Money Stuff: Prediction Market Structured Notes

Yessss here’s a trade:

1. You give me $100.
2. I spend $96.90 buying a US Treasury bill that will mature at $100 in February 2027.
3. I spend $2 buying Kalshi event-market contracts (that is, sports bets) on the Los Angeles Rams winning the pro football championship in February 2027. (The “pro football championship” is the Super Bowl.) The Rams have the best odds on Polymarket right now, but there are 31 other teams, and the Rams’ probability of winning is only 10%. I can buy 20 contracts for my $2. If the Rams win the Super Bowl, those contracts will pay out $20; if not, they will pay out $0.
4. I keep the other $1.10 for myself; I’ve earned it.
5. In February 2027, I will pay you back $120 if the Rams win the Super Bowl, or $100 if they don’t: I will hand you the payoff of the Treasury bill plus the payoff of the Kalshi contracts.

What is this trade, from your perspective? Well, I mean, it’s sort of like you have bought a bond from me, and the bond pays interest, and you have wagered all of your interest on the outcome of the Super Bowl. It’s a bond plus a football bet.

But of course the financial industry is full of trades with the form “a bond plus an unrelated derivatives bet.” They are traditionally called “structured notes,” or “structured products.” They are sold, often by financial advisers, as a single package, a bond issued by a bank or broker with a payoff that varies based on some index or fact. The point is that the derivatives bet is fully embedded in the bond. The structured note is not a bond plus a separate derivatives bet; the derivatives bet is in the bond. 

This product thus has the following potentially interesting features:

1. Your financial adviser could sell it to you. (As opposed to your bookie.) “I have a cool new structured product,” she tells you. “It offers 100% principal protection and high potential upside. The upside is risky but uncorrelated.”
2. She’s right: Your returns on this trade depend on the Rams winning the Super Bowl, which is probably uncorrelated to the rest of your investment portfolio. (It might be correlated to the rest of your sports gambling portfolio!) Investors love uncorrelated returns.
3. If you are a Rams fan, you might find this structured note more appealing than some other structured note with a higher expected value but no embedded football bet.
4. If you are a Seahawks fan, you might find this structured note appealing as a hedge against the risk that the Rams win the Super Bowl. (Or you might want a similar note that pays 20% if the Seahawks win.)
5. If your spouse, or your accountant, or your boss at the mutual fund where you work, asks you about this note, you can be like “oh yes, that’s a structured note that I purchased from a reputable broker-dealer. It has a lot of embedded optionality. Uncorrelated returns! Convexity!” To your spouse or accountant, this looks like a securities trade, because it is a securities trade. You have bought a bond. It sits in a securities custody account at your broker, it has a CUSIP, its cash flows work like all of your other bonds. The tax treatment is favorable. No one is going to be like “honey I think you might have a problem” about your structured notes portfolio.
6. I keep saying “structured note,” but we have talked a lot around here about the ETF-ization of structured notes. Trades of this form — bond plus embedded derivative — have traditionally been marketed as structured notes, but the modern trend is to put them into exchange-traded funds. (The ETF just buys Treasury bills plus the relevant derivative.) In ETF form, this might be easier for some financial advisers to sell to their customers. And it’s a lot easier for self-directed retail investors to buy. Go on Robinhood and buy the Rams 2027 Principal Protection ETF, why not. [1]

Of course these days you can go on Robinhood and bet directly on football games, but it is possible that principal-protected sports bets would attract a different audience. “Bet on the Rams, but you can’t lose money,” it’s a decent pitch!

Obviously Kalshi and Polymarket offer contracts on all sorts of events; sports are most popular, but you can substitute freely. A bond that pays you $100 if Democrats win the Senate and $108 if Republicans do, or vice versa. [2] A bond that pays you $110 if xAI has a top-ranked artificial intelligence model this year, and $100 if it doesn’t. A bond that pays $107 as long as Taylor Swift gets married this year, but $100 if she doesn’t.

Or something economic, even! A bond that pays $110 if the economy is in stagflation at the end of 2026 and $100 if it isn’t. A bond that pays $100 plus $3 for every Fed rate cut this year. A four-year bond that pays back $100 in 2030, plus $3 of interest each year, with a $20 one-time bonus payment if unemployment ever touches 9% in that time. It is not especially hard to tell a story about why investors — even institutional investors — would want a thing like that. You might have some thesis about stagflation or unemployment or the number of rate cuts, and rather than translating that thesis into some prediction of asset prices (for Treasuries, stocks, whatever), you can just buy an asset whose payoff directly reflects the number that you care about.

