If you’ve been even a casual observer of election-year media coverage, you are probably familiar with Intrade, the Internet-based “prediction market platform.” Intrade enables members to make “yes” or “no” predictions on the outcomes of future events on a variety of topics by trading shares in markets for specific propositions such as whether President Obama will be re-elected in 2012, or whether the Dow Jones Industrial Average will close on or above 13,000 on Dec. 30. Intrade is based outside the U.S. however, and is not subject to U.S. regulation.
Recently, the North American Derivatives Exchange (NADEX), which is registered as a derivatives clearing organization with the U.S. Commodity Futures Trading Commission (CFTC), sought approval to create a political prediction market through the use of “political election event derivatives” that would allow those who wished to speculate on certain outcomes of the 2012 federal election to do so, for money, in a fully regulated environment. Specifically, NADEX sought to establish markets to trade derivatives contracts relating to whether Democrats or Republicans would hold the majority in the U.S. House of Representatives and U.S. Senate, and which party’s candidate would be elected president.
NADEX contended that its political event contracts were consistent with the requirements of the Commodity Exchange Act (CEA) and CFTC regulations, and were not contrary to the public interest. The CFTC disagreed, and issued an order on April 2, finding that the proposed political event contracts violated several state statutes prohibiting wagering on elections, and were not permissible under the CEA or CFTC regulations as they involved gaming. The CFTC’s order calls into question the potential for real money predictions markets to be made available in the U.S.
History of prediction markets in the U.S. Beginning in the late 1980s, the University of Iowa began operating “political stock markets” to determine whether markets can aggregate information and predict election outcomes more accurately than alternative techniques like public opinion polling. In 1992, the University of Iowa inquired whether its research project, which did permit investors to buy and sell shares in political candidates with real money, was subject to regulation by the CFTC. The CFTC concluded that although the interest being sold to investors was more akin to a futures contract than a stock, the University of Iowa was not required to register as an operator with the CFTC or otherwise comply with the CEA, since the market was created for academic and experimental purposes, and the market operators received no compensation.
Prediction markets go Hollywood. More recently, in 2010, a company called Media Derivatives (MDEX) sought approval from the CFTC to establish a market in futures and binary option contracts based on the opening-weekend revenue of a film called “Takers.” At the same time, the CFTC was also reviewing a request for approval of a futures contract on domestic box office receipts on the motion picture “The Expendables,” submitted by Cantor Futures Exchange, a wholly-owned subsidiary of Cantor Fitzgerald. In a statement dated June 14, 2010, the CFTC determined that the futures and options contracts proposed by MDEX did not violate CEA or CFTC regulations. The CFTC also summarily approved the Cantor Fitzgerald proposal two weeks later based upon its prior statement. Congress subsequently effectively prohibited the maintenance of markets associated with motion picture box office receipts by excluding such receipts from the definition of a “commodity” whose market is subject to regulation by the CFTC. See 7 U.S.C. Sec. 1a(4). Nonetheless, the CFTC’s analysis of proposed markets related to such receipts is instructive of the commission’s approach to other event contracts.
CFTC analysis of prediction markets. An entity that seeks to establish an exchange for the trading of commodity futures and options must apply to the CFTC to be designated as a contract market. In order to obtain contract market designation, an applicant must make a showing that it satisfies eight designation criteria and complies with 18 core principles specified in the CEA. The designation criteria and core principles serve to ensure market and financial integrity, prevent market manipulation and ensure fair trading.
What is a commodity under the CEA? The CFTC interprets the definition of “commodity” broadly, and has interpreted its regulatory authority to extend to futures and options on “all commodities, goods, articles, services, rights, and interests which are or may be the subject of futures contracts.” A statutory commodity is not required to have an underlying cash market, however. The CEA permits trading of “event contracts”; i.e., contracts relating to the occurrence of a future contingent event, and has approved more than 500 of these types of futures and options contracts, including contracts relating to corporate earnings, economic indicators, environmental conditions or other events having economic or commercial significance. This expansive definition is what enabled the CFTC to conclude that predictions on box office revenues are a “commodity” suitable for trading.
Event contracts contrary to the public interest are prohibited. The CEA, however, also identifies several categories of event contracts that may not be listed for trading. Prohibited contracts or transactions include those that involve:
(I) activity that is unlawful under any Federal or State law;
(V) gaming; or
(VI) other similar activity determined by the Commission, by rule or regulation, to be contrary to the public interest.
See 7 U.S.C. Sec. 7a-2(c)(5)(c)(i). See also, 17 C.F.R. § 40.11(a).
CFTC concludes that box office revenues are permissible, but political prediction markets are not. In approving futures markets for motion picture revenues, the CFTC determined that the markets would not be susceptible to manipulation, and that the proposed transaction would provide a reasonable means to manage risks associated with box office revenues. Applying an “economic purpose test,” the CFTC concluded that the proposed market could be used by industry participants and their financiers who seek to mitigate the financial risks associated with film production — large upfront capital commitments coupled with long lead times to completion — by trading in futures contracts. Significantly, the CFTC did not require that either MDEX or Cantor Fitzgerald demonstrate that industry participants or their financiers sought out such markets or had developed informal markets where similar trading occurred, only that industry participants could use such markets to find the market prices for investments in film projects or to hedge financial risks associated with such projects.
Conversely, the CFTC denied NADEX’s request to trade its political event contracts, rejecting NADEX’s arguments that since national elections had both macroeconomic and microeconomic impacts, political event contracts had legitimate hedging and risk-management purposes. The CFTC’s order concluded that political event markets had no legitimate “economic purpose,” finding that: (i) “the unpredictability of the specific economic consequences of an election means that the Political Event Contracts cannot reasonably be expected to be used for hedging purposes”; and (ii) the CFTC could see “no situation in which the Political Event Contracts’ prices could form the basis for pricing of a commercial transaction involving a physical commodity, financial asset or service[.]“
Looking beyond the “economic purpose” test, the CFTC further found the proposed political event contracts to be in direct violation of several state statutes prohibiting wagering on elections. NADEX asserted that its political event contracts should not be considered gaming, citing legislative history which it claimed distinguished political election contracts from activities such as wagering on sporting events. NADEX also asserted that, to the extent any state statutes would prohibit trading in political election contracts on the grounds that they involved gaming, those laws were expressly pre-empted by the CEA. See 7 U.S.C. Sec. 16(e)(2). The CFTC was unpersuaded by these arguments as well, and expressly found both that “the Political Event Contracts involve gaming as contemplated by CEA Section 5c(c)(5)(C)(i)(V) and Commission Regulation 40.11(a)(1),” and that “the Political Event Contracts are contrary to the public interest as contemplated by CEA Section 5c(c)(5)(C)[.]“
Proponents of prediction markets claim that the information aggregation capabilities of these sorts of futures contracts provide a valuable societal benefit. The CFTC’s rulings in this area suggest that the agency may agree with this principle, but that it does not view the widespread expansion of prediction markets to be appropriate in the absence of valid economic or hedging purposes. Given the high level of interest in the outcomes generated by online predictive markets, the only certainty appears to be that the parameters of what are and are not acceptable future event contracts will continue to evolve as the CFTC tackles other event contract proposals.?