Saturday, December 16, 2006

Prediction Markets "Excluded" from CFTC Jurisdiction?

Can the Commodity Futures Trading Commission ("CFTC") properly claim jurisdiction over prediction markets? Jason Ruspini recently tackled that difficult question. Following a gracious caveat about the limits of his legal expertise, Jason concluded that "the agency has legal jurisdiction over prediction markets, but does not want to exercise it" for various reasons.

I've addressed the same question at some length in Gambling for the Good, Trading for the Future: The Legality of Markets in Science Claims, 5 Chapman L. Rev. 159, 172-76 (2002), and more briefly in Prediction Markets for Promoting the Progress of Science and the Useful Arts, 14 Geo. Mason L. Rev. __ (2006) (forthcoming). Jason refers only to the later paper, which relies on the earlier one for detailed analysis. That perhaps explains his complaint that, "Bell [] does not cite a relevant part of the [Commodity Exchange Act's] definition of 'excluded commodity' . . . ." I do cover that topic; I simply don't do so in the paper that Jason relies on.

What do I say in that earlier paper? First off, consistent with my later paper, I argue that the CEA does not give the CFTC jurisdiction over run-of-the-mill prediction markets. "The CEA does not cover contracts intended to effectuate future delivery, much less contracts that effectuate immediate delivery." 5 Chapman L. Rev. at 170-71 (footnote omitted). With that in mind, it becomes obvious why prediction markets should generally fall outside the CFTC's jurisdiction. Such markets typically deal in the present delivery of conditional rights: claim coupons payable in the event some contested claim comes true.

As all my writings on the topic have taken pains to concede, however, defining the exact scope of the CFTC's jurisdiction proves frustratingly difficult. A court might well decide that my argument smacks of logic-chopping. The Gambling for the Good paper thus spends a fair amount of time exploring what would transpire if the CFTC did win jurisdiction over prediction markets. Specifically, pages 172-76 discusses whether the claims traded on a prediction market would qualify as "excluded commodities" and, if so, what sort of regulations would apply. Here's my bottom line:
[S]hould a market in science claims find itself subject to the CEA, it could attempt to qualify for the “excluded commodity” loophole that would largely free it from CFTC regulation. It looks highly probable, however, that the CFTC would have wide discretion to thwart any such attempt. At the least, to judge from precedent, the CFTC would probably not exclude a market in science claims from its regulations without also imposing crippling conditions.

Friends of prediction markets should not despair, however. First, as I've said, there remain good reasons to deny the CFTC jurisdiction over prediction markets. Second, the "hybrid instrument predominantly a security" category, described in Prediction Markets for Promoting the Progress of Science, offers yet another promising but untried legal hack for both preempting state gaming laws and forestalling CFTC regulation. Third, various state law pertaining to games of skill may well provide shelter for prediction markets.

That last legal strategy remains, so far as I can tell, completely unexplored in the extant literature on prediction markets. My initial research on that topic has proved heartening, encouraging me to learn more. I'll plan to say more about the topic later.

[Crossposted to Midas Oracle.]


Jason Ruspini said...

Yes, and while I apologize for intervening beyond my area of expertise, the arguments in the earlier paper don't change my opinion.

The earlier paper also proposes without any real discussion that rights are being delivered in the CEA's definition of CFTC jurisdiction — what i called the crucial interpretation of the second paper. And as I argued last time, "Delivery could instead refer to delivery of a thing, or of cash, the amount of which is conditional."

It just confuses many readers to write as you did that, "The CEA does not cover contracts intended to effectuate future delivery, much less contracts that effectuate immediate delivery." All this means, I think, is that the CEA would not have jurisdiction over a furniture delivery contract, for instance — in which there is little risk or room for speculation anyway. This idea is orthogonal to whether or not event markets fall under CFTC jurisdiction. Even if you liken the furniture delivery contract to a science claim contract in form, the latter still carries risk and is conducive to the type of speculation the CEA sought to curb as described by Lynn Stout's paper, so it is not all obvious that they would be excluded — quite the opposite, by that line of logic.

Even accepting the likely crippling "eligible contract participant" requirement of an excluded commodity, science claims (or at least their use to reward innovation) might not qualify since outcomes would not be "beyond the control" of researchers. Likewise, a hybrid (future/security) instrument designation might invoke insider trading laws.

Although I am not familiar with all of the court decisions and opinions relevant to CFTC purview, the actions of the agency in approving the single-event catastrophe future and hedgestreet's payroll market suggest that they do consider themselves to have jurisdiction over event markets. Their opinion on CME's credit event and Nymex's property damage futures will probably only reinforce this.

I agree that a bottom up strategy of navigating state laws is a much-neglected option in "the literature", and I look forward to more discussion on this. Thanks again for educating the prediction market sphere on all of this.

Tom W. Bell said...

I don't think you should *apologize* about discussing legal issues, Jason. It's not as if lawyers have a monopoly on such things! Um, well, I mean to say that it's not as if they *should* have one. I think it suffices to disclose, as you've taken pains to do, that you approach the topic without the benefits or burdens of specialized training.

Regardless of the *policy* behind the scope of the CFTC's authority, it must have legislative authority to act. That is why I start with the language of the CEA. Policy matters, but only at the margin. The margin does matter, here, I grant, given that the CEA speaks so abstractly. But textual arguments matter, first and foremost.

Ditto the example afforded by past practice. I think it most reasonable to understand some of the CFTC's regulations over event markets as questionable but as-yet unchallenged (indeed, probably even *welcomed*) extensions of its authority. What the CFTC has gotten away with by no means establishes the proper scope of its authority.

jheuristic said...

Hi --

These points will be among the topics for discussion at The AEI-Brookings Joint Center Conference on Prediction Markets on 18 Jan 2007 in Washington, DC USA.

The worldwide PM Consortium is among the sponsors of this seminal conference.