Let's Tell the CFTC Where to Go

Update: I've extended the deadline for signing up until 7 p.m. Pacific, Sunday, July 6. Also, I fixed a typo in paragraph 3, changing "denying" to "giving." (Thanks, Gil!)

The deadline looms for interested parties to respond to the Commodity Futures Trading Commission's request for comments about regulating prediction markets ("event markets" in the CFTC's usage). I may or may not get around to a detailed, point-by-point response to the CFTC's many questions. In the meantime, though, I've drafted a general statement that many of you might agree with. I invite you to sign it with me, so that together we might tell the CFTC where to go. Please see below for details on how to sign on. Here is the draft statement:

What regulatory treatment should the Commodities Futures Trading Commission ("CFTC") apply to event markets? We the undersigned, who represent a wide range of viewpoints, agree on three general observations. First and foremost, the CFTC should do no harm. Second, at a minimum, the CFTC should make more general the sort of "no action" status enjoyed by the Iowa Electronic Markets ("IEM"). Third, if the CFTC decides to regulate event markets more substantively, it should adopt clear and limited jurisdictional boundaries and allow affected parties to step outside of them.

First, do no harm: Many sorts of event markets—including public ones, private ones, ones that offer only play-money trading, and ones that offer real-money trading—already thrive in the U.S. They have provided a rich array of benefits without evidently harming anyone. The CFTC could help event markets achieve still greater success by clarifying their legality. Instituting the wrong sort of regulations could suffocate event markets in their cradle, however. The CFTC should exercise a light hand, taking care to do no more than offer qualifying event markets the shelter of federal preemption and freeing them to continue operating under the extant legal regime.

Second, open up the "no action" option: Thanks in part to the "no action" letters that the CFTC has issued to it, the IEM has for many years benefited the public by offering real-money event markets. No sound reason precludes the CFTC from giving similar treatment to other institutions that, like the IEM, offer event markets solely for academic and experimental purposes and without imposing trading commissions.

Although the CFTC's "no action" letters do not specify the exact criteria the IEM had to satisfy, they took favorable note of the IEM's account limits. Those account limits effectively prevent the IEM from supporting significant hedging functions. If the CFTC builds a similar requirement into any general "no action" guidelines, it should adopt limits considerably more generous than the meager $500/trader limit adopted decades ago by the IEM. Even a limit ten times that amount would still effectively preclude hedging.

The CFTC should not limit "no action" status to markets run by tax-exempt organizations. The no-action letters that the CFTC issued to the IEM emphasized not the nature of the hosting institution, the University of Iowa, but rather the business model adopted by the IEM itself. Profitability could not have mattered, as tax-exempt organizations can and do earn profits (indeed, as their burgeoning endowments demonstrate, many universities earn immense profits). The CFTC apparently cared only that the IEM did not plan to profit from charging traders commissions. A tax-paying organization could satisfy that condition just as easily as a tax-exempt organization could. In either event, price discovery would flourish and consumers would win a safeguard against getting fleeced.

Third, preserve regulatory exit options: If the CFTC decides to write substantive regulations for event markets, it should recognize and guard against the risk of overregulation. Even well-intentioned and well-informed regulators remain human and, thus, all too apt to make mistakes. They run an especially large risk of making mistakes when they first attempt to regulate new institutions, such as event markets. To make matters worse, regulators typically lack reliable signals to determine when they have gone too far. Industries wither away for many reasons, after all.

The CFTC's approach to regulating event markets should accommodate these policy considerations by establishing clear jurisdictional boundaries and preserving regulatory exit options. Thus, for instance, the CFTC might specify that it has no jurisdiction over event markets that offer trading only to members of a particular firm, over markets that offer only spot trading in negotiable conditional notes, or over markets that do not support significant hedging functions.

The CFTC's approach to regulating event markets should accommodate these policy considerations by establishing clear jurisdictional boundaries and opening exit options. Thus, for instance, the CFTC might specify that it has no jurisdiction over event markets that offer trading only to members of a particular firm, over markets that offer only spot trading in negotiable conditional notes, or over markets that do not support significant hedging functions. Then, if the CFTC enacts unduly burdensome regulations, an event market could opt out of them by changing its business model. So long as markets publicly announce that they operate outside the CFTC's purview, allowing them that freedom of exit would harm nobody. To the contrary, it would help the CFTC gauge the suitability of its regulations and serve the public by protecting the continued viability of event markets.

Interested in signing on? Please drop me a private email (tbell at chapman dot edu) with your name, institutional affiliation, and snailmail address. I welcome your comments—I'm sure a typo or two persists in my draft—but I of course cannot revamp the entire statement without mucking up the entire process. To leave me time to get everything together and out the door before the July 7 deadline, you'll have to contact me before noon Pacific time on Sunday, July 6.

[Crossposted at Agoraphilia and Midas Oracle.]

