Money Stuff: Don’t Hedge the KPIs

We talked last week about a proposal by Cboe Global Markets Inc. to list binary options on key performance indicators (KPIs). A “key performance indicator” is a measurable value that shows how well an organization is achieving its goals. Cboe wants to list options on KPIs for public companies, things like net income or revenue or, in the case of a car company, how many cars it makes. These KPIs tend to demonstrate how well the company is creating shareholder value, and so they correlate with stock price. Not perfectly — a car company can make more cars in a way that is bad for shareholders — but as a rough approximation.

We also talked about KPIs for public companies that happen to be sports teams, like Madison Square Garden Sports Corp., which owns the New York Knicks. The obvious KPI for the Knicks is how many basketball games they win. I suggested that there’s probably some correlation between basketball wins and business success, writing that “if the Knicks do great, MSGS makes more money selling tickets and whatever; if the Knicks are terrible MSGS makes less money.” 

One purpose of KPIs is to measure and reward employee performance: You figure out what you want from a division manager, you set some KPIs to reflect those goals, and then if she hits those KPIs you pay her a bonus. Senior corporate executives will often get bonuses based on achieving company-wide KPIs like revenue growth or profit margin. Elon Musk gets a bonus at Tesla Inc. for delivering a million robotaxis. 

A company that promises its chief executive officer a bonus for hitting her KPIs is taking on some financial risk. The risk is like: “If our CEO succeeds in selling a million cars, we have to pay her a $20 million bonus; if she doesn’t, we don’t.” Twenty million dollars is a lot of money, and you could imagine the company wanting to hedge that risk. Perhaps it could go to Cboe and buy a contract — on its own car deliveries — that pays it $20 million if it sells a million cars, and $0 if it doesn’t. Now it is hedged; it is indifferent between hitting the KPI (and paying the bonus) and not hitting the KPI (and not paying the bonus).

Except this is stupid? The company (1) is not indifferent between hitting the KPI and not hitting the KPI and (2) obviously shouldn’t be. The company wants to sell a million cars. Selling a million cars is good: The company set “sell a million cars” as a goal because it thought that would be correlated with increasing shareholder value. The reason the company promised to pay its CEO a $20 million bonus for selling a million cars, and $0 for failing to sell a million cars, is because the company expected to be better off, financially, in the state of the world where it sells a million cars, even after paying the bonus. [1]

And so hedging the bonus feels misguided. If the executive fails to hit the target, (1) the company is worse off overall and (2) it loses on the hedge. If the executive succeeds in hitting the target, (1) the company is better off overall and (2) it gets paid on the hedge. It’s not a hedge. Or rather: It’s a hedge to the executive’s bonus, but it’s not a hedge to the overall situation of the company. The executive’s bonus is, itself, the hedge. The executive costs the company more in good states of the world (for the company), and less in bad states of the world. Why go to prediction markets to reverse that?

(Of course you don’t need prediction markets. A company could just buy regular options on its own stock, to hedge the risk that its executives’ stock options will turn out to be very valuable because they successfully increase the value of the company. But, again: stupid! The company doesn’t need to hedge against the risk that its value will increase! Though of course companies often do buy back stock to offset dilution from stock-based compensation.)

Anyway a several readers sent me this story from InGame:

A third party helping Louisiana State University hedge against potential bonus payments to football coach Lane Kiffin used bets on the team’s performance on Kalshi to offset exposure. Similar trades were placed last month on South Carolina’s football team, again from a third party rather than the university, though the exact risk being hedged for those trades is less clear.

Two weeks ago, five “block” trades — trades negotiated off exchange — were placed on LSU to have a successful college football season, worth a combined $3 million.

In July, there were block trades in two markets concerning the University of South Carolina.

The trades were not placed by the schools. In fact, Kalshi’s trading prohibitions for the market would ban employees of teams involved.

Instead, InGame understands that the trades were placed by a third party that assists with hedging of risks such as coach bonus payments for sports teams.

