Regulation Looms for Prediction Markets

The Commodity Futures Trading Commission is likely to become involved in regulating event futures—and it just may boost these markets

By Ricky McRoskey

Here's a prediction: Prediction markets are about to become federally regulated.

On July 7, the federal agency that regulates futures markets will begin reviewing two months' worth of responses to a question the agency posed to the public in May: "Should the Commodity Futures Trading Commission regulate prediction markets?" If the public's responses thus far—or the language in the CFTC's request for comment—is any indication, it's likely that the agency ultimately will. When it does, get ready to see more small-stakes prediction markets like the experimental, $500-maximum-bet Iowa Electronic Markets, or IEM, that forecast things like Presidential elections or future monetary policy.

Prediction markets, or event futures, are a set of contracts that people can trade like a stock. They would pay out if a predetermined event happened and would be worth nothing if it didn't. Market questions could range from "Will the U.S. enter a recession in 2008?" to "Will bird flu strike the U.S. in August?" The price of each contract would in theory reflect the probability that an event will or won't occur, based on the information that each trader contributes with every "buy" and "sell."

Uncertain Environment

But for years, the legality of the markets has been ambiguous. In 1993, the University of Iowa launched its electronic market to forecast Presidential elections, but only after it had received a "no action" letter from the CFTC that neither promoted nor condemned the markets as long as the maximum bet didn't exceed $500.

Some argue that investing in prediction markets is tantamount to gambling, which places it within states' purview. Others claim the markets fall under the scope of the federal Commodity Exchange Act, which created the CFTC in 1974 to regulate futures markets.

In 2000, when the Iowa markets offered a contract on the likelihood of Hillary Clinton's being elected to the U.S. Senate from New York, a New York-based district attorney threatened to prosecute any New York citizen who participated in the markets. There was an "arcane state law against gambling on elections," says George Neumann, who serves on the board of directors at the IEM. Neumann successfully argued that the CFTC's no-action letter defended against such state action. That's why, for prediction market advocates, the prospect of federal regulation would be momentous.

The current aura of uncertainty has stifled innovation, says Tom W. Bell, a law professor at Chapman University in Orange, Calif., so the CFTC's interest is a good sign to potential market makers looking for direction. "People have been scared to invest in or play these markets," says Bell, "and now they want to get this stuff rocking and rolling."

"Close to Gambling"

"I think the request for comment is a step in the right direction," says Robert Hahn, a senior fellow at the American Enterprise Institute who has advocated for greater experimentation in prediction markets. "The CFTC recognizes the potential for prediction markets to inform public policy and also to improve private decision making."