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Hahn & Tetlock on Legalizing Prediction Markets

My current writing project discusses a variety of strategies for legalizing prediction markets. Very little scholarship on the topic exists. I wrote about it a few years ago, granted, but even I regard that effort as incomplete (hence my present project). I thus took great interest in a forthcoming paper offering a fresh perspective on legalizing prediction markets: Robert W. Hahn & Paul C. Tetlock, A New Approach for Regulating Information Markets, J. REG. ECON. (forthcoming). Thinking that some of you might share my interest, and confident that I would benefit from your comments, I here offer from my draft paper an excerpt, absent footnotes, wherein I review Hahn and Tetlock's commendable, if flawed, proposal:

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In one of the few academic papers to address the legality of prediction markets, Robert W. Hahn and Paul C. Tetlock argue that the CFTC should have the power to regulate the field. The authors argue that extant law gives the CFTC sufficient authority to act on their suggestion. Should that prove infeasible, however, they would welcome new legislation clearly giving the CFTC jurisdiction over qualifying prediction markets. Hahn and Tetlock's proposal would at all events preempt state regulation of prediction markets and clarify their legality, subject to various regulatory conditions, under federal law. In that, the authors deserve credit for setting forth a relatively detailed and plausible account of how prediction markets might escape from the legal failure that now inhibits their development.

The law can fail in many ways, however. Although Hahn and Tetlock's regulatory scheme would certainly dispel much of the legal uncertainty surrounding prediction markets, it would do so only by imposing significant legal burdens on them. Perhaps, on net, we would come out ahead. We might rationally favor a few heavily regulated but clearly legal prediction markets to none at all. So, at least, Hahn and Tetlock appear to reason. That supposed policy bargain suffers from an excluded middle, however: The option, described here in various guises, of clarifying the legality of prediction markets and regulating them with little more than generic contract and anti-fraud laws.

Hahn and Tetlock probably never even considered that third, relatively light-handed approach to legalizing prediction markets. It would have been ruled out by the two questionable assumptions driving their legal analysis: First, that prediction markets would necessarily qualify as gambling services under state law, thus making federal preemption necessary; and, second, that winning preemption would require a fair amount of regulation by some federal agency. Hahn and Tetlock thereby both misdiagnose the legal disease afflicting prediction markets and prescribe an unnecessarily painful cure.

Hahn and Tetlock overestimate the likelihood that that courts would place prediction markets at the mercy of state gaming laws, placing it at near certainty. Granted, there remains some risk that an over-eager attorney general might attack prediction markets as illegal gambling conspiracies. A cool-headed analysis of gaming law and policy indicates, however, that courts would most likely protect prediction markets from such legal grandstanding. That largely obviates Hahn and Tetlock's primary justification for seeking the preemptive protection of CFTC regulation.

Nonetheless, we cannot fault Hahn and Tetlock for wanting to protect prediction markets from whatever uncertainties state law threatens. Nor can we fault them for seeking shelter under federal preemption. The problem arises when they assume the necessity and propriety of having the CFTC regulate prediction markets largely as the agency regulates existing futures markets. Granted, Hahn and Tetlock would have the CFTC hold off, at least presumptively, from burdening all prediction markets with the full weight of its regulatory authority. In particular, they advocate two exemptions that would give fairly free rein to small-stakes prediction markets: one exemption for those that sharply limit the size of investments and another for prediction markets that stay below certain volume or revenue caps. Of any prediction claim that falls outside of those limits, however, Hahn and Tetlock say, "[T]he CFTC should regulate it as a futures contract."

Should it, though? Probably not. Hahn and Tetlock err in giving the CFTC too broad a jurisdiction over prediction markets. They would define the ageny's authority over such markets based on an "economic purpose test." Their test would authorize the CFTC to regulate any prediction claim that either provides significant financial hedging opportunities or the price of which "could provide valuable information for improving economic decisions." The first criterion should cause no alarm; it basically echoes the current test for establishing CFTC jurisdiction. The second criterion, however, would extend CFTC jurisdiction far beyond its current limits, to dangerously uncertain bounds. What contract price does not provide "valuable information for improving economic decisions"? Hahn and Tetlock try to justify their second economic purpose test as "a logical extension" of the price discovery and dissemination functions that at least in part justify CFTC regulation. However beneficial, though, price discovery and dissemination cannot alone suffice to define the agency's jurisdiction. Under the CEA Act, as written and interpreted, those represent at most necessary but not sufficient conditions for CFTC authority.

To their credit, Hahn and Tetlock recognize that they may have misjudged the extant authority of the CFTC. "[W]e are not legal experts," they confess. Foreseeing that the law might block their proposed regulatory fix, Hahn and Tetlock suggest that, as a fallback strategy, "Congress could provide more explicit guidance on the type of market it wants the CFTC to regulate."

Having thereby dealt with the legal objections to their proposal for regulating prediction markets, Hahn and Tetlock turn to defending it on grounds they doubtless find more familiar: via cost/benefit calculations. Their economic analysis suffers from the same sorts of blind spots that plague their legal analysis, however. Hahn and Tetlock recognize only two costs to their proposed regulatory program: an increase in the CFTC's workload and a slight risk that legalized prediction markets might generate some of the same social costs allegedly associated with gambling. They propose increasing the CFTC's budget to cure—or at least shift to taxpayers—the first cost, and discount the latter cost as easily outweighed by the many benefits that would follow from legalizing CFTC-regulated prediction markets.

Hahn and Tetlock thus do not consider the largest cost that their proposal would impose: The opportunity cost of burdening prediction markets with unnecessary regulations. That lacuna in their economic analysis follows directly from a lacuna in their legal analysis. As noted above, the authors apparently assume that prediction markets face a choice between prohibition by state anti-gambling laws or regulation by federal agencies. In fact, the law admits several alternative strategies for legalizing prediction markets, strategies that chart a course between the rock of outright prohibition and the hard place of heavy-handed regulation.

