Tag Archives: CFTC

Will the CFTC allow FOR-PROFIT prediction exchanges to deal with event markets?

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The feedback I have received about my speculative post is that I put too much weight into the CFTC requesting that the prediction exchanges organizing &#8220-event markets&#8221- (event derivative markets that can&#8217-t be used for hedging risks) be not for profit &#8212-as the Iowa Electronic Markets is.

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Just below, in bold, are the phrase and the word I&#8217-m told I have mis-read.

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CFTC – (PDF file):

CFTC&#8217-s Concept Release on the Appropriate Regulatory Treatment of Event Contracts

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D. Legal Implementation

16. Is it appropriate for the Commission to direct certain or all event contracts onto markets that are regulated differently from and perhaps less stringently than DCMs? For example, it may be warranted or necessary to treat event markets that aggregate information solely for academic or research purposes, event markets set-up for internal corporate purposes, or event markets that offer exceedingly low notional value contracts to traders differently than markets that possess the attributes of traditional DCMs.

19. What are the benefits and drawbacks of permitting certain event markets to operate pursuant to Commission established conditions that are similar to the conditions under which the IEM operates?

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UPDATE: CALL TO ACTION: Let&#8217-s fight so that the CFTC allows the FOR-PROFIT prediction exchanges to deal with &#8220-event markets&#8221-.

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UPDATE: NOT-FOR-PROFIT&#8230- or&#8230- FOR-PROFIT&#8230- That is the question.

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UPDATE: In the for-profit vs not-for-profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

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Since 2005, the Commission’s staff has received a substantial number of requests for guidance on the propriety of offering and trading financial agreements that may primarily function as information aggregation vehicles.

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&#8220-Since 2005&#8243-&#8230-

Interesting&#8230-

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2003: Robin Hanson&#8217-s PAM ends up on newspaper frontpages&#8230- – [That’s when I got started in prediction markets.]

2004: James Surowiecki launches &#8220-The Wisdom Of Crowds&#8221-&#8230-

2004: InTrade-TradeSports popularize &#8220-Bush Re-Election&#8221- prediction markets&#8230-

2005: Wannabe prediction market entrepreneurs begin to question the CFTC about the regulation of real-money prediction markets&#8230-

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What I find interesting here is the time lag&#8230- It took a while, it seems&#8230-

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More info about prediction market history&#8230-

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How the CFTC try to define our prediction markets

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CFTC – (PDF file):

CFTC&#8217-s Concept Release on the Appropriate Regulatory Treatment of Event Contracts

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II. Commodity Options and Futures and the Attributes of Event Contracts

The Commission, with some exceptions, has exclusive jurisdiction over two relevant types of derivative instruments &#8212-commodity options and commodity futures contracts.

Section 4c(b) of the Act gives the Commission plenary jurisdiction over commodity options, and provides that &#8220-[n]o person shall * * * enter into * * * any transaction involving any commodity regulated under this Act which is of the character of, or is commonly known to the trade as, an option * * * contrary to any rule, regulation or order of the Commission[.]&#8221-

Section 2(a)(1)(A) of the Act provides that the Commission shall have exclusive jurisdiction with respect to accounts, agreements, and transactions (including options) involving contracts of sale of a commodity for future delivery.

Event contracts, depending on their underlying interests, can be designed to exhibit the attributes of either options or futures contracts.

A significant number of event contracts are structured as all-or-nothing binary transactions commonly described as binary options. 8 Binary event contracts typically pay out a fixed amount when an outcome either occurs or does not occur. The trading of such contracts can facilitate the discovery of information by assigning probabilities, through market-derived prices, to discrete eventualities. For example, a binary contract based on whether a particular person will run for the presidency in 2012, can pay a fixed $100 to its buyer if and only if that individual runs for the presidency in 2012. If the contract&#8217-s traders believe that the likelihood of the individual&#8217-s candidacy in 2012 is around 17 percent, the price of the contract will be around $17, and will approximate the market&#8217-s consensus expectation of the individual&#8217-s candidacy.

