Why betting on the financial performance of movies is a dangerous idea.

Max Keiser is unhappy. “I feel like Robert Oppenheimer. I invented something and it destroyed civilization.”

Keiser, unlike Oppenheimer, didn’t have access to atomic bombs. His lethal weapon is more the financial kind, and after a long hibernation it has become the root of this year’s biggest controversy in
Tinseltown: an exchange on which traders could bet on the performance
of movies. What Keiser created along with Michael Burns in 1996 was the
Hollywood Stock Exchange, a virtual technology where over 350,000
registered players traded shares of movies and celebrities using fake
dollars. If Congress approves the idea, real trading should go live on exchange as soon as June 28—with real money.

For much of its life, the HSX has functioned as a prediction market, and pretty accurately; in 1999, its users correctly called 82 percent of the major Oscar nominees. Keiser’s technology eventually got
acquired by Wall Street bond trading firm Cantor Fitzgerald, then
warehoused in favor of different technology created by Cantor
itself—although the name and idea of his creation have lived on for the
past 12 years.

Now that it is trading with real money, the question raises itself: Is this really a good idea? Given the rampant recent history of derivatives trading destroying investors and investment banks,
shouldn’t we be afraid of an investment instrument that combines the
worst of two greed- and gossip-driven entities, Wall Street and
Hollywood? The financial reform bill currently being hammered out in
Congress perpetuates the idea that derivative trading is out of control
and carries high risk. So why does anyone think we can effectively
regulate movie star futures if we had to bail out AIG (AIG)?

Championing the idea are Cantor Fitzgerald and Veriana, a company looking to create the new Trend Exhange on which to trade derivatives based on Hollywood movies. Except this time, Wall Street firms don’t
want to use fake dollars to bet on movies; they want to use real money.
Instead of trading imaginary “shares” based on Hollywood movies, they
want to create derivatives, like the ones that allow traders to bet on
everything from corn prices to the weather.

Opposing the idea is the Motion Picture Association of America, which believes that derivatives will skew the movie business’s important opening weekends, that rivals could sabotage films by betting
against them, that insider trading would be rampant as gossip leaked
from every set in the incestuous world of Hollywood. Hollywood is based
on hype, and a derivative of hype is zero, Keiser argues. “This could
be the Enron of 2011 or 2012,” Keiser warns. He adds with sarcasm,
“Let’s take the fantasy of Hollywood and mix it with the fraud of Wall
Street. That’s a winner. You’re mating two species of egomaniacs.”

In the middle is the Commodity Futures Trading Commission, which is deciding whether to approve these kinds of derivatives. "I think it is pretty cool," CFTC member Bart Chilton told the Associated Press last week. "But I'm not sure that cool means a business."

There are a lot of technical arguments on both sides as to why the derivatives will or won’t work, but the debate comes down to your ability to trust Wall Street, Hollywood, and human nature, despite
their collective checkered pasts. Those who believe that markets can
and must be free, that money can be won and lost without defrauding
others, and that most of the people in those markets will act
honorably—well, those people are likely to support the exchanges. Those
who believe that Wall Street is predisposed to greed and Hollywood to
venality, and that the financial system is inherently flawed and
derivatives inherently problematic, will oppose the derivatives.

This particular year, it’s fair to say that much of the public probably falls into the latter camp. So we have to dig deeper: How prone are these Hollywood derivatives to manipulation and insider
trading? In a completely cynical, venal world, what, exactly, about
them could be manipulated?

It turns out: quite a bit. Hollywood is completely opaque about its finances and has a horrible track record of success. So lumpy and random are its successes that when studios invite investors to fund a
slate of films, investors usually don’t get to choose which specific
films they’ll put their money into. It’s all or nothing, because
Hollywood needs the money to pay for the dogs as well as the swans.

Critical to success is the opening weekend. Hollywood studios will work on a movie for two years or more, then earn about 40 percent of the cost of the movie back in just the opening weekend. Hollywood has
long based the success of those opening weekends on smoke and
mirrors—on the creation of image and the manufacturing of hype, on
tremendous marketing budgets to create television ads, branded toys,
and snack foods all centered on the biggest movies.

In a Hollywood derivative, the bets are all based on opening weekend dollars, and those opening weekends are in turn completely a function of the success of big Hollywood marketing budgets. Mess with the
marketing budget, you mess with the opening weekend’s results.