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Architzel on Legality of Prediction Markets

The indefatigable Chris F. Masse directed my attention to a new analysis of the legality of prediction markets: Paul Architzel, Event Markets Evolve: Legal Certainty Needed, FUTURES INDUSTRY, March/April 2006, at 50-53. By my count, that marks the fourth author and fourth paper to give serious consideration to the question. (The others: my 1998 paper in CHAPMAN LAW REVIEW, my recent draft paper, and Hahn & Tetlock's forthcoming J. REG. ECON. paper.)

Architzel seems very well qualified to comment on commodity futures regulations. He recently joined the financial services and products practice group of the blue-chip law firm, Alston & Bird. Prior to that gig, he served as chief regulatory counsel of EurexUS for three years and as chief counsel of the CFTC's Division of Market Oversight for over 20 years. His article, though brief and unfootnoted, speaks with authority about commodity futures law.

As his article's title indicates, Architzel thinks that the uncertainty of U.S. law currently hinders the development of prediction markets. He flags three recent developments that hint that the CFTC might consider extending its jurisdiction to cover such markets. (I blogged about one of those regulatory incidents—the settlement between TEN and the CFTC—and concluded that it showed the CFTC recognizes that it does not have regulatory authority over prediction markets.) Architzel goes on to suggest four possible legal outcomes of operating a prediction market under U.S. law. Unsurprisingly, each involves either conformity with CFTC regulations or the risk of "operating in violation of Commission rules." P. 52.

Architzel is a CFTC man, through and through. He says next to nothing about whether gambling regulations reach prediction markets, and nothing about whether securities regulations do. Just as he finds that legal uncertainty about CFTC action hinders prediction markets, Architzel looks to the CFTC for a cure. He writes, "The CFTC could provide greater certainty to event markets in a manner that would also nurture their unique nature by promulgating a non-exclusive safe-harbor rule under which event markets could operate." P. 53.

In assuming that the CFTC could and should have jurisdiction over prediction markets, Architzel's analysis largely mirrors that of Hahn & Tetlock. I critiqued that approach in my draft paper, excerpting the most relevant part in a blog post. In very brief, I both doubt that the CFTC has jurisdiction over prediction markets and that CFTC regulation of them would generate net benefits.

Even sticking with the assumption that the CFTC has jurisdiction over prediction markets, however, Architzel's otherwise very solid analysis of commodity futures regulation raised my eyebrows twice. First when he said, at p. 52, that if the events subject to trading on prediction markets were "considered to be 'commodities,' they might even be offered on designated contract markets without restriction as to market participant." Would the CFTC really give so unusual and broad a definition to "commodity" under the Commodity Exchange Act? I must admit that I'd never even considered that possibility. Second, I was surprised and disappointed that Architzel did not discuss the "hybrid instrument predominantly a security" exclusion in CEA § 2(f)(1), a legal loophole I discuss in my draft paper.

I've written to Architzel on both counts, but as yet heard no reply. Those represent mere quibbles, though. By and large, I've very happy to have another ally in the struggle to clear the legal path for prediction markets.

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CFTC Targets Prediction Markets; Hits First Amendment

Would you pay good money for accurate predictions about important events, such as election results or military campaigns? Not if the U.S. Commodity Futures Trading Commission (CFTC) has its way. It recently took enforcement action against overseas prediction markets run by InTrade and TEN. The alleged offense? Allowing Americans to trade on claims about future events.

The blunt version: If you want to put your money where your mouth is, the CFTC wants to shut you up.

A prediction market allows its participants to buy and sell claims payable upon the occurrence of some future event, such as an election or Supreme Court opinion. Because they align incentives with accuracy and tap the wisdom of crowds, prediction markets offer useful information about future events. InTrade, for instance, accurately called the recent U.S. presidential vote in all but one state.

As far as the CFTC is concerned, people buying and selling claims about political futures deserve the same treatment as people buying and selling claims about pork futures: Heavy regulations, enforcement actions, and bans. Co-authors Josh Blackman, Miriam A. Cherry, and I described in this recent op-ed why the CFTC’s animosity to prediction markets threatens the First Amendment.

 The CFTC has already managed to scare would-be entrepreneurs away from trying to run real-money prediction markets in the U.S. Now it threatens overseas markets. With luck, the Internet will render the CFTC's censorship futile, saving the marketplace in ideas from the politics of ignorance.

Why take chances, though? I suggest two policies to protect prediction markets and the honest talk they host. First, the CFTC should implement the policies described in the jointly authored Comment on CFTC Concept Release on the Appropriate Regulatory Treatment of Event Contracts, July 6, 2008. (Aside to CFTC: Your web-based copy appears to have disappeared. Ask me for a copy.) 

Second, real-money public prediction markets should make clear that they fall outside the CFTC's jurisdiction by deploying notices, setting up independent contractor relations with traders, and dealing in negotiable conditional notes. For details, see these papers starting with this one.

[Aside to Jerry and Adam: Per my promise.]

[Crossposted at Technology Liberation Front, and Agoraphilia.]

