Hedging is Not a Product

Hedging is not a tool that can be purchased casually. It should be a carefully constructed relationship.

Written by: Prathik Desai

Compiled by: Block unicorn

When I first read this guest article, what came to mind was how insurance reveals human behavior. Ask most people what insurance they have purchased, and you are likely to hear about mobile phone insurance. Not health insurance, nor a safety net for dependent income. But mobile phone insurance can be bought for just a few hundred rupees at checkout, and choosing it requires almost no decision-making.

This reveals how we make risk decisions. No one sits down to list all the things that could go wrong, rank them by the severity of loss, and then decide to prioritize the phone screen. Risk coverage is provided by default, and the coverage is designed around what is easy to sell. The risk exposure itself seems unimportant.

However, it works. Claims are approved, screens are replaced, and the insurance delivers on its promises.

This leads to what I want to discuss today.

Lauris studies how countries become financial markets—event contracts, derivatives, corporate risks, and the legal and market structures between them.

In today’s article, Lauris argues that hedging is not a tool that can be purchased casually. It should be a carefully constructed relationship that revolves around the risk exposure you have already identified. If you get it backward, what you end up holding may only hedge a particular investment, while your real problem remains.

Anyone can engage in trading hedges. But that does not mean anyone can sell “hedging products” to companies.

For traders, any position that can reduce risk elsewhere on the books can reasonably be called a hedge, whether the trader is working on a macro trading desk, trading cryptocurrencies, or using a retail brokerage account.

Purchasing a hedge contract related to election outcomes can hedge that portfolio. While the match may not be high and the protection may not be complete, it still counts as a hedge.

Corporate finance uses the same term to describe a relationship that demands more rigor. Risk exposure is first and foremost risk: cash flow, liabilities, or operational risk. Trading instruments must match in amount, duration, and risk factors. Any deviation constitutes basis risk. Credit, collateral, documentation, and accounting treatment revolve around the trade because the product itself is a relationship, not just a return.

Swap contracts, forward contracts, options contracts, or event contracts can hedge the risk of one account and express views on another account. Their economic function depends on the risk exposure of other accounts on the holder’s balance sheet. For companies, the relevant questions are: what risk exposures does the tool offset? What is the amount offset? And how long is the offset period?

Both meanings of the word are valid. The category error lies in treating them as interchangeable.

In several recent conversations I participated in, this misunderstanding arose: people assumed that experience in quantitative trading or market making could be applied to structured trading. This misunderstanding is particularly common in the tech industry, where a quantitative background often gives the impression of exceptional capability, which is often indeed the case: traders have built excellent exchanges, many of whom are themselves strong operators.

But technical prowess does not make the knowledge of a specific role transferable. Quantitative trading and market making revolve around price, information, and inventory. Constructing products or swap contracts that can serve as hedging tools is a service operation centered around customer risk exposure. The two are not the same.

Market operators often make the same mistake when considering this issue. Their usual unit is contracts: listing events, attracting liquidity, and then seeking funding flows. The same process does not work in corporate risk transfer because risk exposure is the primary consideration. However, this practice has spread from trading and cryptocurrency: using existing “yes/no” contracts, linking them to corporate issues, sending orders to exchanges, and then calling this portfolio a hedge.

International Financial Reporting Standard 9 (IFRS 9) applies this distinction at the operational level. It requires the provision of hedged items, hedging instruments, hedged risks, risk management objectives, and the economic relationships between them. The U.S. Commodity Futures Trading Commission (CFTC) follows the same principles when testing swaps used for hedging physical positions: risks must arise from assets, liabilities, services, or physical commercial activities.

What Event Contracts Add

The financial argument for prediction markets begins with state-related claims. Arrow and Debreu proposed a relevant framework: the more a market can name, price, and transfer claims for more future states, the more complete it is. For example, if tariffs are passed, mergers are completed, drugs are approved, or carbon emission auction prices exceed a certain level, event contracts can pay out.

Traditional markets, even if they can price these states, often do so only through proxies. Event markets can create observable market prices for states that previously existed only in research reports, scenario models, or bilateral dialogues.

For price threshold claims based on the same underlying asset, their connection to traditional derivatives is entirely consistent in extreme cases: the price of digital returns is the negative slope of the call option price curve relative to the strike price and can be approximated as an increasingly small vertical price difference. Event contracts isolate the final state. Before the expiration date, option trades may contain volatility and market value risks that buyers do not wish to bear, as well as intermediary and replication frictions.

This equivalence is limited. “The S&P 500 Index closing above 7000 points” can map to the S&P options surface. “The Federal Reserve cutting rates in March” or “the tariff bill passing” remains a legitimate prediction, even if it is not a derivative of a call option curve, as its market price differs from the actual probability of occurrence because it also reflects risk preferences, collateral, liquidity, trading channels, and settlement rules.

Government claims are input factors for corporate cash flow issues. Prediction markets can artificially create missing claims, but they cannot artificially create the relationship between that claim and the corporate balance sheet.