8 See, e.g., Intrade Prediction Markets, Current Events Contracts

In addition to binary event transactions, the term event contract has also been used to identify transactions, based on interests other than market prices, which resemble futures contracts. For instance, these types of event contracts can price consensus estimates of moving values, such as the number of hours the average U.S. resident spends in traffic or the share of votes that a particular candidate for political office may receive. Unlike binary transactions, and similar to any commodity futures contract, this type of contract creates continuous and ongoing obligations that are linked to moving measures or levels, as opposed to being dependent on the outcome of a single discrete occurrence.

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III. The Commission&#8217-s Regulatory Purview

[…]

For the purpose of discussion and analysis, the types of event contracts that Commission staff has reviewed can be categorized, albeit imperfectly, as contracts that are based on narrow commercial measures and events, contracts based on certain environmental measures and events, and contracts based upon general measures and events.

Narrow commercial measures quantify and reflect the rate, value, or level of particularized commercial activity, such as a specific farmer&#8217-s crop yield.

Narrow commercial events, on the other hand, are events that might, in and of themselves, have commercial implications, such as changes in corporate officers or corporate asset purchases.

Environmental measures can be characterized as quantifications of weather phenomena, such as the volatility of precipitation or temperature levels, that do not predictably correlate to commodity market prices or other measures of broad economic or commercial activity.

By comparison, environmental events can include the formation of a specific type of storm, within an identifiable geographic region, the likelihood of which will not predictably correlate to commodity market prices or measures of broad economic or commercial activity.

General measures can be described as measures that are not commercial or environmental measures. As such, general measures do not quantify the rate, value, or level of any commercial or environmental activity and can, for example, include the number of hours that U.S. residents spend in traffic annually or the vote-share of a particular presidential candidate.

Similarly, general events, such as whether a Constitutional amendment will be adopted or whether two celebrities will decide to marry, can be described as events that do not reflect the occurrence of any commercial or environmental event. The category of general measures and events can be further divided into a multitude of subcategories, such as political or entertainment measures or events.

Since 1992, Commission-regulated exchanges have listed for trading a variety of commodity futures and options contracts with payout terms based on interests other than price-based interests. These contracts involve interests as diverse as regional insured property losses, the count of bankruptcies, temperature volatilities, corporate mergers, and corporate credit events. 12

While not strictly price-based, the interests underlying these contracts have been viewed by Commission staff as having generally-accepted and predictable financial, commercial or economic consequences.

In other words, unlike the interests that event contracts cover, these underlying interests have been viewed as measures and occurrences that reasonably could be expected to correlate to market prices or other broad-based commercial or economic measures or activities.

12 For example, the Chicago Board of Trade&#8217-s catastrophe single event insurance option contracts (which are no longer listed) paid out a fixed amount if and only if insured property damage exceeded $10 billion for a specific region during a specified interval of time.

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The lawyerly questions that the CFTC are asking to Tom W. Bell

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CFTC – (PDF file):

CFTC&#8217-s Concept Release on the Appropriate Regulatory Treatment of Event Contracts

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V. Issues for Comment

A. Request for Comment

The following questions consider the Commission&#8217-s regulatory purview over event contracts, the interests that may appropriately underlie Commission-regulated transactions, and the appropriate regulatory treatment of event contracts. The Commission encourages comments on the specific questions posed, as well as the broad range of issues raised in this concept release. In providing comments, please describe your relevant experience and discuss in detail the facts and legal provisions that support your conclusions. Furthermore, please consider the Commission&#8217-s mandate to protect commodity futures and options markets and customers, and ensure the integrity of the commodity derivatives marketplace, as well as the expected effects of any Commission action on competition, efficiency, innovation and the financial integrity of transactions. Any recommendation with respect to the regulatory treatment of event contracts and markets should be consistent with and supported by the Act, practical, and amenable to effective and efficient implementation.

B. 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?

C. Jurisdictional Determinations

4. What characteristics or traits are common to or should be used to identify event contracts and event markets?

5. How do these characteristics and traits differ from those of commodity futures and options contracts that customarily have been regulated by the Commission? How are they similar?

6. Are there criteria based on the provisions of the Act that could be used to make jurisdictional determinations with respect to event contracts and markets?