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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.]

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Good News: CFTC Busts Intrade

The CFTC recently announced the filing of charges against Trade Exchange Network Ltd. ("TEN"), the Ireland-based provider of the Tradesports and Intrade markets, for offering unauthorized trades on commodities futures contracts to U.S. citizens. Hat tip: Chris F. Massey. The parties simultaneously reached a settlement agreement [PDF file]. Surprisingly, even to me, I find it this turn of events chock-full with good news.

It is not good news, of course, that TEN suffered the CFTC's regulatory attention. But note that this does not presage the CFTC acting as a free-range global exchange-buster. TEN had apparently used a U.S.-based agent to promote the forbidden contracts. Even an isolationist would have to admit that suffices to establish CFTC jurisdiction over TEN.

The good news comes in two flavors: Express and implied. Expressly, the settlement agreement discloses that TEN plans to offer a U.S.-based, CFTC-regulated exchange. It says, at VI.10, page 5: "TEN, in September 2004, began the process of submitting to the Commission an application seeking to have its newly-incorporated U.S. business, and internet company known as Trade4Real, designated as a contract market. Ten took this measure in recognition of the need to be regulated by the Commission to offer certain products."

The implied good news comes out of that last sentence, as well as the whole of the settlement: The CFTC expressed no interest in regulating any claims not already traded on CFTC-regulated U.S.-based exchanges. It went after TEN only for offering contracts on, inter alia, Gold Futures Year End, Daily Crude Oil, and U.S. Dollar versus Yen Cash Rate. That sends the signal that the CFTC won't mess with an exchange offering trades on purely political or scientific claims.

Note that TEN does not claim that it will trade political or scientific claims on the CFTC-regulated, U.S.-based market that it has announced. It mentions only pretty traditional sorts of contracts. But it doesn't say it won't offer trading on political or scientific claims. And, even if it does not, its wrangle with the CFTC hints that somebody else might do so without suffering similar regulatory action. That should come as good tidings to The Washington Stock Exchange and the (soon to be relabeled) Simon Exchange.

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Building Exits into CFTC Regulation

Much of my draft paper, Private Prediction Markets and the Law, focuses on nuts-and-bolts fixes for the legal uncertainty that currently afflicts private prediction markets under U.S. law. I'll say more about those in later posts to Agoraphilia and Midas Oracle. The paper also dicusses a more theoretical and general issue, though: The benefits of designing regulatory schemes to include exit options.

The Commodity Futures Trading Commission recently issued a request for comments about whether and how it should regulate prediction markets. In earlier papers, I explained why the CFTC cannot rightly claim jurisdiction over many types of prediction markets. I recap that view in my most recent paper, but add some suggestions about how the CFTC might properly regulate some types of prediction markets. In brief, I suggest that the CFTC build exit options into any regulations it writes for prediction markets, allowing those who run such markets the same sort of freedom of choice that U.S. consumers already enjoy, thanks to internet access to overseas markets like Intrade, with regard to using prediction markets. Here's an excerpt from the paper:

Those practical limits on the CFTC's power should encourage it to write any new regulations so as to allow qualifying prediction markets to operate legally, and fairly freely, under U.S. law. . . . Ideally, the CFTC would offer prediction markets something like these three tiers, each divided from the next with clear boundaries.

• Designated Contract Markets. Regulations designed for designated contract markets, such as the HedgeStreet Exchange, would apply to retail prediction markets that offer trading in binary option contracts and significant hedging functions.
  
• Exempt Markets. Regulations for "exempt" markets, which impose only limited anti-fraud and manipulation rules, would apply to prediction markets that:
  
  
  • offer trading in binary option contracts;
    
  • thanks to market capitalization limits or other CFTC-defined safe harbor provisions do not primarily support significant hedging functions; and
    
  • offer retail trading on a for-profit basis.
  
  
• No Action Markets. A general "no action" classification, similar to the one now enjoyed by the Iowa Electronic Markets, would apply to any market that duly notifies traders of its legal status and that is either:
  
  
  • a public prediction market run by a tax-exempt organization offering trading in binary option contracts but not offering significant hedging functions;
    
  • a private prediction market offering trading in binary option contracts, but not significant hedging functions, only to members of a particular firm; or
    
  • any prediction market that offers only spot trading in conditional negotiable notes.

Notably, regulation under either of the first two regimes would definitely afford a prediction market the benefit of the CFTC's power to preempt state laws. It remains rather less clear whether the third and lightest regulatory regime would offer the same protection, though the cover afforded by its two "no action" letters has allowed the Iowa Electronic Markets to fend off state regulators. Markets that by default qualify for the third regulatory tier described above thus might want to opt into the second tier, so as to win a guarantee against state anti-gambling laws and the like. So long as they satisfy the first two conditions for such an "exempt market" status, public prediction markets run by non-profit organizations or private prediction markets that offer trading only to members of a particular firm should have that right. Why offer this sort of domestic exit option? Because it would, like the exit option already open to U.S. residents who opt to trade on overseas prediction markets, have the salutatory effect of curbing the CFTC's regulatory zeal.

The footnotes omitted from the above text includes this observation: "Because they fall outside the CFTC's jurisdiction, markets offering only spot trading in conditional negotiable notes could not opt into the second regulatory tier."

