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

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."

The intersection of prediction markets and politics can also be controversial, depending on the nature of the forecasts. In 2003, the Defense Dept. commissioned a $1 million project to monitor some of the world's most volatile regions via prediction markets. Yet when the project's Web site suggested that occurrences such as political assassinations could affect a political stability index, politicians lambasted the idea as morally repugnant. Senator Byron Dorgan (D-N.D.) called the idea "grotesque," and Senator Ron Wyden (D-Ore.) termed it a "federal betting parlor of atrocities." Amidst the ensuing media circus, the Defense Dept. canceled the project immediately and the project's director resigned.

The mere fact that federal regulators are considering prediction-market regulation shows how far the concept has come (BusinessWeek.com, 8/3/06). For years, academics petitioned the agency to consider the valuable forecasting mechanism of prediction markets, arguing they ideally reward well-informed traders and aggregate consensus quickly. Yet the forecasting tools don't closely resemble futures contracts. They typically don't give users hedging capabilities and sometimes convey more of an entertainment value than an economic one. An example: The Irish-based prediction market Intrade offered a contract on the likelihood that Get Smart would gross $40 million in its opening weekend at the box office. (It fell just short, with revenues of $39.2 million.)

"It comes in my mind very close to gambling," says Michael Greenberger, a former CFTC markets director who is a law professor at the University of Maryland. "The CFTC staff is already overwhelmed, and it distracts them from the work they have."

Is It "Responsible" Innovation?

The issue of jurisdiction raises the question, "Is an event contract a commodity?" The act that established the CFTC in 1974 said that exchanges could only offer commodity contracts "not contrary to the public interest," which meant that the contract had to offer participants the ability to hedge risk and to discover the commodity's true price.

But that changed in 2000. The "public interest" criteria was scrapped by the Commodity Futures Modernization Act as being too burdensome for exchanges to prove, especially considering that exchanges were already offering useful contracts based on everything from weather indexes to the likelihood of a corporate merger. For instance, in 2007 the U.S. Futures Exchange offered a contract on the likelihood of a merger between the Chicago Board of Trade and the Chicago Mercantile Exchange.

In its request for comment, the CFTC reminded the public that the commission should "promote innovation for futures and derivatives." It also added that—hint, hint—the Iowa markets have been valuable sources of public information and have predicted Presidential outcomes better than polls. The 2000 act gave the CFTC the authority "to promote responsible economic or financial innovation" by creating an exemption for certain types of contracts (such as one in a prediction market).

Does this innovation loophole mean that the CFTC will open its doors to more event contracts?

"Somebody there wants to help out these markets," says Bell, who thinks that prediction markets fall short of gambling or being traded as commodities and more closely fall under states' contract laws. "What they're likely to do is establish some sort of regulatory safe harbor for certain specific types of markets."

Not Exactly High-Rolling

Thus far, 9 of the 11 people who have filed formal comments with the CFTC support broader adoption of prediction markets, to varying degrees. Says Joshua Hall, a respondent and assistant economics professor at Beloit College in Wisconsin: "The information provided through these markets would appear to be welfare-enhancing, based on what we know about the importance of information to wealth creation."

Experts expect the initial reaction to CFTC regulation to be more low-cap, nonprofit markets like the one created by the University of Iowa. Some doubt the forecasting power in these small-scale markets, since there wouldn't be enough monetary incentive for traders to seek and discover information. "We do not need nonprofit prediction exchanges," says Chris Masse, editor and publisher of the prediction market blog midasoracle.org. He says that British exchanges like Intrade and Betfair, which are for-profit, have the capital to continually offer more cutting-edge pricing systems and additional contracts while nonprofits like the IEM have not.

"Basically I think they're going to expand the IEM no-action letter and take legal measures to make sure that legal contracts aren't subject to antigambling laws," says Chapman law professor Bell. With restrictions on pure entertainment contracts, like those betting on sporting events or celebrity marriages, the CFTC will likely allow contracts, like the corporate merger predictors, whose information is valuable to the general public.

Says Paul Architzel, a former CFTC chief counsel who thinks CFTC regulation is imminent: "Overall, the social utility of the markets will carry the day."


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