Wednesday, December 07, 2005

TEN's Plans for a Legal U.S. Prediction Market

A couple of months ago, I commented on the charges filed by the CFTC against the Trade Exchange Network Ltd. ("TEN"). The CFTC went after TEN, the Ireland-based provider of the Tradesports and Intrade markets, for offering unauthorized trades on commodities futures contracts to U.S. citizens. Since then, Chris F. Masse has been keeping me up-to-date on TEN's progress in winning legal status under U.S. law.

How does TEN propose to win legality under U.S. law? By obtaining the CFTC's permission to set up shop as an exempt board of trade ("EBOT"). Happily for TEN, the CFTC approved its application. TEN now qualifies as one of four EBOTs.

That certainly ought to clear TEN to operate legally under U.S. law. Indeed, qualifying as an EBOT looks like a pretty sweet deal so far as avoiding regulations goes; an EBOT need only conform to the anti-fraud and anti-manipulation provisions of the Commodity Exchange Act ("CEAct"), 7 U.S.C. § 1 et seq. (2005).

Still, though, I don't quite understand what TEN has in mind. Why am I puzzled? Consider this: An EBOT must limit trading to "eligible contract participants," as defined by § 1a(12) of the CEAct. That section contains a variety of ways to qualify as such, but none appears to allow average folks to trade on an EBOT. This definition of "eligible contract participant" is about as helpful as it gets:
(A)(xi) an individual who has total assets in an amount in excess of--
(I) $10,000,000; or
(II) $5,000,000 and who enters into the agreement, contract, or transaction in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual . . . .

Alternatively, maybe this section of 1a(12) would help:
(C) any other person that the Commission determines to be eligible in light of the financial or other qualifications of the person.

Those sorts of limits are exactly why I've never seriously considered seeking EBOT status for the Simon Exchange. What good is a prediction market open only to a very few rich people? Unless TEN has some pretty neat legal tricks up its sleeve, therefore, it hardly looks as if opening an EBOT under U.S. law will solve its problems. TEN's typical customer—the average punter—will hardly qualify as the sort of "eligible contract participant" authorized to trade on an EBOT. But, then again, maybe TEN does have some neat legal tricks planned. Fans of prediction markets may stand to learn a lot from this developing story.


Anders Borg said...

Hi Tom,

I'm no American, and no lawyer, but couldn't the prediction market be set up as a stock exchange? In that case, only the brokers need to qualify for the financial limits set by the law, and the rest of us could just trade through them, paying them a comission?! As I said, I obviously don't know the legal framework well enough, but that was what instinctively came to mind...


Tom W. Bell said...

Hullo, Anders!

If you like using agents, than you might like an EBOT. You can trade on an EBOT through agents, too, you see. But I just don't think that would suffice to allow the sort of thick and responsive markets that we need for useful price generation.

Although I've not carefully scrutinized the relevant laws, I think that a stock exchange model would not fit a prediction market very well. Why? Because there are no equities being traded on a prediction exchange.

Chris Hibbert said...

Mike Knesevich, of TEN, spoke at the Prediction Market Summit last week. He seemed to be saying that TEN intends to operate a separate exchange for institutions and qualified investors. This may be an attempt to leveage their technology rather than their existing customer base.

The kinds of contracts that EBOTs can offer is also limited, but may be flexible enough to offer many interesting kinds of claims. I think Mike was saying that they intend to offer contracts that large investors would be interested in as a tool for hedging exposures.

I'll give my summary of the prediction market summit shortly at the Now Economy blog.

John Jenkins said...

A stock exchange would subject you to the federal securities laws (Securities Act of 1933 and Securities & Exchange act of 1934) which are more onerous than the commodities laws. There are probably no exemptions that people could use for trading in these sorts of things (the Rule 504 exemption comes to mind as a possibility, but it allows only $1 million annually, though it has no requirements for investor sophistication or accreditation, but I expect there may be other bars as well (like state blue sky laws, particularly if this isn't considered a "covered security" under federal law that would exempt it from state regulation.