Please feel free to download the draft paper and offer me your coments.

[Crossposted at Agoraphilia, Technology Liberation Front, and Midas Oracle.]

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Free Speech in Event Market Claims

In addition to a joint comment with a score of signers, I also responded to the Commodity Futures Trading Commission (CFTC)'s Concept Release on the Appropriate Regulatory Treatment of Event Contracts by firing off a solo comment. I there focused soley on question 14, in which the CFTC asked, "Should certain underlying events or measures--such as those based on assassinations or terrorist activities—be prohibited altogether due to the social perception and impact of such events? What statutory or other legal basis would support this treatment?"

Much of my comment tracked the answer I posted here earlier. Long story short: such claims would not materially promote wrongful acts, so the CFTC has no legal basis to ban them. To that argument, however, I added a First Amendment analysis; to wit:

Could you fault claims about assassinations or other terrorist events for giving incentives for wrongful acts? Not very plausibly; as I explain above, it is very unlikely that anyone would find it profitable or prudent to try to use an event market to cash in on wrongdoing. Furthermore, all sorts of investment instruments offer the same incentives. Thus, for instance, a would-be terrorist might go long on oil futures prior to pulling off an attack on a refinery. Indeed, that sort of scenario seems much, much more likely than one involving event markets.

At root, concern about unseemly event market claims boils down to concern about violating a taboo about what sorts of things people discuss openly in a polite society. Those norms merit our concern, granted. They do not, however, justify imposing a speech restriction on event markets. And make no mistake about it; to bar such claims would constitute a restriction on speech.

Specifically, if the CFTC banned certain sorts of event market claims relating to assassinations, terrorist activities, or criminal acts, it would thereby impose a content-based restriction on speech. That would, under present First Amendment jurisprudence, trigger the highest level of judicial review: strict scrutiny. The ban would almost certainly fail to survive that scrutiny, as it would be too broad (stopping not just the bad guys but also the good ones), too narrow (since it would fail to forbid the use of other financial instruments, such as generic futures, from like uses), and not narrowly tailored (since there are other, better ways to discourage bad acts). Those sorts of claims would, moreover, fall within the core of the sort of speech protected by the First Amendment, as they would concern political events.

Our freedoms of speech and expression include the right to ask troubling questions. The CFTC has no good reason to ban event market claims about assassinations or other illegal acts. Nor can it do so constitutionally.

Suppose that my argument leads the CFTC to doubt that it can ban event markets from hosting claims about assassinations or terrorist activities. Suppose further, as seems likely, that the CFTC has some discretion in deciding whether its jurisdiction encompasses event markets; suppose, that is, that extant law does not command one answer to that question. What result?

I predict that the CFTC would tend to deny that it has jurisdiction over event markets because it would not want to take the blame for encouraging distasteful claims. Indeed, I not only predict that result, I intend it. I don't trust the CFTC to do a very good job regulating event markets, so I want it to know why it does not even want to try.


[Crossposted at Agoraphilia and Midas Oracle.]

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Do Gambling Laws Threaten Prediction Markets?

Because prediction market traders generally rely more on skill than on chance to win, I've argued that they do not qualify in "gambling" as defined by U.S. law. I've also admitted, however, that over-ambitious prosecutors might see the matter differently. A recent email exchange I had with Prof. George R. Neumann, who serves on the Board of Directors of the Iowa Electronic Markets, confirmed my worries. I here quote him, with his permission.

"We have been threatened several times with suits by various states," he wrote, "but so far the CFTC coverage [i.e., the two 'no action' letters that the CFTC gave the IEM] has been our trump card." Prof. Neumann offered this example: When the IEM ran a market on Hilary Clinton's run for the New York Senate seat, an N.Y.C.-based district attorney "contacted us (via a very nasty letter) to tell us that NY had a law that forbade gambling on elections in that state. He demanded a list of each and every NY State resident who was a participant in our market." Wielding the CFTC's "no action" letter in defense of the IEM, Prof. Neumann directed the DA to file suit in, um, a venue at once very local and yet very inconvenient.

Alas for those who would like to match Neumann's feat of legal acumen, the CFTC's treatment of the IEM so far looks like a one-shot deal. Or, rather, it looks like a big-shot deal; you would probably need some political help to squeeze another such letter out of the CFTC. While you're at it, please ask the CFTC to issue an advisory opinion saying, "The CFTC has no rationale to regulate transactions or markets in which price discovery functions predominate over hedging functions." It could state a market cap limit to make clear the limits on its discretion.

Such a "public no action letter" would give a great many useful prediction markets freedom to help us discern the future, just as the IEM has done. It would also, to judge from the IEM's experiences, give new prediction markets a shield from state anti-gaming prosecutions.

[Crossposted to Midas Oracle.]

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The CFTC Deadline . . . Wavers

The Commodity Futures Trading Commission (CFTC)'s Concept Release on the Appropriate Regulatory Treatment of Event Contracts says, "Comments must be received by July 7, 2008." What deadline does that impose? I played it safe, and assumed that I had to send mine in before midnight, this morning. Today, I learned from Bruce Fekrat, Special Counsel to the Office of the Director of the CFTC, that in fact I had up until this coming midnight to email my comments.