Of course, again, you can do that directly on Kalshi — you can bet on rate cuts or stagflation or unemployment or Taylor Swift’s wedding date — but you might not want to. “Bet on unemployment, but you can’t lose money” might be a better pitch than an all-or-nothing binary bet. [3]  Or, you know, you might want to have all your trades in a securities custody account with your broker, and bond-plus-unemployment-bet works better for that than the pure unemployment bet.

Anyway Bloomberg’s Bernard Goyder reports that there are prediction-market structured notes now:

Investors who like the binary bets on Kalshi and Polymarket but without the all-or-nothing risk are being offered an unlikely new asset: a bond-like note tied to prediction market outcomes.

London-based Marex Group Plc created and sold the first instance of this new kind of security, which will pay out a 7% coupon if Nvidia Corp. is still the world’s largest company in a year.

The issuance is the latest sign of how Wall Street firms are trying to harness the fast-evolving energy of prediction markets, which have so far attracted interest primarily from small retail traders. …

Marex was able to create the note because prediction markets like Kalshi offer it a place to hedge its risks as the odds move over time. As a non-bank structured notes provider, Marex doesn’t take market risk with its issuance and fully hedges itself using derivatives.

“Marex is going to effectively build our own prediction market structured products, and then leverage Kalshi and other exchanges to replicate that,” said Nilesh Jethwa, chief executive of Marex Solutions, a unit of Marex.

Yessss. A year ago, I wrote: “I kind of think we are about two years away from a sports gambling ETF.” We are perfectly on schedule.

I think a lot about this 2018 Wall Street Journal article about David Einhorn’s hedge fund, Greenlight Capital. Greenlight had had a run of bad performance, and some investors complained to the Journal that performance was bad and they couldn’t get their money back, because they had agreed to strict long-term lockups. One said: 

The liquidity terms are onerous and out of the norm today. … Investors would be more comfortable with those terms if the returns were better.

As I wrote at the time:

Well but the returns aren’t better! And the investors would no doubt be quite comfortable withdrawing their money if the liquidity terms were less onerous! The downside of strict liquidity terms, for a hedge fund manager, is that when your performance is bad your investors complain to the press about your liquidity terms. The upside is that they can’t take their money out.

The correct sequence, for a money manager, is roughly:

1. Have good performance.
2. Now everyone wants to get into your fund.
3. Let them in, but demand a long strict lockup: The only way they can get access to your hot in-demand fund is by agreeing not to take their money out for a long time.
4. Raise as much money as you can on those strict terms.
5. Now you can have bad performance!

Obviously Step 5 is not necessary and is, in fact, bad; better to keep having good performance. The point is that, if you execute Steps 1 through 4 correctly, Step 5 is an option. If you don’t, it isn’t. Your job is to keep managing money. Having good performance is a necessary element of that job, but it is not a permanently necessary element. 

Really you can replace “performance” there with, like, “marketing,” or really anything that makes people want to get into your fund. The core sequence is: People want to get into your fund, you demand a lockup to let them in, and then later, when they want to get out, you say no.

Non-traded business development companies — private credit funds marketed to individual investors — seem to have gone through this cycle. I mean, performance was good (high yields with low defaults) for a while, and the marketing was very good, with financial advisers putting a lot of clients into a lot of non-traded BDCs, and with a big and successful push to allow more private credit in retirement plans.

And now we talk every week about individual investors who want to take their money out — because of worries about credit, because yields are under pressure, or just because the branding has kind of soured — but who can’t. Those BDCs typically offer to redeem up to 5% of their shares each quarter, and if more people want their money back, tough. Today Bloomberg’s Olivia Fishlow reports:

Blue Owl Capital Inc. will limit redemptions from two of its private credit funds after facing a surge in withdrawal requests that is unprecedented among major firms in the $1.8 trillion market.

Investors in its $36 billion Blue Owl Credit Income Corp. fund, one of the industry’s largest, asked to pull 21.9% of shares in the three months ended March 31, according to an investor letter, up from 5.2% in the prior period. The smaller Blue Owl Technology Income Corp. saw shareholders ask for 40.7% back, compared with 15.4% three months earlier, according to a separate letter.

Both funds had previously met the requests in excess of its 5% tender offer. This time, though, Blue Owl said it would join industry peers in capping redemptions at that level, “in accordance with the fund structure, reflecting our commitment to balancing the interests of both tendering and remaining shareholders.”

Blue Owl Technology Income Corp. (OTIC) got 15.4% redemptions in January, and paid them out, but January was a long time ago. In making these decisions as a fund manager, you have to balance between marketing to new investors and keeping the money of your existing investors. Paying out big redemptions is good marketing, and if you think that the big redemptions are caused by temporary volatility or nerves, and that you have huge tailwinds coming when everyone puts private credit in their 401(k)s, then you should prioritize marketing: The important thing is to show confidence and get a good reputation, and the money will come flowing back.

