’s price is high.

In fact SpaceX closed that day at $114.92 and opened the next day at $114.965, so in the narrowest possible sense I was right, but more broadly I think it is fair to say that the SpaceX lockup release was not especially smoothly averaged into the price. In fact, it seems to have been overdone: The stock got as low as $104.84 on Aug. 3, it rallied into the close on Aug. 6, and it has traded up ever since. Bloomberg’s Carmen Reinicke reports:

Since SpaceX went public in June, Wall Street had been dreading Aug. 6, when the first lockup preventing early investors from selling the stock expired and millions of shares were set to flood the market.

They needn’t have worried.

SpaceX shares have been on a tear since the lockup ended, soaring 35% in just five sessions, adding roughly $500 billion in market capitalization, and vaulting back over their $135 initial public offering price. The surge bucked concerns about an impending wave of selling and gave investors optimism that future expirations won’t be as painful as feared.

“We’ve gotten through the big hurdle, which was the unknown,” said Andrew Plum, managing partner and investment committee head at Loxahatchee Capital, which holds SpaceX shares. “It’s like the market discounts a negative event, maybe too much, as it’s waiting for that information to come to pass. And then it’s usually not as bad as what was discounted or as expected.”

One way to phrase “the market discounts a negative event, maybe too much” might be “shorts sold more stock ahead of the lockup release than was actually sold in the lockup release.”

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