Any lawyer worth his or her salt knows better than to use the ambiguous "by" when specifying a deadline. The CFTC should have said, "Comments must be received before July 8, 2008." Thanks to its poor drafting, I rushed my comment out the door, missed the chance to get lots of new signatures, and wasted time swapping emails with various people equally confounded about what the CFTC meant.

Sigh. And to think that some people hope the CFTC will assert jurisdiction over prediction markets and clarify their legality under U.S. law! If the CFTC cannot get even something so routine as specifying a deadline right, I shudder to think what sort of confusion it might impose on prediction markets.

[Crossposted at Agoraphilia and Midas Oracle.]

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Let Prediction Markets Fight Terrorism

The Commodity Futures Trading Commission (CFTC)'s recent request for comments about the regulation of prediction markets includes a number of specific questions. I am not sure whether I will manage to write up answers to all of them before the July 7 deadline, but question in particular—question 14—has attracted my attention. The CFTC there asks, "Should certain underlying events or measures--such as those based on assassinations or terrorist activities—be prohibited altogether due to the social perception and impact of such events? What statutory or other legal basis would support this treatment?"

I answer the first part of question 14, "No," (and thus need not answer the second part). I doubt that the CFTC wants to hear that sort of reply, frankly; I instead suspect that it wants a legal excuse to avoid the sort of political firestorm that followed the Pentagon's proposal to create a Policy Analysis Market that included claims about assassinations and terrorist events. My draft answer to question 14 explains why I'm willing to risk disappointing the CFTC:

The CFTC should not forbid trading in claims based on assassinations, terrorist activities, or other criminal acts. Because event markets would offer only relatively thin and traceable trading, they would not offer an attractive investment option to anybody planning to profit from wrongdoing. A would-be terrorist would risk revealing both his plans and his identity if, for instance, he invested in a contract predicting another 9/11. He would instead find it more safe and profitable to simply short certain publicly traded stocks.

Furthermore, event markets in terrorist or criminal acts might benefit the public by revealing life-saving information. Suppose, for instance, that an anthropologist's study of corrido culture convinced her that narcoterrorists had begun planning military raids on border checkpoints in Arizona and California. If she had the opportunity to buy terrorist event claims, she might both profit from her research and tip us all off about looming trouble. Sound public policy suggests that we should encourage that sort of trading—not forbid it.

To judge from their reactions to the Policy Analysis Market proposed by the Pentagon in 2003, politicians might need to learn more about the benefits of using trading to help predict assassinations or other terrorist events. That poses a public relations problem, however—not a legal one. The CFTC thus has no sound reason to presumptively forbid trading in contracts related to such events.

Notably, my answer to question 14 differs sharply from the answer offered by Jed Christiansen. He said, "There should never be any incentive to break a law, so there should never be any contracts that would pay someone if a law was broken." I disagree, of course, but I thank him for stimulating me to offer an alternative take.

[Crossposted at Agoraphilia and Midas Oracle.]

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Hacking the EBOT

In my last post, I puzzled over why a prediction exchange might want to qualify as an EBOT (exempt board of trade). The benefits: relatively light federal regulatory burdens and preemption of state laws. (On the latter point, which I ignored to make earlier, see CEAct, 7 U.S.C. § 7a-3(e).) The large cost: Narrow limits on who can trade; only a "eligible contract participant" can. I doubt that a prediction market open only to, say, multimillionaires or registered brokers would do very well at quantifying the current consensus about future events.

But maybe I dismissed the EBOT status too quickly. Look again at CEAct § 1a(12)(C). It defines an eligible contract participant as "any other person that the Commission determines to be eligible in light of the financial or other qualifications of the person," (emphasis added). That suggests two legal hacks.

First, I could get the CFTC to allow a market in science claims open only to a large group of presumptively qualified commentators. That group of "eligible contract participants" might, for instance, include all faculty of accredited institutions of higher learning. And maybe their students, too. And what about mere high school graduates? Would you really want to exclude the likes of Bill Gates? Well, anyhow, you get the idea: Use § 1a(12)(C) to set up a usefully open EBOT.

Second, I could get the CFTC to define "other qualifications" relative to the market itself. In other words, I'd have the CFTC say, "Any person is qualified to trade on an EBOT that deals only in claims fitting the following description: . . . ." (More likely, the CFTC's statement would refer to a supplementary document, as defining the proper sort of claim would prove tricky.)

That second hack stretches the law a bit. Recall that the relevant statutory language reads, "other qualifications of the person," (emphasis added). Does the nature of the market you play constitute one of your qualifications? Arguably not. It looks more like a qualification of the market.

At all events, I've written to the CFTC to see how it reads §1a(12)(C).

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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.

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Protecting Private Prediction Markets

My draft paper, Private Prediction Markets and the Law, offers a variety of detailed suggestions about how to protect the former from the latter. Specifically, I offer strategies for avoiding the scope of CFTC regulation, for discouraging liability for illegal insider trading, and for ensuring that a private prediction market does not offer gambling. Because I've already blogged about the CFTC angle several times, I'll pass over that topic. Here, though, is my conclusion about how to guard against illegal insider trading and gambling laws:

Publicly-traded firms subject to U.S. law can minimize the risks of illegal insider trading by either making public all prices and claims traded on their prediction market or by:

• Keeping trading by traditional insiders separate from trading by others;
  
• Broadening safeguards against illegal insider trading to cover all traders;
  
• Treating the market's claims and prices as trade secrets; and
  
• Seeding the market with decoy claims and prices.