When everyone is constantly getting 10+% redemption requests for their private BDCs, and saying no, you chuck the marketing and focus on keeping the money. The Financial Times reports:

Craig Packer, Blue Owl’s co-president, said in an investor update that he believed the uptick in redemptions reflected a “period of heightened negative sentiment toward the asset class that has intensified as peers have reported tender results”.

“While we believe market perception has driven elevated tender activity, underlying credit fundamentals across our portfolio have remained resilient,” he added. “We continue to observe a meaningful disconnect between the public dialogue on private credit and the underlying trends in our portfolio.”

When market perception gets bad, that’s when you’re glad to have the gates.

(Disclosure: Through a financial adviser, I have some money in Blue Owl Credit Income Corp.)

Elsewhere, Bloomberg’s Alison McNeely reports that “KKR & Co.’s non-traded business development company KKR FS Income Trust … curbed redemptions after receiving an increase in such requests,” though only to a relatively tame 6.3%.

One simple theory of private markets is that investors like it when prices don’t go down. If you can buy a thing for $100 that pays you $10 a year, pays $100 at maturity and is always valued at $100 on your balance sheet, that is better than a thing with a similar expected payoff but a more volatile price. High returns with low volatility are best. If you pay $100 for a thing that trades in a liquid public market, the next day it might trade at $99 or $101. If you pay $100 for a thing that never trades, you know it will never trade at $99 or $101. You have completely solved volatility.

I mean, not completely. There are two problems with this theory:

1. The lesser problem is that, like, Cliff Asness will make fun of you. Everyone is aware of these dynamics. “Volatility laundering” is Asness’s phrase for it.
2. The greater problem is that sometimes a $100 thing becomes worth $90 because of a genuine increase in the probability that it will pay back $0. Oh, you can ignore that! But every so often that probability comes true and you can’t. “BlackRock Slashed Private Loan Value From 100 to Zero,” is a good Bloomberg headline from a few weeks ago. If you take this stuff very literally, then there are only two possible states for a private loan: Either it is worth 100 cents on the dollar, or it is in default. You mark it at 100 until you are absolutely sure it is worth zero. [4] Most of the time it never gets to zero, and you have no volatility. Occasionally it gets to zero, and then you have “BlackRock Slashed Private Loan Value From 100 to Zero,” whoops.

Anyway here are three stories about that. First, at Pitchbook, Sami Vukelj reports:

More private credit loans are up for sale than ever before on a nascent secondary market, driven by elevated investor redemptions in BDCs that are pushing credit managers to seek ways of boosting liquidity in a skittish market.

However, the elevated inventory of loans for sale does not necessarily mean that secondary trading has increased significantly, market participants say. Instead, the supply of loans is outpacing demand for them, and aftermarket liquidity for private credit loans is thin.

Most offers for the loans are at or very near par, limiting investor appetite for them, market sources say.

“If BDCs are able to sell close to par, they absolutely are considering it. But buyers are not really there in a systematic way to buy these loans at par, and the bid/ask spread remains very wide in reality,” one direct lender said.

Uh, right. The simplest way to interpret private BDC redemption requests is that the redeeming investors don’t think that the BDCs’ loans are worth what the managers say they are worth: If the managers mark the loans at 100 cents on the dollar, and you think they’re worth 80, then you should redeem and get back 100 cents on the dollar while you still can.

If you redeem, the BDC will probably look to sell some loans to balance out your redemption. But if the BDC marks the loans at 100 cents on the dollar, it will try to sell the loans at 100 cents on the dollar. If everyone else thinks they’re worth 80, well, hmm.

Second, at the Wall Street Journal, Jonathan Weil has a story about Blue Owl’s loan sales from a few weeks ago. In response to a previous round of redemptions at private BDCs, Blue Owl sold some loans. It sold the loans for 99.7 cents on the dollar, which is pretty good. But Weil points out that “some of these purchasers, particularly Calpers, already owned stakes in the same assets they were buying, giving them an interest in avoiding a markdown of their existing holdings”:

If a buyer already owns a large amount of the same assets through its existing funds, it has a natural incentive to protect those valuations. Buying at a discount could force a write-down of the existing book, while buying near par validates it.

It’s not clear how big a deal this is — “people familiar with the matter … said Calpers liked the terms and rejected some assets, and that supporting valuations wasn’t a consideration,” and the other buyers did not have much overlap — but in a situation where (1) current owners of private credit loans really think they’re worth 100 and (2) everyone else thinks they’re worth 80, you’d expect the main buyers at 100 to be the current owners.