7. Given the purposes and history of the Act, would it be appropriate for the Commission to apply a test premised on commercial risk management or pricing functions to demarcate the Commission&#8217-s jurisdiction over particular contracts? If so, what factors could be used to make such a determination?

8. Given the purposes and history of the Act, would it be appropriate for the Commission to apply any test premised on the economic purpose of certain types of transactions to demarcate the Commission&#8217-s jurisdiction over particular contracts? If so, what factors could be used to make such a determination?

9. What calculations, analyses, variables and factors would be appropriate in determining whether the impact of an occurrence or contingency will result in a financial, commercial or economic consequence that is identified in Section 1a(13) of the Act?

10. What calculations, analyses, variables, and factors would be appropriate in determining whether an economic or commercial index that is based on prices, rates, values, or levels should or should not qualify as an excluded commodity under Section 1a(13) of the Act?

11. What identifiable factors, statutorily based or otherwise, limit the events and measures that may underlie event contracts when such contracts are treated as Commission-regulated transactions?

12. What objective and readily identifiable factors, statutorily based or otherwise, could be used to distinguish event contracts that could appropriately be traded under Commission oversight from transactions that may be viewed as the functional equivalent of gambling?

13. The Commission notes that Section 12(e) of the Act generally provides that the CEA supersedes and preempts other laws, including state and local gaming and bucket shop laws, with respect to transactions executed on or subject to the rules of a Commission-regulated market, or with respect to transactions exempted from the Act pursuant to the Commission&#8217-s exemptive authority under Section 4(c) of the Act. What are the implications of possibly preempting state gaming laws with respect to event contracts and markets that are treated as Commission-regulated or exempted transactions?

14. Should certain underlying events or measures &#8211-such as those based on assassinations or terrorist activities&#8211- be prohibited altogether due to the social perception and impact of such events? What statutory or other legal basis would support this treatment?

15. Are there event contracts, such as political event contracts, that should be prohibited from trading under the Act, or that deserve separate treatment or consideration, due to the nature and importance of their outcomes? What statutory or other legal basis would support this treatment?

D. Legal Implementation

16. Is it appropriate for the Commission to direct certain or all event contracts onto markets that are regulated differently from and perhaps less stringently than DCMs? For example, it may be warranted or necessary to treat event markets that aggregate information solely for academic or research purposes, event markets set-up for internal corporate purposes, or event markets that offer exceedingly low notional value contracts to traders differently than markets that possess the attributes of traditional DCMs.

17. Is it appropriate for the Commission to use the Section 4(c) exemptive authority of the Act for implementing a regulatory scheme for event contracts and markets? In this regard, the Commission notes that it has the discretion to grant an exemption under Section 4(c) to certain classes of transactions without having to make a determination as to whether such transactions are subject to the Act in the first instance.

18. Is the issuance of staff no-action relief, such as the relief issued to the IEM, an appropriate or preferable means for establishing regulatory certainty for event contracts and markets? Is a policy statement appropriate or preferable?

19. What are the benefits and drawbacks of permitting certain event markets to operate pursuant to Commission established conditions that are similar to the conditions under which the IEM operates?

E. Market Participants

20. Would it be appropriate to allow market participants, and in particular, retail customers, to trade on Commission-regulated event markets with the knowledge that the Commission may not be able to effectively monitor the measures or events that underlie certain event contracts?

21. What unique protections and prophylactic measures are appropriate or necessary for the protection of retail users of event contracts and markets?

22. What are the implications of permitting the intermediation of event contracts, including intermediation on behalf of retail market participants, both with respect to trade execution and clearing?

23. Are there any types of trader or intermediary conduct, peculiar to event contracts and markets, that should be prohibited or monitored closely by regulators?

24. What other factors could impact the Commission&#8217-s ability, given its limited resources, to properly oversee or monitor trading in event contracts?

Our prediction market luminaries signed Bobs petition -and the losers are InTrade, TradeSports and BetFair.

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I have re-read the American Enterprise Institute’s proposals to legalize real-money prediction markets in the United States of America.

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AEI advise the CFTC not to allow for-profit companies (like InTrade, TradeSports and BetFair) to operate socially valuable prediction markets &#8212-in a legal way, in the US.

