PredictIt's Legality and the Future of Prediction Markets
Thanks for reading Flip Incoming, your source for prediction market news and analysis. We break down market moves daily and offer longer form thought pieces roughly weekly. This is one of the latter.
This week, we’re looking at a selected history of the interplay between prediction markets and U.S. regulators. Disclaimer: this post is for informational purposes only and should not be construed as legal advice.
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Prediction Markets: False Start
Prediction markets are not a new idea. Economists have studied these market incentives for aggregating the knowledge of crowds for decades.
However, it was only with the growth of internet adoption that efficient methods to test prediction markets were possible. Therefore, prediction markets only entered the broader national consciousness in the last ~25 years.
If you want a new concept to catch on, it’s usually best to find a use case that feels like a natural extension of familiar ideas.
Unfortunately, the first highly publicized prediction market didn’t do that.
In the early stages of the Iraq War in 2003, the Pentagon built a prediction market covering the likelihood of future terrorist attacks. The hope was that as publicly-quoted prices changed, intelligence analysts would gain signal that something meaningful was on the horizon.
Predictably, this didn’t go over well.
And so died the first attempt at applying prediction markets to a public good. And rightfully so. Those of us who believe in prediction markets can take an important lesson from this, though:
Pick early markets carefully and don’t be an idiot.
Prediction markets typically consist of contracts that resolve to two possible values: $1 or $0 (though other structures exist as well). In the finance world, these are known as binary options. Binary options, as well as futures, swaps, and other option types, are covered under U.S. law by the Commodity Futures Trading Commission (CFTC).
The CFTC’s Mandate (Heavily Summarized)
Operators of prediction markets must apply to the CFTC to become ‘designated contract markets.’ These are described on the CFTC’s website:
Designated contract markets (DCMs) are exchanges that may list for trading futures or option contracts based on all types of commodities and that may allow access to their facilities by all types of traders, including retail customers.
Per the U.S. code, DCMs are evaluated across 23 requirements. Among these, operators must:
Only list contracts not readily subject to manipulation
Have the technical capability to prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process (i.e., must demonstrate market surveillance, compliance, and enforcement practices and procedures)
Establish and enforce rules to protect markets and market participants from abusive practices committed by any party, including abusive practices committed by a party acting as an agent for a participant; and to promote fair and equitable trading on the contract market.
Adhere to position limits and have the capability to enforce them
In short, the CFTC needs to know that the markets being listed cannot be easily gamed, and that the operator of the market has the competence to monitor and enforce the rules.
To better understand how the CFTC makes decisions, let’s look at additional actions it has taken over the last 10 years.
Hollywood Derivatives: Almost Famous
In the late 2000s, prediction markets on Hollywood Box Office receipts were starting to gain traction. Successful markets had operated with play money in the past, and the owners saw an opportunity to transition to real-money and offer a meaningful hedging instrument to studios. And so Media Derivatives (MDEX) and Cantor Exchange filed for DCM status with the CFTC.
The timing was challenging, though. After the financial crisis in 2008, Wall Street and anything that sounded like Wall Street was hugely out of favor. The Motion Picture Association of America (MPAA) lobbied hard against the move (gatekeepers don’t like losing power), and fought against the “commodification” of their industry.
Dodd Frank: Revenge of the MPAA
But while the MPAA’s opposition lobbying effort failed with the CFTC, it was more effective with Congress. The massive Dodd-Frank Wall Street Reform bill was being debated at the time, and MPAA managed to add a neat little provision to it. From a great article by the Ringer:
[The Wall Street Reform Act] changed the definition of a commodity to exclude exactly two things: onions and “motion picture box office receipts, or any index, measure, value or data related to such receipts.”
Changing the definition of commodity meant the CFTC’s previous ruling was void, and so motion picture box office receipts futures cannot be traded on real-money exchanges. The Hollywood Stock Exchange lives on in play-money form.
While the Dodd-Frank provision was a blow to this specific prediction market, the success of MDEX/Cantor with the CFTC still provides the best positive example for operators to follow.
Nadex: The 2012 Election Game
In late 2011, the North American Derivatives Exchange (Nadex) filed for DCM status to list markets related to the 2012 U.S. Presidential Election.
The CFTC’s back and forth with Nadex is instructive. While there was some concern around the potential for price manipulation, the eventual decision hinged on a different factor:
Should contracts based on a political events be considered ‘gaming’?
This point is meaningful because the CFTC will not approve contracts that are deemed ‘contrary to the public interest.’ These include anything unlawful under Federal or State law, terrorism, assassination, war, gaming, or “other similar activity determined by the Commission, by rule or regulation, to be contrary to the public interest.”