Large block trades worth between $300,000 and $900,000 were placed on LSU to make it to the College Football Playoff, make it to the quarterfinals, make it to the semifinals, make it to the national championship game, and win the national championship.

The total combined payout of $3 million if LSU won the national championship (causing all five trades to pay out) is exactly equal to Kiffin’s national championship bonus payment. The payout for making it to the playoff or advancing to the quarterfinals, semifinals, or finals are all close to Kiffin’s bonus payment for each round, though never exactly matching.

One point here is that, within living memory, people thought it was bad for athletes and coaches and teams to bet on their own games. Now it’s “hedging” and it’s fine.

Another point here is: If it is bad — insider trading, under Kalshi’s terms [2]  — for teams to bet on their own games on Kalshi, is it also bad for teams to do over-the-counter trades on their own games with counterparties who then lay off the risk on Kalshi? Isn’t LSU essentially trading on Kalshi, in this scenario? 

But the main thing that bugs me here is: Why should LSU hedge this risk? Surely LSU wants to have a successful college football season? Surely winning the national championship would be good for LSU? Like, economically? I am not an expert in the economics of college sports, but I gather that if you win national championships that helps you recruit tuition-paying students, and extract donations out of alumni, and get lucrative television contracts. The reason that you offer a celebrity coach a cash bonus for winning the national championship is that you expect a national championship to bring in more money. Why do you need to hedge that?

I wrote above that perhaps a car company “could go to Cboe and buy a contract — on its own car deliveries — that pays it $20 million if it sells a million cars, and $0 if it doesn’t.” Here’s a question: Is that insider trading?

One simple answer is that, if the company has no material nonpublic information about its own car deliveries, it’s not insider trading. After all, the company is buying that contract as a hedge, meaning that it is genuinely uncertain about how many cars it will deliver. Perhaps the company announces its 2026 results in February 2027, and in the earnings announcement gives guidance about how many cars it expects to deliver each quarter, and then it goes out and buys a contract on its 2027 car deliveries as a hedge. It can argue “the market knew everything we knew, so we weren’t insider trading.”

You could quibble — even after the company issued that guidance, surely it knew more about its own sales prospects than the market did — but this is in fact a traditional analysis when companies trade their stock. When a company wants to issue stock, it puts out a prospectus disclosing its financial results and any material business news; when it wants to buy back stock, it usually waits until after announcing earnings to start a buyback program. [3]  After those disclosures, everyone just agrees to pretend that a company does not know more about its business than the market does, so the company can trade its stock. Perhaps prediction-market contracts on KPIs like net income, revenue or units sold would work the same way.

But let’s assume that the company does have material nonpublic information about its own deliveries. Let’s say it’s totally trading on the basis of material nonpublic information: Let’s say there’s a contract on “Company X announces deliveries of at least 1 million cars for the year through August,” and that contract is trading at 40% on Aug. 31, and the company knows it has sold 1.05 million cars this year, so it goes and buys up a ton of the contract at 40 cents to make a quick profit of 60 cents. Is that illegal?

Nothing here is legal advice, and I don’t really know the answer, but let me make four points:

1. It would be illegal if the company was trading its own stock, or its own stock options: Companies are not allowed to trade their own stock using material nonpublic information, on the theory that this violates their fiduciary duties to their shareholders. [4] The same rule applies to stock options. What we discussed last week is that Cboe wants to list these sorts of KPI binaries as, essentially, stock options: The theory is that a contract that pays $1 if a company’s earnings or revenue or car deliveries exceed X, and $0 if they don’t, is close enough to a bet on its stock that it should be listed on a stock options exchange, regulated by the US Securities and Exchange Commission, and treated like a stock option. If that’s correct — if the SEC lets Cboe list these KPI binaries — then the same insider trading rules might apply, and it would be illegal for the company to bet on its KPIs using inside information.
2. It would not, on the other hand, be illegal for an oil company to make bets on the price of oil, even if it had inside information about its own oil production that could be material to oil prices. Trades in commodity derivatives — like oil futures contracts — are regulated by the US Commodity Futures Trading Commission, not the SEC, and the rules are slightly different. I sometimes quote a CFTC commissioner’s point that commodity insider trading is only illegal if it involves “misappropriated confidential information in breach of a pre-existing duty of trust and confidence to the source of the information,” because of “the special characteristics of the derivatives markets, where end users necessarily trade on the basis of their own proprietary information in order to hedge their risks.” That is: Oil companies trade oil futures to hedge their oil-price risk, and they’re allowed to do that using their own proprietary information. And US prediction markets like Kalshi are generally regulated by the CFTC and treated as commodity derivatives markets. And Kalshi does list contracts on car deliveries; part of our discussion last week was about a turf fight between Kalshi (which wants these contracts to be regulated by the CFTC) and Cboe (which wants them regulated by the SEC). If a bet on car deliveries is a commodity swap, then maybe the company is allowed to bet on its own deliveries using inside information?
3. Nonetheless Kalshi, the leading US prediction market, seems to take a more expansive view of insider trading than is required by US commodities rules. Kalshi’s exchange rules, which “are approved and certified by the CFTC,” prohibit trading by “any person who has access or is in a position to access material non-public information before such information is made publicly available,” and by “any person who is a decision maker, direct or indirect, or has any influence, direct or indirect, on the outcome of the underlying event for any contract.” Does that cover the case of a car company betting on its own deliveries? I think so. (Thus the discussion above about LSU betting on its football results over-the-counter rather than directly on Kalshi: Kalshi appears to prohibit LSU from betting on itself directly.) If a car company bet on its own deliveries on Kalshi, using inside information, that would probably violate Kalshi’s rules. Would violating Kalshi’s rules also make it illegal insider trading? I dunno, maybe.
4. In any case, if an employee at the car company bet on its deliveries using nonpublic information, surely that would be illegal. Whether or not the company can trade using its own information, an employee can’t trade using her employer’s information. (“Misappropriated confidential information in breach of a pre-existing duty of trust and confidence to the source of the information.”) “Insider trading,” I often write, “is not about fairness, it’s about theft,” and that would be a theft of the company’s information.

By the way. You can see why Kalshi would have a blanket prohibition on insider trading: It’s trying to position itself as a well-regulated safe exchange, and to market itself to retail gamblers; letting companies bet on their own results using inside information sort of undermines Kalshi’s positioning. On the other hand, Kalshi also wants to be a good platform for corporate hedging, and corporate hedgers do sometimes trade with inside information. (Oil companies trade oil futures, or LSU hedges its football results.) I feel like we are still early in figuring out the right insider trading rules for prediction markets. Should a sports team be allowed to bet that it will lose a game, to hedge the risk of its star player getting injured? Should it be allowed to bet against itself, knowing that the star player is injured? Etc.

Anyway here’s a Wall Street Journal story about insider trading on KPI binaries on Polymarket, a less-regulated exchange:

Another case authorities are pursuing focuses on an employee at KPMG, the global accounting and consulting firm, people familiar with that investigation said. The employee is under investigation for betting on whether a specific public company would beat the consensus estimate for quarterly earnings, one of the people said.

Authorities view such bets as illegal if the person was entrusted with material nonpublic information about the company’s financial performance as part of their job. 

Right that one seems straightforward. Elsewhere, Kalshi banned George Santos for life, sure.

I used to say that “one of the best services a retail broker can provide is not answering the phones during a crash.” The idea is that a lot of retail investors have some bad ideas, and the more opportunities they have to trade, the more bad trades they will make. I have softened a bit on the specific point: Actually modern retail investors tend to buy the dip, not sell in a panic when markets crash, so a retail broker who doesn’t answer the phone [5]  during a crash, these days, is costing investors money. 

Still, there is probably some continuing relevance to the intuition that, the more retail investors trade, the worse they will do, so retail-investor-facing technology should be glitchy and hard to use. We talked a few weeks ago about the rise of agentic artificial intelligence for retail investors, which is the opposite of this: Agentic AI will let retail investors make tons of trades effortlessly, which will be convenient for them, but also, in expectation, expensive. In general, financial markets — all markets — have a tendency to eliminate frictions and make everything easier, faster, more efficient and more pleasant. But making it easier to lose money is bad.