That’s why there’s a big difference between betting on opening weekends and betting on the weather: You can’t change the weather by betting on it. There is, by contrast, a good possibility that you can
change the outcome of an opening weekend by betting against it—not by
driving moviegoers away, but by allowing Hollywood studios to radically
change the marketing budget.

Rob Swagger, the CEO of Veriana takes issue with that characterization. He believes that some Hollywood studios are being disingenuous about the influence of box-office numbers; ever since USA Today
started publishing box-office returns over a decade ago, the general
public has taken an interest in the results. The information is out
there already, he said. He maintains that Hollywood hype has been due
for a reality check, and that allowing traders to gauge the real market
for Hollywood films is a necessary counterpoint to the hype machine.
“That opinion of the public is more transparent, more real than
anything the studios can come out with,” Swagger said. “The people who
are buying tickets to see a movie, they love to have an opinion and a
thought. They deserve to communicate with other people. Is an exchange
going to affect that? No, it existed long before an exchange.”

Swagger has a point; Twitter, of all things, turns out to be a far better predictor of m... than, say, a marketing budget, and even better than the Hollywood Stock Exchange itself. In fact, Twitter is one of the things that Swagger
wants to factor into his contracts, along with the risk of global wars,
weather that might drive people away from the box office, political
upheavals, and other issues that would affect opening weekends.

There is also the cultural issue. Hollywood runs on relationships and image; Wall Street runs on money. The two are likely to clash. Every actor or actress is an “insider” and could trade on, or leak,
information from a working set that would influence how the derivatives
trade. The movie industry is essentially an unregulated monopoly that
won’t know how to adapt its chaotic, emotional behavior to strict rules
on derivatives trading. “In Hollywood, insider information is legal. In
the mind of a Hollywood executive it is—because they can’t tell the
difference between markets and marketing. They see no legal
difference,” Keiser objects.

Keiser points to the popular phrase “Hollywood accounting,” a euphemism for the opaque and often dishonest ways of keeping the books to maximize studio profits. “They’re going to take an industry famous for its false accounting, and create a derivative on that!” Keiser said. In addition, many of the
biggest movie studios are part of giant public companies like Disney (DIS). If movie executives participate in the trading of derivatives, it could create a nightmare of regulatory disclosures.

Swagger counters that while there are a lot of potential insiders who could leak damning information about movies, they only have the power of gossip. “They know what happens on the set, but not what the
box office would be,” he said. The derivatives contracts would start
trading only four weeks before a movie’s release, meaning that the
movie would be well past the production stage and all the gossip from
the set would have leaked already. There is not a lot of key
information that can change a movie’s box office four weeks out, he
argued.

Swagger is half right. Gossip won’t take a movie down four weeks before it launches. But the existence of a derivative whose price is easy to find would inevitably influence Hollywood executives to scale
down—or scale up—their marketing budgets according to the derivative’s
price. Rival studios could theoretically sabotage the derivative,
vengefully buying or selling the derivatives to manipulate its price in
order to make their nemeses’ opening weekends look weaker. While
Swagger maintains that executives would be unwise to do so—and that
they would be banned from the exchange—Hollywood’s rivalries are known
to become incredibly bitter regardless of restrictions.

Swagger also maintains that the structure of his derivatives doesn’t allow a lot of room for manipulation. Trend Exchange plans to launch two kinds of derivatives this fall if it gets CFTC approval.

The first derivative is a binary one, allowing investors to bet on opening weekends and be either right or wrong about a certain dollar amount. The other derivative will allow for more leeway, paying back
investors based on how close they were to the actual box-office
receipts.

Almost anybody can play this game. The minimum contract size is $5,000—a paltry amount in Wall Street terms, which indicates that there will be a wide audience of potential traders for the product. That
means that the people trading these futures don’t have to be—and are
not likely to be—Wall Street professionals who deal with contracts
millions of dollars in size.

“There are more people in the movie business than the six studios at the MPAA. The market is far larger,” Swagger said. Swagger says if the studios are concerned, they should hire risk-management specialists or
consultants to advise them. Even more, he encourages them to use the
derivatives to hedge their own risks in launching movies. He also wants
movie theater owners to use the derivatives to protect their returns on
ticket sales. If the studios are really concerned, he said, they should
take an economic interest in the exchange and participate in it. “There
are a lot of natural buyers and sellers within a studio market,” he
insists. “They don’t know how this works, so they’re scared.”

That’s a fair assessment. The question is: Should they be scared? And should we be?