Will CFTC Let Us Short The 7 Dwarfs?

The Commodity Futures Trading Commission (CFTC) is considering authorization of trading in movie futures contracts and all Hollywood, including the studios most likely to benefit from the new contracts, is screaming foul.  What is going on here?

One movie futures contract, proposed by an affiliate of  Cantor Fitzgerald, has been filed with the CFTC.  On settlement, the contract value is set at $1 for each $1 Million the film grosses in the first four weeks of wide release.  Consider a greatly oversimplified example.  Palin Pictures is about to release a new film, Tea Party Terror starring Barack Obama, which cost Palin $110 Million to make.  A few days before release, the Tea Party Terror futures contract is trading at $110 per contract.  Palin sells (aka goes short) a million contracts at $110 and keeps its short position open until the settlement date (shortly after the four weeks ends).  If the four week gross for Tea Party Terror is only $90 Million, then Palin nets $20 ($110 sales price - $90 settlement value) on each contract, or $20 million total, from the buyers (aka longs) holding open long positions on the settlement date.  Thus Palin has successfully used the contract to hedge what otherwise would have been a money losing production.  If the four week gross is $130 million, then Palin has a loss of $20 per contract ($130 - $110), $20 Million total,  but Palin has extra box office receipts to fund this expense, so the hedge did not cause Palin to lose, it just limited  Palin's gain.

Why was the example above so oversimplified?  Besides the auction mechanism to establish the initial price and volume  and a ton of details, we left out the fact that two different contracts are proposed, one by Cantor the other by Veriana Networks.  Cantor is an established investment bank.  It owns FSX.com, which, essentially, lets any visitor buy play movie futures with play money.  Another (real) futures contract sponsored by Cantor involves low prices and small investors.

Veriana, an incubator for media start-ups,  is proposing to limit trading in its contract to institutions, with clearing and settlement handled by the Minneapolis Grain Exchange.  Sounds more businesslike, but from whence are those deep pocket longs coming -  will professionals really lay out serious money to speculate on the movies?

In a letter to the CFTC,  the MPAA notes that studios would not use the futures contracts to hedge, and raises concerns of insider trading, market manipulation, conflict of interest and impact of the futures markets on the real world box office.  Normally, trading futures with “inside” information is legal, but movies aren't exactly orange juice (except maybe Trading Places).  Cantor's proposed rules for the movie futures include a prohibition on insider trading. The studios/producers/possibly directors and cast would have a real advantage in assessing box office potential and some opportunity to manipulate box office predictions in the trade press, not to mention the actual box office.  The contract's susceptibility to manipulation could run afoul of  exchange rules.  The studios are also apparently worried that a director or editor might take a short position then sabotage the final cut – although the MPAA's discussion of conflict of interest is not this blunt.

Futures contracts ordinarily serve some real world purpose.  They provide an opportunity to hedge for  those that use the underlying commodity in their regular business and offer a basis for pricing that underlying commodity (which can theoretically be anything – from aardvark hides to zucchini- except onions).  The pricing function probably has no application in the world of movies, at least as currently constructed.  The studios, the most logical hedgers, are saying they won't hedge and could not even if they wanted to, because of insider trading issues.  Even if the studios wanted to hedge, it's not clear where the buyers for any serious volume are coming from.  An exchange based on $2 bettors playing the movies instead of the ponies (which seems to be suggested by the Cantor approach) is a nightmare for the CFTC.  What commissioner wants to see a sports gambling futures contract in the next application?  The movie futures contract might even generate some concern from the SEC  - especially if it's marketed as a chance to invest in potentially profitable films.

In sum, the CFTC is looking at a contract with a shaky value add to the real business of making movies, a production industry that doesn't want it and a slippery slope of regulatory problems that might follow an approval.  Add in the fact that derivatives are still a dirty word in Washington and  the prospects of the movie futures contract are ...well, for those interested in trading the new contracts, let's just say this is looking more like an exercise in neo-neorealism than a classic happy ending.

Photo Credit: Sklathill