To separate contracts from a ‘gaming’ use case, the CFTC assesses whether contracts provide economic utility, for example, through commercial risk management.
The CFTC asks Nadex the key question:
Assuming arguendo that the outcome of the US 2012 federal elections will have macro- and micro- economic consequences, as Nadex contends in its submission, would political event derivatives contracts provide any utility as a commercial risk management tool? If you believe that the contracts would provide effective risk management, please provide examples of possible hedging strategies and how political contract trades could offset commercial risk.
In other words, what economic function do these contracts provide? Nadex’s response involved a retail investor hedging his or her possible tax increase. While we side with Nadex in believing these contracts have economic utility, the example they provided is not very compelling. At least, the CFTC wasn’t compelled.
And as you may have guessed by now, the CFTC eventually found that Nadex’s contracts did constitute gaming and were therefore contrary to the public interest.
So for would-be prediction market operators, the real test is clear:
Can you prove your market provides economic utility?
An Alternate Path: IEM and PredictIt
The Iowa Electronic Market (IEM) is the earliest cited example of an electronic prediction market, having run contracts on the 1988 presidential election. In 1993, the CFTC granted them leeway to operate outside of the restrictions of DCM based on their academic nature.
In 2014, PredictIt filed for the same treatment, and was granted a similar no-action letter from the CFTC allowing it to operate a small-scale, not-for-profit, prediction market for academic purposes.
The CFTC’s reasoning for its positive decision:
The Division’s conclusion is based upon the facts that, among others, your proposed market for event contracts has been designed to serve academic purposes and the operators will receive no compensation.
As a clear example of its reliance on the IEM precedent, $850 limit per contract rule was calculated by taking IEM’s $500 limit per contract and inflation adjusting it from 1993-2014.
Other items covered in PredictIt’s no action letter included:
A limit of 5,000 traders in a given contract
A limited level of advertising (unspecified)
This remains PredictIt’s legal standing today.
Enforcement Actions: InTrade
Many traders may have been familiar with InTrade, which was a popular prediction market platform in elections in years past.
In November 2012, the CFTC sued InTrade for knowingly allowing U.S. customers to trade on an unregulated exchange. InTrade had been operating without DCM status for years, which eventually caught up to them. For a more detailed account, see this Atlantic article.
The platform shut down access for U.S. customers and the resulting volume drop caused its eventual collapse in 2013.
This is a consequence worth highlighting. Love or hate the CFTC, healthy volume is crucial to the liquid operation of any market and institutional volume usually plays inside the bounds of the law.
InTrade and others like it (i.e., TEN) should be viewed as cautionary tales for any entrepreneurs looking to run unregistered prediction markets. Work with the CFTC, not around them.
A Warning to Augur
This summer, the blockchain-based prediction market platform Augur is expected to launch version 2 of its software. Version 1 saw low user counts due primarily to poor user experience and the limited technological capabilities of Ethereum at the time.
Augur v2 promises faster transactions and a better user experience. These improvements will also leverage advances in crypto exchanges allowing dollar (technically, DAI) denominated trades. This suggests the potential to draw a large user base. However, while the developers of Augur have maintained that compliance with the CFTC’s guidelines is up to market participants, it’s not clear that the CFTC agrees.
Market operators building on top of Augur must either avoid U.S. participants or work with the CFTC for appropriate designation. Given that the most successful Augur markets will be those with the best volume and liquidity, we expect those will be the markets operating inside of US law.
LabCFTC for FinTech Innovation
If the first wave of prediction markets was made possible by internet adoption, the second wave will likely be made technologically possible over blockchain.
The CFTC has been actively monitoring blockchain tech and in 2017 set up LabCFTC to work with FinTech entrepreneurs — an example output is their smart contracts primer. While the effectiveness of this lab in fostering innovation and working together peacefully is still unknown, it nonetheless represents a potential positive step for the future prediction markets.
The Path Forward
Would-be prediction market operators should draw several lessons from history:
First: do not attempt to ignore the CFTC. They have proven that they will move on enforcement actions against market operators that attempt to skirt them. Volume dries up and those markets collapse. InTrade provides a clear example.
However, the initial success of the MDEX/Cantor box office receipts market filings is an example of how to successfully work with them. Drilling deeper on how they successfully proved robustness, market manipulation, and economic utility should be any entrepreneur’s first step.
Lastly, the failure of the Nadex filing shows a clear counter-example. Why was it that the 2012 CFTC did not find economic value in political prediction markets and what lessons can we draw from that? How might market creators adjust their arguments and prove economic utility where Nadex came up short?
Innovators using new technology have a pathway through LabCFTC to work with the Commission as they build. They should take advantage of it.
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