Although the skill-based trading emphasized on private prediction markets should in theory remove them from the scope of gambling regulations, a prudent firm could help to ensure that result by:

• Forbidding traders from investing their own funds in the market; and
  
• Requiring its agents to participate in its market.

As should perhaps go without saying (but as hereby will not), any firm implementing these legal strategies should back them up with ample record-keeping. Each person who trades on a firm's market should, for instance, receive clear notification that the market does not deal in CFTC- or SEC-regulated instruments, and that it does not offering services subject to oversight by any state gambling commission. Better yet, traders should be required to access the market only through a click-through agreement in which, among other things, they consent to that stipulation.

[Crossposted at Agoraphilia and Midas Oracle.]

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Getting from Collective Intelligence to Collective Action

I really enjoyed attending the Collective Intelligence FOO Camp, sponsored by Google and O'Reilly Media, last weekend. I'd been expecting a sort of geek slumber party, and had looked forward to rolling out my awesome Darth Vader impersonation. I was all set to cut loose with a growling, "I'm your father, Luke." It didn't quite come to that, but I still had a blast, meeting lots of smart, informed, articulate, creative, and successful people. Friendly people, too.

I described how to establish the legality of real money, open-access prediction markets under U.S. law. I called my presentation, Getting from Collective Intelligence to Collective Action [PPT file]. In very brief, I proposed this algorithm:

1. Set up an enterprise prediction market, make playing it a condition of continued employment, and offer valuable prizes to the best predictors.
   
2. Set up a limited access prediction market, hire a number of independent contractors researchers to play it, pay them a relatively low salary for doing so, and offer valuable prizes to the best predictors.
   
3. Set up an open-access prediction market but require anyone playing it to go through a click-wrap license that creates the sort of independent researcher relationship described at step 2, above.
   

When and if standing for declaratory judgment obtains, a litigation team should bring suit seeking to establish the legality of the prediction market under U.S. law. The market should be run by a worthy institution and deal only in claims likely to generate large positive externalities. Google.org, for example, might set up a market in earthquake claims and ask for a court's blessing.

That strategy would stand a fair chance—a 75% chance, I'd say—of establishing the legality of a great many in-house and (effectively) public prediction markets under U.S. law. The strategy would not impose great costs or risks, though it would take some careful planning and execution, and would almost certainly generate large private and public goods. It might even save lives; we could really use a reliable early-warning system for major earthquakes.

This legalization program would most directly benefit subsidized markets; it would not plainly establish the legality of markets where traders could invest their own funds or hedge against off-market risks. I'm still working out a legal hack for that step. It will be an easier step to take, however, if we've already made it as far as establishing the legality of open-access, real money prediction markets under U.S. law.

We should still pursue other routes to establishing the legality of prediction markets under U.S. law, of course. It already helps that so many U.S. residents evidently make and lose money on Ireland-based InTrade. That at least goes to show that prediction markets hurt nobody. Getting the CFTC to issue safe-harbor regulations would help, too. All of those routes to public, real money prediction markets in the U.S. merit exploration. Any of them might offer a shortcut to a better, freer future.

[Posted at Agoraphilia, The Technology Liberation Front, and Midas Oracle.]

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Money Mouth

I'm wrapping up my most recent paper on prediction markets, "The Prediction Exchange: Progress in Promoting the Sciences and Useful Arts." By way of the grand finale, I'm toying with putting in the conclusion this passage:

I hereby offer to sell for $.10 each up to 1000 prediction certificates, each of which contains the following promise: "The bearer of this certificate is entitled to receive $1.00 from Tom W. Bell if, before January 1, 2010, a federal or state court in the United States holds that a prediction exchange fitting the definition set forth in [this article] violates state or federal gambling laws or falls within the jurisdiction of the SEC or CFTC." The certificates will contain some additional fine print, naturally. That promise captures the heart of my prediction, however. It moreover shows that I am willing to risk $1000 on my claim that, all told, prediction markets should not be illegal under U.S. law. More exactly, my asking price shows that I think it only 10% likely that my prediction errs.

So, dear readers and fellow prediction market geeks, what do you think of that? Yes, I know it's typically nutty; I mean only to ask if this admittedly rough proxy for a real prediction market contains some fatal flaw. Also, you may have some ideas about what I need to put in the fine print. I certainly to discuss, in a footnote, the need to name judges, the choice of law provision, the fact that I can delegate my duty. I may even include a sample certificate. I doubt I can easily go as far as Robin Hanson did, so many years ago, in his Extropy article on prediction markets. He included, in each hardcopy, a real coupon!

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The Forecast for Information Markets

USD law prof Tom Smith waxes enthusiastic about information markets, a view I share. He also wonders about their legality under U.S. law, as well he should. That’s a question to which I've given a good deal of thought, and about which I've written a legal analysis. You can read the results in Gambling for the Good, Trading for the Future: The Legality of Markets in Science Claims, 5 Chapman L. Rev. 159 (2002) [PDF format]. The short take: information markets (a.k.a. "idea futures markets," "prediction markets," etc.) could pretty easily dodge U.S. anti-gambling laws, but would face a somewhat trickier task avoiding CFTC regulation.