Third, the Financial Times reports:

Investors who specialise in scooping up distressed assets at bargain prices have identified a downturn in private credit as their best opportunity since the 2008 financial crisis.

These funds, which typically invest in companies with bad balance sheets but viable underlying businesses, have been largely sidelined for a decade as markets surged but are now betting on making money from strains in private credit.

“Biggest opportunity since 2008,” said Victor Khosla, founder of Strategic Value Partners, which manages $22bn in assets.

I … kind of don’t even know what that means? If you enjoy scooping up distressed assets at bargain prices, private credit is not currently offering you a ton of opportunities; all those loans are for sale at 100 cents on the dollar. But I suppose the bet is that they will be at 100 for a while, and then they’ll be at zero, and at zero there will be some bargains.

Here is a New York Times story about a guy named Matthew Gallagher, who runs a business called Medvi that sells GLP-1 weight-loss drugs online. The workflow is roughly that a customer comes to Medvi’s website, the customer fills out some forms, a doctor reviews the forms, the doctor prescribes the drugs, the drugs are shipped to the customer, and Medvi charges the customer’s credit card. The Times story is about how Medvi is “on track to do $1.8 billion in sales” this year and is this close to being a one-person company:

Sam Altman, the chief executive of OpenAI, predicted the rise of a new breed of superefficient company in 2024. A one-person business worth $1 billion “would have been unimaginable without A.I.,” he said on a podcast, “and now it will happen.” ...

In an email, Mr. Altman said that it appeared he had won a bet with his tech C.E.O. friends over when such a company would appear, and that he “would like to meet the guy” who had done it.

Medvi is technically not a one-person $1 billion company, since Mr. Gallagher hired his brother and has some contractors. The start-up, which has not raised outside funding, also has no official valuation. But many highly valued tech companies can only dream of hitting $1 billion in revenue with so few workers. Medvi is also profitable, Mr. Gallagher said.

Okay but. Gallagher and his brother do not have a factory that makes the drugs; they get them from established drug makers who employ lots of people. Also, they are not doctors. Who is prescribing the drugs? Well, a different company:

CareValidate offers what is essentially a telehealth-in-a-box kit. Companies, employers or retailers that want to sell customers prescription drugs can use CareValidate’s technology and network of online doctors to set up a business. The company’s software connects patients with doctors and pharmacies, which write, fulfill and ship the prescriptions. CareValidate charges fees for its software.

Mr. Gallagher saw an opportunity for his own telehealth business. He could use A.I. to do the branding and marketing and let CareValidate and a similar platform, OpenLoop Health, handle the doctors, pharmacies, shipping and compliance. 

CareValidate has the doctors and pharmacists and ships the drugs, which it gets from other companies that have factories. Presumably some humans work at the factories, and the doctors and pharmacists are also humans. And then there is Medvi, which as far as I can tell does some customer service (via chatbot but also humans) and a lot of online marketing.

You could imagine a world in which the companies that make the drugs also had a fully integrated sales and customer service channel, and they did all this. You could imagine a world in which the doctors, or the telehealth-in-a-box companies, also had good marketing and search-engine-optimization and checkout functions, and they sold all the drugs. Or you could imagine a world in which the drug companies said “you know what, we’re going to outsource some of our consumer sales and marketing to this guy Matthew Gallagher,” and paid him a cut of the sales he generated. And then if he generated $1.8 billion of sales, his cut would be, you know, some percentage of that number. 

But in the world we actually live in, lots of companies exist to provide essentially APIs to other companies. There is a generation of US-based direct-to-consumer online retailers that do design and branding and checkout and advertising for products that are made on contract by factories in China. There are people who have gotten rich on dropshipping, just interposing themselves as online middlemen between companies that make stuff and consumers who want to buy it. If you buy fully finished products online for $98 and sell them for $100, your revenue is $100, even though in some obvious sense $98 of the economic value was created and captured by the company that made the products.

That is interesting! You can run a one-person dropshipping business, and have a lot of revenue in the strict accounting sense, and also have nice profit margins for yourself. But that is result of the increasing modularity of companies and the fact that capturing consumer attention online is a specialized business that a lot of, like, even drug manufacturers aren’t good at. Is it also about AI? I dunno, maybe.

Sure:

JPMorgan Chase CEO Jamie Dimon teased to Axios’ Jim VandeHei in an interview for “The Axios Show” that he may look to start a media venture after he’s done leading one of the world's most influential banks. ...

Dimon said he’s also considering teaching, in addition to writing a book once he’s done with his role.

He should start a podcast? Elsewhere: “OpenAI acquires TBPN.”

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