South Korea is pushing the other way, though, making at least some retail trading unpleasant for paternalistic reasons:

Leveraged exchange-traded funds targeting twice the daily returns of chipmakers Samsung Electronics Co. and SK Hynix Inc. have seen their trading value collapse to 4% of its June peak and are set for their first monthly outflow.

Key to sapping demand has been a series of regulatory tightening moves, most recently a rule to complete five-day simulated trading. Investors must download a Windows-only program on PCs and spend at least an hour a day learning the ropes — and the risks — of leveraged trading with virtual cash. Interviews with several Korean retail investors suggest the new requirement, effective Aug. 19, is too cumbersome to meet.

When Kim Jung-hoon, a 41-year-old resident of Gyeonggi province outside Seoul, heard about the mandatory mock trading, his first reaction was that he wouldn’t even attempt it because it was “too much of a hassle.”

“The hours sound long and you can only download the program on PCs,” Kim said. “My work computer can’t download external programs. It doesn’t sound easy to bring an extra laptop with me to work.”

“Make people download annoying software” does not sound like an effective financial stability tool, but it probably is.

A crude story that you could tell is that, for a while, the preferred currency of online criminals was Bitcoin. The US government caught a number of those criminals and was able to seize their Bitcoin. And thus the US government has a stash of Bitcoin that it acquired from criminals. The libertarian anti-establishment currency is now an asset of the federal government.

A more speculative story you could tell is that, for a while, the preferred currency of risk-loving effective altruists was Anthropic shares. The effective altruism movement and Anthropic — the most vocally AI-safety-worried of the big AI labs — are deeply intertwined, and in the early days, before Anthropic was a $2 trillion company that can raise money from everyone, it seems to have raised a lot of money specifically from EA types who love (1) worrying about AI safety and (2) otherwise taking every positive-expected-value bet that comes their way. 

With that attitude, they tend to blow up. But Anthropic doesn’t blow up. Anthropic is doing great, and provides some cushion for the blowups. Leopold Aschenbrenner’s Situational Awareness hedge fund owns a big chunk of Anthropic, because of course it does, and when it blew up it shopped that stake around, though ultimately it kept the stake and sold other stuff instead. And when Sam Bankman-Fried’s FTX crypto exchange blew up, its Anthropic stake was similarly sold to pay off its debts. Or not quite. Actually FTX didn’t own Anthropic stock; Bankman-Fried did, and he turned his stock over to FTX to help cover its customer claims. But he wasn’t the only one. Business Insider’s Jacob Shamsian reports on the personal Anthropic stakes of other FTX executives:

Bankman-Fried's own Anthropic stake was liquidated in the bankruptcy of his failed cryptocurrency exchange. The Anthropic equity owned by Caroline Ellison and Nishad Singh, two associates who invested alongside him, took a different path. The government seized those shares and sold them to existing Anthropic shareholders, according to a person familiar with the sale. …

Bankman-Fried, Singh, and Ellison each invested in Anthropic's 2022 Series B funding round. Bankman-Fried bought $500 million worth, which according to court records represented 13.56% of Anthropic at the time. Singh acquired $40 million in shares, and Ellison acquired $10 million in shares, court records reviewed by Business Insider show. …

The Anthropic shares purchased by Singh and Ellison could together be worth between $4.17 billion and $5.03 billion today, based on the $965 billion valuation the company announced this May, according to Olav Sorenson, who teaches venture capital strategy at UCLA. Harrison Rolfes, an analyst at PitchBook, put the combined figure at $2.62 billion. If Anthropic went public at a $2 trillion valuation, the shares would be worth about $5.44 billion, Rolfes said.

For a while everyone was just out there flipping coins for vast wealth or ruin. And then all their coins came up “ruin,” but much later their Anthropic coins all came up “vast wealth.”

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