Haircuts on Intrade

When Intrade halted trading abruptly on March 10, my initial reaction was that the company had commingled member funds with its own, MF Global style, in violation of its Trust and Security Statement. I suspected that these funds were then dissipated (or embezzled), leaving the firm unable to honor requests for redemption.

The latest announcement from the company confirms that something along these lines did, in fact, occur:

We have now concluded the initial stages of our investigations about the financial status of the Company, and it appears that the Company is in a cash “shortfall” position of approximately US $700,000 when comparing all cash on hand in Company and Member bank accounts with Member account balances on the Exchange system.

A shortfall of this kind could not have emerged if member funds had been kept separate from company funds. As it stands, the exchange is technically insolvent and faces imminent liquidation.

But the company is looking for a way to "rectify this cash shortfall position" in hopes of resuming operations and returning to viability. It has requested members with large accounts to formally agree to allow the exchange to hold on to some portion of their funds indefinitely:

The Company has now contacted all members with account balances greater than $1000, and proposed a “forbearance” arrangement between these members and the Company, which if sufficient members agree, would allow the Company to remain solvent...

By Tuesday, April 16, 2013, we expect to be able to inform our members if sufficient forbearance has been achieved. If so, we will then resume limited operations of the Company and we will be able to process requests for withdrawals as agreed. If sufficient forbearance has not been achieved, it seems extremely likely that the Company will be forced into liquidation.

So traders find themselves in a strategic situation similar to that faced by holders of Greek sovereign debt a couple of years ago. If enough members accept the proposed haircut, then the remaining members (who do not accept) will be able to withdraw their funds. The company might then be able to resume operations and eventually allow unrestricted withdrawals. But if enough forbearance is not forthcoming, the company will be forced into immediate liquidation.

What should one do under such circumstances? As Jeff Ely might say, consider the equilibrium. The best case outcome from the perspective of any one member would be immediate reimbursement in full. But this can only happen if the member in question denies the company's request, while enough other members agree to it. As long as members can't coordinate their actions, and each believes that his own choice is unlikely to be decisive, it makes no sense for any of them to accept the haircut. Liquidation under these circumstances seems inevitable.

On the other hand, what choice do members really have? Although their funds are senior to all other claims on the firm's assets, the cash shortfall will prevent such claims from being honored in full. And since members are scattered across multiple jurisdictions and lack the power to coordinate their response, even partial recovery through litigation seems improbable. Facing little or no prospect of getting anything back anytime soon, some might choose to roll the dice one last time.

The obvious lesson in all this is that in the absence of vigorous oversight, "trust and security" statements can't really be trusted to provide security.