The Importance of Event Contracts

Two factors determine the financial importance of event contracts:

1. Whether traditional derivatives or credible replicas exist.

2. Whether companies or investors actually bear the relevant risks.

When significant risks already have derivatives, event contracts become an alternative. They must provide better matching or lower overall costs. The structural costs embedded in traditional channels must exceed the price differences, depth, collateral, and impact costs of the event market. This is the replication cost differential.

The biggest long-term opportunity lies in significant risks that currently have no derivatives. Event contracts may be the first such tool that will make risks like shutdowns, policy decisions, regulatory milestones, weather conditions, and corporate events observable and transferable for the first time.

If derivatives exist but no relevant users actually hold those derivatives, the demand for risk transfer is almost nonexistent. Another binary option may still be a useful trading product. If neither of the above conditions is met, the market is better suited for prediction, entertainment, or general price discovery rather than corporate hedging infrastructure.

Tradability tells you whether a scheme can be priced. Importance tells you whether someone is bearing the risk worth transferring.

A contract-first sales funnel skips the second test: it starts with the available list and searches for companies that can be associated with those lists.

The Wrong Side of the Desk

Trading thinking begins with profit objectives and seeks profit opportunities. Structured thinking begins with the balance sheet and builds trading strategies.

In fixed income, currencies, and commodities, corporate clients come with existing risk exposures, such as floating rate debt or currency mismatches; fuel costs, inventory, or planned bond issuances; and acquisition financing, which is an abstract object referred to as hedging.

It identifies risk factors, selects tools, and sets amounts and durations. It then calculates the residual value basis and incorporates the results into the client’s documentation, credit arrangements, and accounting policies.

ISDA organizes the derivatives market in the following order: users, underlying risks, tools. HSBC’s Autohedge system follows the same principle, taking risk exposures, hedging strategies, and risk preferences as inputs before calculating trades. The tools themselves may be legally independent; but economically, hedging refers to the relationship built around that tool.

In fixed income, currencies, and commodities (FICC) trading, traders can respond to requests for quotes (RFQs) at determined principal risk prices. This is execution: it prices defined tools without considering the client’s risk exposure or whether that tool can hedge those risks. Adding RFQs to mismatched contracts can provide pricing for that mismatch.

What Problems Does Contract Priority Bring?

Suppose an importer is concerned about potential tariffs. Their loss depends on shipment volume, shipment timing, inventory, costs passed on to customers, exchange rate fluctuations, and the company’s ability to find alternative suppliers. An event contract may stipulate that if publicly imposed tariffs exceed a certain threshold before a specific date, the company will pay one dollar. This scheme is simple in itself, but its fit with the importer’s cash flow is not satisfactory.

This mismatch is basis risk. Structured traders decide which risk exposures can be transferred and which risk exposures are retained by the client. Intermediaries starting from contracts do the opposite. They find a public binary option that is similar to the client’s issue and treat that similarity as a hedging tool. After the trade is completed, the financial officer holds that binary option but still bears most of the original risk.

Contract customization brings a second problem. Robert Bartlett and Maureen O’Hara studied 41.6 million Kalshi contract trades. Under their framework, there are no liquidity traders in the sense of Glosten-Milgrom because the tool does not frequently serve the role of hedging and portfolio rebalancing as it does in mature markets, thus generating liquidity flows. Individuals can still use the contract for defensive purposes.

The credit market demonstrates how institutions purchase state-related risks. In the Significant Risk Transfer (SRT) mechanism, banks retain their loans and purchase first-loss protection through credit-linked notes funded by investors; the Bank for International Settlements (BIS) statistics show that by the end of 2024, the protected loan pool will be approximately €800 billion. This is a banking capital precedent and not a recommendation for companies to purchase credit-linked notes. It explains why institutions place risks in financing tools that have coupons, documentation, loss allocation, and authorized limits.

The paper also finds that the impact of informed pricing is greater in single brand markets than in macro markets. Tariff decisions are often exogenous for ordinary importers, so the information contained in their directives is minimal. Market makers may welcome the flow of goods, but the publicly available tariff schedules have only a weak correlation with the losses incurred by importers.

If contracts surrounding mergers, drug trials, factories, or other company-specific outcomes are tighter, the basis will improve. At this point, companies may have more information than the quote providers, leading market makers to expand or reduce trading volumes, or even abandon trading altogether. The most popular trades are those with the largest basis. Conversely, the trades that the market is least willing to underwrite are those with excessively large bases.

Even with contracts in place, companies still need to explain objectives, ratios, bases, valuations, and financial statement handling. Dashboards cannot establish this connection, nor can request for quotes force audit committees to accept.

This business model faces pressure from two sides. If the risk exposure is small and matched with listed contracts, clients can trade directly. If the risk exposure is large or requires customization, clients need structured design and funding support. Companies that only provide information on listed contracts cannot increase trading capacity. Those responsible for designing yield schemes, preparing documentation, committing or raising funds are less a new business category and more like brokers, insurance companies, or structured firms in fixed income, commodities, and currencies (FICC).

Packaging Changed the Market

WeatherBill launched a self-service weather derivatives platform in 2007. The idea was that businesses affected by weather would purchase protection products. However, this was not the case. The company subsequently narrowed its target customers to farmers, shifted to insurance products and external distribution, and rebranded as The Climate Corporation.

