CFTC, SEC Acknowledge Need for Prediction Market Rules, Need Help Figuring Them Out
It's clear something must be done, but what?
Last year, the CFTC and SEC issued a “joint statement on innovation” that effectively declared an anything-goes approach to prediction markets, but now they’re looking for help wrangling the monster they created. A series of missives over the last two days culminated in a 40-point plea to the general public to tell the agencies how prediction contracts should be regulated.
Yesterday, the two agencies announced a “Joint Harmonization Initiative,” stating that they’d be working together to hammer out policies to deal with prediction markets, crypto, and other novel products.
“For decades, regulatory turf wars, duplicative agency registrations, and different sets of regulations between the SEC and CFTC have stifled innovation and pushed market participants to other jurisdictions,” said SEC Chairman Paul S. Atkins. “This updated Memorandum of Understanding will serve as a roadmap for a new era of harmonization between the agencies – one that is critical to support U.S. leadership in this next chapter of financial innovation.”
The announcement was light on details, but it was followed up by two rapid-fire releases by the CFTC today.
CFTC Warns Prediction Markets About Risky Contracts
The first of these was a vague warning to the prediction market industry. The notice is a reminder to the companies offering these markets of their obligations to be diligent when self-certifying contracts and to monitor trading for signs of market manipulation.
In particular, the notice reminds the companies that the CFTC can prohibit contracts that it deems to be related to terrorism, war, or assassination — likely a reference to the controversy surrounding contracts on the removal of Ali Khamenei as leader of Iran. It also hints strongly that, while sports contracts on full-game results may be okay, individual player props and short-interval contracts are more susceptible to manipulation and might not be.
The notice doesn’t forbid exchanges from offering those contracts. However, it reminds them that when self-certifying, they have to provide a detailed explanation of their reasoning. It cautions that:
“Overly broad or general contract specifications may affect a [prediction market operator]’s ability to analyze the compliance of the contract’s various permutations with the CEA and Commission regulations, including the contract’s susceptibility to manipulation.”
In other words, it is a warning that exchanges that give themselves blanket permission to offer all manner of prop bets may find themselves in trouble the next time a spot-fixing scandal emerges.
Lots of Questions, Few Answers on Prediction Regulation
The second release from the CFTC was a notice of proposed rulemaking.
Typically, such notices are accompanied by an explanation of the proposed rules. The agency issuing the notice then solicits comment, amends the rules based on feedback, and either passes them or does not.
In this case, there are no proposed rules, only a series of questions. The public now has 45 days to offer comment, and the CFTC will presumably attempt to amend its rules based on the answers. However, the dilemmas they’re attempting to solve are such that it would take a dedicated body of policymakers far longer than that to come up with satisfactory answers.
Yesterday, I took a look at the complexities surrounding just one of those questions: how to determine if a market is functionally equivalent to a bet on someone’s death.
That amounts to one point out of the dozens raised by the CFTC. Its questions are numbered from 1-40, but many of those include several subpoints. They cover everything from speculative questions about hypothetical future developments, to technical questions about sequencing of procedures, to important philosophical questions like what it means for two contracts to be “similar.”
To provide a sense of the breadth of the rulemaking that the CFTC is considering, I tried to condense those questions and sub-questions into a more concise list, and still ended up with the 27 items below.
If you believe that you’ve got the answers, you can tell the CFTC here.
What the CFTC Wants You to Solve for Them
- Do we need to amend the rules to clarify how anti-market manipulation principles apply to prediction markets?
- To what extent do prediction markets need their own rules? Do the precedents set by other types of swaps and futures contracts make sense in the context of prediction markets?
- Should margin trading on prediction markets be permitted, and if so, how do we determine how much leverage is appropriate to allow for a given type of contract?
- Should we allow prediction markets to be put on the blockchain, and if so, are any new rules needed to govern that?
- Do we need special rules for institutional liquidity-providers — for instance, public disclosure requirements — or would that just make things worse?
- Do we need to standardize public reporting requirements for trading and price data?
- Do prediction markets create unique opportunities for abuse in terms of tax evasion (e.g. wash sales) or disruptive trading practices?
- The CFTC is supposed to prohibit contracts that are “contrary to the public interest.” How do we decide what is contrary to the public interest?
- In earlier versions of the rules, a contract needed to have a demonstrable economic purpose to be legal. Should we bring that back?
- How do we weight our responsibilities to foster innovation and protect participants from market manipulation and fraud, when those goals are sometimes in conflict?
- Is there an overlap between prediction contracts and insurance contracts, and does that contribute to the “public interest”?
- It’s not permitted to offer contracts on any illegal activity, but as a non-judicial body, how do we determine what’s illegal? And what if it’s illegal in some states but not others?
- What are “terrorism” and “assassination”? Are those terms self-evident, or are there corner cases we need to clear up, such as the distinction between “cyberterrorism” and garden-variety cybercrime?
- What is “war”? Do any and all military actions count as war, or are some okay to trade on?
- What is “gaming”? Is it synonymous with state and federal definitions of “gambling,” or is it broader than that? Are sports gaming?
- The rules say that something is contrary to the public interest if it’s similar to something else that we’ve already determined is contrary to the public interest. How do we test similarity?
- At what point in the listing process for an event contract should we make the public interest determination?
- Under what circumstances should we make the public interest determination categorically, rather than on a contract-by-contract basis?
- It’s illegal to offer contracts that “involve” things like war, terrorism, and gaming. What does “involve” mean?
- According to the rules, we have to take final action within 90 days of beginning our investigation into the question of public interest. How should we budget that time, and should we take any interim action while making that final determination?
- Is it in the public interest when insider trading causes information to get out earlier than it otherwise would have? Are there some markets for which that should be allowed, but not others? How do we make that determination?
- Do we need special rules for contracts where the underlying event can be controlled by a single person or a small group of people?
- Do we need special rules for contracts whose prices are closely correlated, where a trader could manipulate one in order to influence the other?
- Do we need special rules to avoid the manipulation of markets through the dissemination of false information?
- Do we need special rules for politicians and government employees?
- Technically speaking, are event contracts swaps, futures, or something else?
- When changing any of these rules, are there factors that could be deemed anti-competitive under antitrust law that we need to take into account?
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