Hidden Opportunities

Unfortunately, the effort to develop new markets in recent years has been severely hampered by the regulatory tentacles of overreaching government. Between Sarbanes-Oxley, the SEC and the Commodity Futures Trading Commission, just to name a few, bureaucratic red tape has slowed innovation even as technology has pushed trade far past the Buttonwood tree. Thankfully, a few pioneers have created exciting new marketplaces in which I see gobs of profit opportunity. These are two of my favorites.

Prosper.com
Prosper.com, a lending marketplace, offers probably the most exciting and innovative development in online dealing since the Iowa Electronic Markets pioneered presidential futures contracts over a decade ago. Here's why.

Online banks like ING Direct and Bank of Internet have come to offer comparatively higher savings rates thanks to less overhead. Without having to maintain the expense of physical branches, Internet banks are able to offer significantly better returns on savings accounts and CDs. To get a loan, however, you're still at the mercy of banks' rather traditional loan departments. In other words, submit your credit information and cross your fingers for a positive outcome. Banks lend money on their terms and their terms alone. The system is closed, uncompetitive and inefficient.

Prosper.com turns that paradigm upside down by running an open marketplace where anybody — from the urban Fat Cat to the rural grandmother — can become a banker. Essentially, Prosper has created a marketplace for unsecured consumer loans that connects those looking to borrow directly to those looking to lend. An individual seeking funding for anything from home repair to a college education creates an online ad, describing the size of the loan he'd like, what interest rate he'd be willing to pay and how he intends to use the money.

The listing in essence sells the loan, and although some borrowers prefer to stay anonymous the smart ones provide email addresses and links to web pages in order to better assuage lenders' fears. Just as a loan officer at a bank would frown on an applicant who came in wearing unkempt clothing, Prosper.com loan listings with misspelled words or shoddy design don't receive much attention.

Lenders also evaluate loans based on an applicant's debt-to-income level as well as a credit rating provided by Experian. (Ratings range from a pristine AA down to HR, or high risk.) Just like a traditional bank, your credit ranking affects the rate at which people are willing to lend you money. Right now on Prosper.com, highly rated borrowers are paying as little as 6% for loans, while those with lower marks are paying 15% or more. The loans are unsecured and all carry a three-year term.

If you don't need money, but rather have some extra to lend, you can click through pages and pages of loan requests, deciding for yourself what risks you feel comfortable in taking. Amounts range from a few thousand dollars up to $25,000, and you can fund the entire loan yourself or contribute as little as $50. Because a number of lenders band together to fund one loan, you're able to diversify your exposure. If a high-risk borrower skips payment for a $10,000 loan, you might only be on the hook for $75 of it. Payments are made monthly, and Prosper.com handles all loan servicing for a nominal fee.

Because loans are made through a competitive bidding process, borrowers might find themselves paying less interest than they originally thought. A listing that started at 10%, for example, might end up being made at 8% as Prosper's community of lenders competitively offers better rates. As volume of business and depth of user base grow, you'll see bigger loans being made at more competitive rates, benefiting lenders and borrows alike.

HedgeStreet
Another breakthrough market worthy of your page views is HedgeStreet, a small but rapidly growing futures exchange specifically designed for retail (read: small) traders. Less than two years old, the CFTC regulated marketplace's focus on small, limited-risk contracts is unique. With the exception of the Chicago Mercantile Exchange's e-Mini futures franchise, most of the recent developments in derivatives trading have sought to attract the big-money hedge players with billions to wager.

HedgeStreet is different. You can open an account with as little as $100, and trading is done directly through a web-based interface with no separate commodity brokerage account required. Two types of contracts are offered, binary options and capped futures. Both are referred to as "Hedgelets."

Binary options are short-term, small-size bets on any number of underlying instruments including precious metals, currencies, energy and short-term interest rates. Often referred to as "yes-no" contracts, the options pay either $10 or nothing, depending on whether the underlying asset settles above or below the strike price at expiration.

For example, the exchange listed a "Gold > $554.00 (Feb 27 2006)" option, which as of Friday was trading around $7. The underlying asset is the Comex April 2006 future, the strike price for the option is $554.00, and the expiration was today (Monday) at 1:30 p.m. ET.

Since the price of gold stayed above $554, the option paid off at $10 per contract. If the price of gold had fallen below $554, then the option would've paid nothing. So assuming you bought the contract at $7, you made $3 because gold stayed above $554. If gold had dropped below $554 by Monday's close, then you would've lost your entire $7.

The exchange also offers "capped futures," which allow you to potentially profit based on how much an asset rises or falls before the expiration date. Similar to the binary options, the potential loss (or gain) on the capped futures are limited, so you know going into a trade exactly what your potential risk or reward might be.

For example, the exchange is currently trading a "Crude Oil $43.00 to $73.00 (Feb 28 2006) Future," which as of Friday was trading around $62.91. The underlying asset is the April NYMEX Crude Oil contract and the expiration date is Tuesday at 2:30 p.m. ET.

If you believe the price of crude is going to rise, then you'd buy. Assuming you bought one contract at $62.91, the most you could potentially make would be $10.09, the difference between the price paid and the upper "cap" on the contract. The most you could lose would be $19.91, representing the difference between the price paid and the lower "floor" of $43.00. Knowing many of their target users have never traded futures before, HedgeStreet offers a simple interface that details the potential gain/loss on every trade.

Unique to HedgeStreet, even among the large professional exchanges for now, are contracts based on residential real estate. Using either options or futures, traders can speculate on the price of single-family homes in Chicago, Los Angeles, Miami, New York, San Diego or San Francisco. Think Chicago housing is undervalued? You can get exposure to the asset class without even buying a plane ticket to the Midwest. Or if you're worried about a drop in the price of your Manhattan walkup, you can sell short a futures contract that will pay off if the East Coast real-estate market tanks.

Last week, the firm received a major vote of confidence in signing a strategic alliance (along with a sizable equity investment) with the Chicago Board Options Exchange, which pioneered listed options trading more than a quarter century ago. The CBOE not only plans to jointly develop new products, but also to market HedgeStreet's existing contracts as well. You'll undoubtedly see more liquidity, tighter spreads and even better opportunity in the months to come.

Jonathan Hoenig is managing member at Capitalistpig Asset Management LLC, a Chicago-based hedge fund.