March 17, 2006

Legal Prediction Markets

Prediction Markets By: ams

Tom Bell’s paper on how to interpret, skirt or redefine the laws to ensure that real money prediction markets are clearly legal to operate covers a lot of ground, and is a substantial addition to his previous paper on the subject. This paper, though I can’t comment on whether the legal arguments will hold up, makes a clearer and more explicit case that prediction markets fall outside the jurisdiction of most US law. The paper covers

  • What a prediction market could do,
  • how prediction markets compare to other markets,
  • what the legal obstacles are,
  • why legality in the US matters,
  • arguments that prediction markets aren’t covered by gambling law, the CFTC, or the SEC, and
  • an explanation of his draft of an act to explicitly make Prediction Exchanges legal.

In order to draw a clearer line around the kinds of markets he’s interested in, Tom presents his proposal in the context of a critique of the effectiveness of patents and copyrights in promoting Science and the Useful Arts. This gives him a platform from which to argue in favor of claims on open questions in science, technology and public policy, and he focuses on markets that deal exclusively in those subjects as worthy of extra attention and especially deserving of protection from onerous regulations. (Those are the Prediction Exchanges the draft act would legalize.) In choosing this narrow focus, he omits one of the goals originally identified for prediction markets: PMs can also enable hedging exposure to risk in areas covered by relevant claims. But that requires substantial liquidity, which may be forever out of reach on these kinds of claims, so perhaps it’s better to try to take advantage of the kind of legality he promotes than to look for a more encompassing definition that might be harder to defend.

Markets v. Benefits
  Purpose:
Type:  
Express
Prices
Promote
Discovery
Entertain Hedge
Risks
Raise
Capital
Prediction Market primary secondary tertiary tertiary? N.A.
Futures Market secondary tertiary N.A. primary N.A.
Securities Market secondary tertiary? N.A. tertiary primary
Gambling Market N.A. N.A. primary N.A. N.A.

In order to clarify how prediction markets differ from other organized markets, Tom presents the table on the right. He points out that the most important goals and achievements of prediction markets are at best secondary goals for the others, and their primary goals are relatively unimportant for prediction markets. A second table shows that prediction markets work differently, but doesn’t have as strong a conclusion. Each of the features of PMs is either present in some of the other kinds of markets, or at least is already a visible variation

Market Type v. Market Feature
  Feature:
   
Type:  
Skill-based
Trading
Spot
Trading
Zero-Sum
Trading
Underlying
Assets
Risk of Loss
Greater Than
Investment
Prediction Market yes yes usually no no
Futures Market yes no yes usually yes
Securities Market yes usually no usually sometimes
Gambling Market no yes yes no sometimes

among them.

As Bell says, The gambling and financial laws that menace prediction exchanges do so almost accidentally. They serve several different purposes, and each is written fairly narrowly, as the various authors weren’t thinking beyond prohibiting or regulating particular activities that they thought they could clearly distinguish. That’s as it should be: laws should be tailored to the circumstances, and should leave non-infringing behavior to proceed in peace. Unfortunately, innovations sometime tread near old paths, and the old laws don’t clearly say whether they cover ideas which hadn’t been conceived when they were written. As Bell continues, The policies behind those restriction do not fit prediction markets at all. This leaves a gap which entrepreneurs (or more specifically, their backers) are wary of entering, for fear that all their work will go for nothing. Underwriters prefer the uncertainties of their ventures to be in areas they have more chance of affecting.

The heart of the paper is the argument that existing laws and oversight agencies don’t apply to Prediction Markets. IANAL, so I can’t comment on whether the arguments would hold up in court, but they are clearly a good start on a brief that should at least give a D.A. reason to pause before attacking a (narrowly science-based) prediction markets as gambling. There aren’t as many restraints on the CFTC or the SEC, so it’s more plausible that they would search for alternative interpretations that would allow them to regulate. But the plain law says that the CFTC is limited to regulating contracts for future delivery of commodities. The only future consideration traded in prediction claims is the underlying currency, and the asset itself (which will pay out depending on some future conditions) is transferred at the time of the transaction.

There’s also an explicit exception for instruments which are “predominantly a security”. This seems to fit prediction markets very closely. I would add a single caveat: one of the requirements of the definition of “predominantly a security”, is that the instrument not be subject to “mark-to-market” margining requirements. As I understand that term, it’s not much of a stretch to apply it to the way that TradeSports handles short sales. As I explained in my introduction to Prediction Markets, TradeSports reserves a varying amount of your short holdings against the possibility of losing the bet. They have rules about frozen funds, margin requirements, and explicitly says they may make Margin Calls. I said before that the short selling model doesn’t have any different effect on trading than the other ways of betting against a particular claim. This seems to be a difference; if there are regulations that cover trading in which there might be margin calls, then the short selling model is affected and the others are not.

Escaping the jurisdiction of the SEC seems to come down to a point highlighted in the first table: After all the technicalities are covered, the SEC regulates instruments that are designed to allow people to raise capital in order to form an enterprise. There are steps you can take to make it less likely that prediction market activities will seep over the line and appear too similar to securities. They need not be onerous: a prominent disclaimer about SEC oversight ought to suffice.

In case all the legal analysis isn’t enough to get business started, Tom proposes legislation that could be passed either by the federal government or (to lesser effect) by individual states in order to create a protected status for somewhat limited prediction markets. The limitations would be enough to keep the more lucrative markets from opening up shop within the US, but could be sufficiently broad to allow a variety of markets in science, technology and social policy. Given the number of new markets opening up recently, that may be enough to encourage some experimentation in real money claims. Given those same new startups, we may not have to wait long to find out whether the exemptions Professor Bell has identified are sufficient on their own.

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