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It&#8217-s a shame that our prediction market luminaries signed that piece of ****.

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Long live Steve Levitt and Koleman Strumpf.

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And long live the prediction markets on sports&#8230- &#8212-and on anything else.

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UPDATE: In the for-profit vs not-for profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

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The American Enterprise Institutes proposals to legalize real-money prediction markets in the United States of America

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The Promise of Prediction Markets – by Kenneth J. Arrow, Robert Forsythe, Michael Gorham, Robert Hahn, Robin Hanson, John O. Ledyard, Saul Levmore, Robert Litan, Paul Milgrom, Forrest D. Nelson, George R. Neumann, Marco Ottaviani, Thomas C. Schelling, Robert J. Shiller, Vernon L. Smith, Erik Snowberg, Cass R. Sunstein, Paul C. Tetlock, Philip E. Tetlock, Hal R. Varian, Justin Wolfers, and Eric Zitzewitz – 2008-05-XX

#1. The Commodity Futures Trading Commission (CFTC), the federal regulatory agency that oversees futures market activity, should establish safe-harbor rules for selected small-stakes markets. One limited safe harbor is the no-action letter, in which the CFTC market oversight staff confirms in writing that it will not recommend enforcement action if the recipient acts in specified ways. The only prediction market to receive a no-action letter (in 1992) is the Iowa Electronic Markets, which is run by professors at the University of Iowa and which initially focused on presidential elections. Although such no-action letters reduce the chances of legal action under other state and federal laws, they may not be adequate. We would therefore urge the CFTC to explore other approaches to ensuring safe harbors, for example, formal rules or guidance approved by the commission. We suggest that three types of entities be eligible for safe harbor treatment. The first would be not-for-profit research institutions, including universities, colleges and think tanks wishing to operate exchanges similar to the Iowa Electronic Markets. The second would be government agencies seeking to do research similar to that of nongovernmental research institutions. The third group would consist of private businesses and not-for-profits that are not primarily engaged in research, which would only be allowed to operate internal prediction markets with their employees or contractors. In all cases, markets would be limited to small-stakes contracts. Although the definition of small stakes is somewhat arbitrary, we use the term to mean an exchange in which the total amount of capital deposited by any one participant may not exceed some modest sum, perhaps something like $2,000 per year. The exchanges themselves would be not-for-profit but would be allowed to charge modest fees to recoup administrative and regulatory costs. Brokers and paid advisers would be barred, reducing the risks that contracts would be sold to inappropriate or vulnerable customers or that customers would be charged fees above the amounts needed to maintain the markets. Exchanges would be self-regulated, leaving them with the responsibility to make reasonable efforts to keep markets free from fraud and manipulation. For its part, the CFTC should allow contracts that price any economically meaningful event. This definition could allow for contracts on political events, environmental risks, or economic indicators, such as those offered by the Iowa Electronic Markets, but would presumably not include contracts on the outcomes of sports events.

The contracts qualifying under this safe harbor would also create opportunities for more efficient risk allocation. Although the small-stakes nature of these markets would necessarily limit their usefulness for hedging risk, they could serve as proofs of concept for larger-scale markets that could be developed under alternative regulatory arrangements. The CFTC should allow researchers to experiment with several aspects of prediction markets – fee structures, incentives against manipulation, liquidity requirements and the like – with the goal of improving their design. Prediction markets are in an early stage, and if their promise is to be realized, researchers should be given flexibility to learn what kinds of design are most likely to produce accurate predictions. Of course, exchanges would need to inform their customers so that they are aware of the risks and benefits of participating in these markets.

#2. Congress should support the CFTC’s efforts to develop prediction markets. To the extent that the CFTC incurs costs in promoting innovation, Congress should provide the necessary funding. More fundamentally, Congress should explore alternative ways of securing a legal framework for prediction markets if the CFTC’s existing authority proves inadequate. In particular, Congress should specify that a no-action letter, or similar mechanism, preempts overlapping state and federal anti-gambling laws. Because Congress did not intend the CFTC to regulate gambling, it is important to design new regulations so that socially valuable prediction markets easily qualify for the safe harbor but gambling markets do not.