Event contracts found native demand elsewhere: the FanDuel platform at the Chicago Mercantile Exchange launched in December 2025 and reported 100 million contracts in about eight weeks.

Weather forecast products entered the insurance market; sports products found retail channels. Meanwhile, independent hedging products sold through software channels remain a blank space.

Where the Risks Lie

Once the risk exposure is determined, the remaining question is risk tolerance.

In practice, event risk is reflected on the balance sheet in three ways. The risk itself does not appear directly but must be transferred elsewhere.

1. When the investment target is appropriate, direct trading can occur.

A bar in Manhattan insured an event contract worth about $5,000 to cope with a promotion that offered free drinks if the Knicks won; liability and contract issues were resolved in the same game. If the settlement solution is appropriate, the same approach can address larger risks.

Reports indicate that a contract related to California solar tax credits transferred about $600,000 through a transparent central clearing market. Company size is not the dividing line; fit and balance sheet capacity are.

I am collaborating with some talented individuals at kalshi, particularly with 0x_ultra, to provide a showcase for this project as part of the "Builder Program." It will be released soon.

2. Risk pools should only be established when risks can indeed be diversified.

The mutual betting market allocates committed funds to winning bidders and limits total liabilities within existing capital; Goldman Sachs and Deutsche Bank have used this mechanism for economic derivatives trading since 2002, with the average size of non-farm payroll data auctions around $9 million, later moving to the Chicago Mercantile Exchange (CME) in 2005. The Bank for International Settlements (BIS) still questions whether true hedging demand can balance experienced informed traders.

A funding pool can only function when loss amounts differ, risk exposures are opposite, or external funding is involved. If all participants suffer losses simultaneously, the funding pool will only produce a long list of claimants, ultimately requiring those in need of funds to bear the responsibility: either through insurance, reinsurance, or again through warehouse financing.

I know that very smart people like AadvikVashist are studying this issue.

3. Incorporate events into existing institutional tools.

In April of this year, Marex issued structured notes of up to $10 million to a Swiss institutional client, stipulating that if Nvidia remains the world's most valuable company a year later, it will pay 7% interest; the client holds Marex's debt, while Marex uses event contracts for replication. The institution purchased securities containing issuer, documentation, and authorization terms, while the event contract remained on the dealer's side. Before the trade reached the client, Marex had converted the event contract into fixed income, currencies, and commodities (FICC).

The role of software comes after determining risk exposure. It can test traditional tools, identify protection gaps, and compare event claims from aspects such as fundamentals, costs, execution, collateral, legal, authorization, accounting, and residual risk. A practical product should be able to encode this process and allow the final choice not to trade.

Regulatory Shock Radius

Poor corporate hedging schemes often create problems for buyers. However, here, the damage is broader because the event market is still debating its role in the financial system. Commercial use does not determine the jurisdiction of the Commodity Futures Trading Commission (CFTC) over event contracts.

The Cryptocurrency Innovation Committee believes that the swap definitions in the Commodity Exchange Act, federal preemption, and the CFTC's exclusive jurisdiction over the derivatives market, as well as event contracts, will not cease to be federally regulated simply because the buyer is speculating.

The significance of public interest goes far beyond corporate hedging. A regulated event market can price previously unpriced states, generate public prices, and create transparent, collateralized claims with clear settlement rules. Even before financial officers trade, these are important financial functions. But hedging remains at the core of policy arguments.

The CFTC describes prediction markets as tools for forecasting, planning, hedging, and speculation. In February 2026, the commission defended its jurisdiction by emphasizing commercial hedging, portfolio management, and information on future outcomes to counter state gaming regulators. The CFTC distinguishes prediction markets from gambling through features such as multi-to-multi trade execution, transparent pricing, clear settlement benchmarks, regulation, customer protection, and market integrity.

In March, the CFTC reminded prediction market exchanges of their obligations under the Commodity Exchange Act and Core Principle 3. Its June proposal involved event contract design, public interest review, and responsible innovation.

Severe cases of corporate hedging failures typically follow a simple pattern. Companies are told that binary option positions can offset operational risks, and thus invest cash. Even if the company incurs losses, the contract may expire worthless because factors such as trading volume, time, or cost transfer were never included in the revenue considerations; before settlement, the contract's underlying may have been counted as profit, while the original risk exposure remains, ultimately leaving the company with not protection, but a short position.

Regulators have previously witnessed similar schemes. The CFTC and the Securities and Exchange Commission (SEC) jointly issued warnings after receiving complaints about binary option platforms refusing withdrawals, identity theft, and losses caused by software manipulation. The regulated trading venues discussed in this article are not those fraudulent brokers: their markets are regulated, transparent, and centrally cleared, but past cases have also increased the cost of mislabeling trading errors as protective trades.

Opponents of federal prediction markets will not write seminar papers on basis risk. They will say that a company was sold a bet in the name of derivatives.

If intermediaries use mismatched binary options as a means of protection for companies, then it will provide state gaming regulators with the strongest argument against federal regulatory prediction markets.