Prediction Contract Bundles May Soon Be Traded on Stock Exchanges — SEC Seeks Comment
Event contract ETFs would be baskets of predictions.
This week, the Securities and Exchange Commission put out a request for comment on what it’s calling “novel ETFs,” which could include funds whose assets consist of event contracts on Kalshi and other regulated prediction markets.
Gaming America spoke about the possibility with Lucas Kohorst and Doug Crescenzi, cofounders of Adjacent Markets. Their company builds political benchmark indices using prediction market prices — a more elaborate third-party version of what Kalshi has attempted with its KPOW index. Although they emphasize that they will not be in the business of selling event contract ETFs themselves, they imagine their product being used as a data source on which such securities could be based.
Kohorst said that the request for comment comes on the heels of an expression of interest on the part of the industry.
“There were filings for six or seven prediction market ETFs a handful of months ago. It seemed like they were going to be approved, but then they kept getting pushed back, and now the SEC is asking for these comments.”
ETFs, or exchange-traded funds, are “baskets” of assets that trade on stock markets as if they were shares in a company. In their simplest form, they are collections of stocks, similar to mutual funds but available on an open exchange rather than offered through a particular institution.
More recently, however, they’ve come into use as a vehicle for assets that wouldn’t ordinarily be traded on conventional exchanges. Since 2021, for instance, it has been possible to buy exposure to cryptocurrency valuations through ETFs on the NYSE and Nasdaq.
Given NYSE owner International Exchange’s $2 billion investment in Polymarket, it’s perhaps unsurprising that we’d see a push for event contracts to get the same treatment.
Single-Event ETFs Could Be Problematic
Those early applications were for ETFs that would contain only a single type of event contract: shares in the 2028 presidential election, for instance, or an upcoming Federal Reserve interest rate decision.
Buying these, then, would be no different than buying Yes or No shares directly on a prediction exchange. The advantage would only be in terms of convenience for traders who have traditional investment accounts and don’t want to bother with a separate platform.
Crescenzi says he assumes that these applications were made under the assumption that it would be easier to start as simply as possible. Ironically, however, the most common concerns he’s heard stem from the binary nature of an undiversified porftolio.
“The question that’s come up the most from conversations that we’ve had is specific to these initial filings, which are single-event contract events. It’s just the funkiness that happens after the resolution and how they roll forward.”
Kohorst pointed specifically to event ETFs on federal rate decisions. Investor interest in such a fund might only appear a few weeks before the decision. If the fund is on the wrong side of that decision, its value would go to zero. ETFs were not designed for assets so ephemeral.
Kohorst says that index-based funds would work better:
“If you’re benchmarking against an index, if it does go wrong, maybe it goes down 20, 30, 40, 50 percent. But it’s not going to go down 99 percent, because there’s a whole basket of holdings within it that may have staggered maturities or are cross-venue, and so on.”
In other words, such an ETF would perform more like a traditional fund, rolling profits back into new contracts and absorbing losses in an incremental way.
Betting on Company Performance, Not Investor Sentiment
With the midterm election coming up, Adjacent Markets is focusing on getting its political indices up and running. Long-term, however, the most compelling argument for the value of event ETFs might come from applying them to corporate key performance indicators.
Crescenzi says that one of the problems with the stock market is that it’s possible to be objectively correct about something — whether a company beats its earnings target, for instance — yet still get burned on stock price by other factors. A KPI-based prediction ETF would allow investors to take a position in a company’s actual performance, unaffected by swings in public sentiment, acquisition rumors, and so forth.
Meanwhile, single-event contracts on prediction exchanges pose a different sort of risk. Whether it comes down to Polymarket’s “oracle” or Kashi’s resolution team, the outcome of individual contracts can sometimes depend as much on interpreting the rules as on what actually happened. Bundling dozens of similar contracts across multiple exchanges together could mitigate that risk.
If the SEC ultimately approves event contract ETFs, however, it’s inevitable that we’ll see one for more than just politics and business. Crescenzi believes it will start with macroeconomics and corporate KPIs, then proceed to weather markets.
But it won’t stop there.
“If I was betting on it, I would say that someone is going to try to do a sports one,” says Kohorst. “But that’s going to be a hard one to get approved until the Supreme Court makes a decision on sports contracts.”
Prediction Index Funds Mitigate Some Risks, But Create New Ones
Adjacent Markets hasn’t yet submitted its comment on the current request. However, it addressed the topic in a previous comment on prediction market rule-making. In it, the company explains the rationale for its own importance:
“We encourage the Commission to acknowledge that event contract index products should originate from neutral third-party index providers. They should be required to provide transparent methodologies and governance standards that are necessary to earn institutional trust. Doing so will mitigate manipulative behavior similar to what was exposed during the Libor scandal of 2012. Such vulnerabilities risk the advancement of innovative prediction market products and institutional adoption.”
Libor was a London-based interest rate index. The scandal in question originated from claims published in the Financial Times that banks had been inflating or deflating their rates to manipulate the price of Libor-based derivatives, including some that traded on American markets.
Even with third-party indices, some risks remain. Asked whether market manipulation of political indices could produce actual electoral consequences, Crescenzi granted the possibility.
“That kind of happens today with polling. You could argue that with polling data, you might see Democrats or Republicans heavily favored, and that discourages turnout on one side or the other. So, I suppose, could we see something like that with event contracts? Perhaps.”
Derivatives on Prediction ETFs Probably Aren’t Coming Soon
Those risks would become greater if prediction ETFs led to derivatives on those ETFs. For instance, a short squeeze like what happened to Blockbuster stock, and could now happen to Wendy’s, might temporarily produce a highly distorted picture of an election and undermine the predictive value of the underlying event contracts.
Fortunately, Kohorst does not see prediction ETF options coming down the pipe anytime soon. He believes it would be extremely difficult to get approval for those, at least until the ETFs themselves are well-established.
The situation for cryptocurrency ETFs was different, he says, in that they were duplicating products that had already been tried and tested in unregulated markets. Given that even this administration’s unusually risk-tolerant financial regulators are taking it slow with event contract ETFs, the appetite to layer even more complex structures on top of those might still be a way down the road.
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