What Good Are Prediction Markets? Asks the CFTC

Michael Giberson

The U.S. Commodity Futures Trading Commission is thinking about prediction markets and is inviting public comments on several questions as it attempts to sort out questions of public interest and appropriate regulatory treatment. (Now that I’ve mentioned that the CFTC is concerned with prediction markets, I’ll switch to the term the CFTC uses, “event contracts.”) According to a “Concept Release on the Appropriate Regulatory Treatment of Event Contracts” issued by the CFTC last week, the agency seek public comment to help determine:

  1. Whether event contracts are within the Commission’s jurisdiction and if so, why (or why not)?
  2. If event contracts are within the Commission’s jurisdiction, should there be exemptions or exclusions applied to them and if so, why (or why not)?
  3. How should the Commission address the potential gaming aspects of some event contracts and the possible pre-emption of state gaming laws?

The concept paper provides a brief review of the CFTC’s experience with event contracts, namely a “no-action letter” issued by the Commission to the Iowa Electronic Markets, then discusses various elements of the Commission’s legal mandate that may be related to its possible jurisdiction over event contracts. Finally, the CFTC lists twenty-four questions on which it specifically seeks comment.

The CFTC divides the questions into four categories: public interest, jurisdictional determinations, legal implementation, and market participants. I don’t have much hope of developing an informed opinion on narrow legal issues of current CFTC jurisdiction or appropriate legal implementation of CFTC policies (at least not by the July 7, 2008 filing deadline for comments established for this process).

The jurisdictional questions are best addressed by a lawyer with experience in commodities law, though other folks may have useful opinions on questions #12 and #13, how or why to distinguish between event contracts and activities that are governed by laws concerning gambling, (#14) whether certain types of events like assassination or terrorist acts should be prohibited, and (#15) whether political event markets or other specific kinds of event markets may require separate treatment. (Tom W. Bell’s posts at Agoraphilia provide an introduction to jurisdictional issues; start with “Architzel on Legality of Prediction Markets.”)

The legal implementation questions ask about the wisdom of various potential regulatory approaches that the CFTC may be able to take, such as (#16) treating research and academic markets, internal corporate markets, and very small stakes markets differently from other kinds of event contract markets; whether the CFTC should rely on (#17) its exemption authority, or (#18) no-action letters or a policy statement in order to provide greater regulatory certainty; and (#19) the benefits and drawbacks of permitting additional markets under the kind of limits provided in the IEM no-action letter.

The questions concerning market participants address whether the Commission should be concerned about protecting retail participants in any Commission-regulated event contract markets and whether participation in these markets by intermediaries (think “brokers” or “investment advisers” or “investment pool” or “hedge fund”) raises special problems. Without concluding whether event contract markets are or should be within CFTC jurisdiction, I can’t imagine that there is a special role required to protect retail consumers. Event market trading can be risky business, participants ought to be aware that it can be risky, and if participants don’t realize risk is involved they ought not to participate in the markets. I would think that existing anti-fraud law and other consumer protections should be sufficient.

I’m probably naive about the many benefits of the Commission’s protection of retail consumers within Commission-jurisdictional markets. In any case, my impulse is to think that the questions in the “market participant” category raise issues about consumer protection that consumers ought to worry about, but not issues that would benefit from CFTC initiatives. Of course, mere expression of a general laissez faire attitude is not of much help to the CFTC, and achievement of results consistent with my general laissez faire attitude may be more likely from actual engagement with the five questions in this section. Please, someone, take on the hard work of presenting good reasons for the CFTC not to get involved in protecting retail consumers in event contract markets.

That leaves us with the three questions of “public interest”:

  1. What public interests are served by event contracts that are designed and will principally be traded for information aggregation purposes and not for commercial risk management or pricing purposes?
  2. How are these interests consistent with the public interest goals embodied in the Act?
  3. What calculations, analyses, variables, and factors could be used to objectively determine the social value of information to the general public that may be discovered through trading in event contracts? Should this be a factor in determining whether the Commission plays a role in regulating these markets?

These are questions most suitable for an economist’s analysis, and all are worth a little work before I spout off.

A number of folks interested in prediction markets have made preliminary remarks on the CFTC concept paper. David Pennock is excited by the development, Chris Masse is more reserved, Chris Hibbert thinks the industry would be better off if the CFTC waits. I haven’t seen Tom Bell’s response to the recent announcement, but prior remarks on CFTC regulation may be relevant. See earlier related remarks by Jason Ruspini, too: Credit Event Futures and other fauna, and Flora of North America (CFTC regulation again).

My preliminary reaction is to be encouraged. Growth of the industry in the United States is frustrated by a lack of clarity over the CFTC’s role. The CFTC should be encouraged to sort out its position. If CFTC’s conclusions are too restrictive, then appeals can by made – to the Commission itself, to courts, or to Congress. If real money event contract markets are to become serious business in the United States, the government will have to figure out where these markets fit within the legal and regulatory world. The CFTC is taking a step toward figuring these things out.

Whether their next steps are in the right direction, who knows. I think that their steps are more likely to be in the right direction if they get high quality responses from event contract proponents.

I would expect additional comments may come from other experts in the field. Midas Oracle will be the best place in the blogosphere to follow the commentary.