Wednesday, March 29, 2006

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.


David said...

Hi Tom,

I'm curious, what is your impression of James Suroweiki's book "The Wisdom of Crowds"? Does he make a compelling case for prediction markets?

Chris Hibbert said...

Architzel is quite positive about the value of Prediction Markets, contrasting them to "mere betting establishments", and saying that "an impressive body of study on these markets makes the case that these markets may have great social utility" and that they provide the "economic benefit" of "price discovery". He also points out that they can "directly mitigate the risk associated with discrete releases of economic information", a benefit that hasn't been emphasized much.

I think it's worth noting that Architzel suggests that "non-profit educational ... enterprises" could get away with running markets like the IEM and refer to IEM's letter as the reason they believe they wouldn't fall under the CFTC's purview.

Tom W. Bell said...

David: I enjoyed Suroweiki's well-written book, but cannot say it makes a "compelling" case for prediction markets. Making that sort of case would, I think, call for a good deal more theory than Suroweiki offers. Still, though, he makes a strong, if largely suggestive, case that we at least ought to experiment with prediction markets.

Chris: I agree that Architzel's overall argument--indeed, the very fact that he is promoting PMs in a trade publication for the commodity futures industry--strongly supports prediction markets. Even if he takes a slightly more regulatory stance than I do, he evidently wants to see real-money prediction markets flourish.