Tom, like me, has apparently toyed with the launching such a market himself. I take it from his post that he's given up, though. Not so, me. I'm still working on getting the Simon Market in Science Claims up-and-running. I'll soon have some exciting news to relate about that. For now, I'll just observe that Tom's particular interest—claims about weather events—already exist in the form of weather futures, traded on the Chicago Mercantile Exchange.

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Ticket Reserve's Legal Strategy

Most of you readers of Agoraphilia probably also read Marginal Revolution, (if you don't, you should!) You've thus probably read Tyler Cowen's recent, brief reference to the Ticket Reserve. Fans of prediction markets (a.k.a. "decision markets," "idea futures markets," etc.) will want to give the Ticket Reserve careful consideration, as it points toward a viable legal model for a real-money exchange.

The Ticket Reserve basically operates as a prediction market for sports playoffs. It allows members to buy and sell "Event Fan Forwards," defined in paragraph one of the User Agreement (available on the registration page) as "an instrument which: (i) gives the holder the right to purchase a ticket to a possible Fan Forward event the occurrence of which is contingent upon one or more factors and (ii) obligates the holder to purchase the ticket if the event is scheduled to occur."

Essentially, then, when you buy an Event Fan Forward you predict that a particular sporting event will happen. Guess wrong and you lose your investment. Guess right and you get a very valuable right—one you can sell for a nice gain—to buy a ticket to that sporting event at its face value (i.e., a value almost assuredly well below its market price).

The Ticket Reserve makes quite plain that it merely facilitates such exchanges. Paragraph one of the User Agreement offers a fairly succinct description of what Ticket Reserve does:

The Ticket Reserve is a venue where members can purchase and sell tickets, Event Fan Forwards and other ticket-related products relating to sports contests, concerts and other world class events. . . . The Ticket Reserve facilitates the purchase and sale of those rights but does not act as a principal to either the buyer or seller. We simply provide an independent marketplace where interested buyers and sellers can meet to transact at prices established by them in a fair and open market.

This exchange function distinguishes Ticket Reserve from Yoonew.com, a competing service that presently offers only the right to purchase tickets. (Yoonew notes, however, that it plans to offer a secondary market someday; look in its FAQ under "Purchasing Fantasy Seats/Q: Are my Fantasy Seats transferable?")

Does Ticket Reserve operate as a sports gambling establishment? It evidently thinks not, as it nowhere tout a gaming license. At all events, even if some state had issued Ticket Reserve a license to offer sports gambling services, Ticket Reserve would assuredly violate a wide variety of state and federal laws in offering its services across state borders.

Yet Ticket Reserve embraces the fact that many people will use it not to secure tickets to see their favorite teams in the playoffs, but rather to parlay accurate sports predictions into money. It's FAQ explains the "game-within-the-game" thusly:

Since The Ticket Reserve market is driven by supply and demand for Fan Forwards, prices tend to change dynamically based on a number of factors including things such as team performance, player injuries, etc. This dynamic nature of the marketplace provides an opportunity for individuals to profit from price movements in Fan Forwards. The "game-within-the-game" is to purchase Fan Forwards based on the chance to make money in the marketplace, as opposed to securing a seat to the event. In most cases, these market participants have no interest in the team or the event, but rather think a given Fan Forward is under priced and will provide them with the opportunity to profit down the road when they put it back into the market. Many fans that are large supporters of their team will purchase Fan Forwards to both guarantee attendance at events, as well as to speculate on other teams in the hopes of making a profit.

For many people, of course, Ticket Reserve's "game-within-the-game" will be the game. Would we call those people gamblers? Generally speaking, chance must predominate over skill in making the sort of prediction that qualifies as gambling. Roulette thus plainly counts as gambling, whereas engineering reports plainly do not. Sports predictions fall in the middle, raising thorny epistemological—and not inconsequentially, legal—questions.

With regard to sports predictions in particular, however, federal law has simplified those questions. The Wire Act, 18 U.S.C. 1084(a), threatens criminal sanctions against anyone involved in the business of "placing [] bets or wagers on any sporting event or contest . . . ." Suffice it to say that I salute the bravado of the parties who operate the Ticket Reserve. I wish them luck, too. If the Ticket Reserve can escape prosecution, the sort of prediction exchange in science claims that I want to legalize should have an easy go of it.

Since they don't think they're engaged in gambling, how do those responsible for the Ticket Reserve classify their enterprise? Not as a market subject to regulation by the CFTC or SEC, apparently. The only allusions to federal regulations I've seen Ticket Reserve make remain just that: allusions. They describe their service, for instance, in these terms: "The Ticket Reserve marketplace uses the same type of bid/ask technology as traditional stock exchanges to arrive at market based pricing."

The Ticket Exchange apparently regards their service a straightforward matter of contract law. Being based in Illinois, the chose the contract law of that state (see Paragraph 23 their User Agreement). I salute the Ticket Reserve for that bit of legal daring, too, as I'd like for state and federal regulators to apply only contract law to the Simon Exchange. But, again, I must say that I also feel compelled wish Ticket Reserve luck—good luck and a lot of it.

[Update: I found the (in hindsight, obvious) links to the people behind the Ticket Reserve, and so struck a description of them as "mysterious."]

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