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UPDATE: A great rebuttal here&#8230- :-D

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THE MIDAS ORACLE TAKES:

– CALL TO ACTION: Let&#8217-s fight so that the CFTC allows the FOR-PROFIT prediction exchanges to deal with &#8220-event markets&#8221-.

– In the for-profit vs not-for-profit debate, our prediction market luminaries, doctored by Bob, are on the wrong side of the issue.

– COMMENTS TO THE CFTC: What to expect from Tom W. Bell and Jason Ruspini

– A young economist rebuts the American Enterprise Institute.

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BACKGROUND INFO:

– CFTC’s Concept Release on the Appropriate Regulatory Treatment of Event Contracts&#8230- notably how they define &#8220-event markets&#8221-, how they are going to extend their &#8220-exemption&#8221- to other IEM-like prediction exchanges, and how they framed their questions to the public. Here are the comments sent to the CFTC.

– The Arnold &amp- Porter lawyers explain the meaning of the CFTC&#8217-s concept release on &#8220-event markets&#8221-. &#8212- (PDF file)

– The Schulte &amp- Roth &amp- Zabel lawyers&#8217- takes. &#8212- (PDF file)

– The Sullivan &amp- Cromwell lawyers&#8217- takes. &#8212- (PDF file)

– What Vernon Smith told the CFTC.

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APPENDIX:

Paul Wolfowitz&#8217-s profile at the American Enterprise Institute

– How the neo-cons drove the United States of America into the unecessary Iraq war

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The term event markets sucks -and the uncritical thinkers using this crappy term suck too.

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Google: &#8220-event markets&#8221- &#8212- Funny enough, the first link is to the Futures Industry Association, which promoted the term&#8230- and the second to CFM, which advises not to use that term (see the bottom of the CFM frontpage). :-D

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Just because 2 or 3 bureaucrats at the CFTC have decided to use that term does not mean that that term makes sense. It does not. &#8220-Event derivative markets&#8221- or &#8220-prediction markets&#8221- are better terms. It&#8217-s with great displeasure that I saw our own Mike Giberson (supposedly, a libertarian, and supposedly, a wannabe academic) followed the step of the CFTC like an obedient little poodle. :-D

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Just because somebody in power says something stupid that makes no sense at all does not mean that you should swallow it and direct it straight to your stomach.

Use your brain to perform critical reasoning.

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How to run enterprise prediction markets… legally

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Private Prediction Markets and the Law – (PDF file) – by Tom W. Bell – 2008-05-18

Abstract

This paper analyses the legality of private prediction markets under U.S. law, describing both the legal risks they raise and how to manage those risks. As the label &#8220-private&#8221- suggests, such markets offer trading not to the public but rather only to members of a particular firm. The use of private prediction markets has grown in recent years because they can efficiently collect and quantify information that firms find useful in making management decisions. Along with that considerable benefit, however, comes a particularly worrisome cost: the risk that running a private prediction market might violate U.S. state or federal laws. The ends and means of private prediction markets differ materially from those of futures, securities, or gambling markets. Laws written for those latter three institutions nonetheless threaten to limit or even outlaw private prediction markets, as the paper details. The paper also details, however, how certain legal strategies can protect private prediction markets from violating U.S. laws or suffering crushing regulatory burdens. The paper concludes with a legal forecast, describing the likely form of potential CFTC regulations and a strategy designed to ensure the success of private prediction markets under U.S. law.

Conclusion

This paper has described the legal risks facing private prediction markets under U.S. law and how firms that want to runs such markets should respond. To minimize the risk of CFTC regulation, firms should institute mechanisms to ensure that their private prediction markets do not support significant hedging functions and make clear, both in the documentation supporting their markets and in their markets&#8217- structures, that they offer trading not in binary option contracts but rather in conditional negotiable notes. Publicly-traded firms subject to U.S. law can minimize the risks of illegal insider trading by either making public all prices and claims traded on their prediction market or by:
• Keeping trading by traditional insiders separate from trading by others-
• Broadening safeguards against illegal insider trading to cover all traders-
• Treating the market&#8217-s claims and prices as trade secrets- and
• Seeding the market with decoy claims and prices.

Although the skill-based trading emphasized on private prediction markets should in theory remove them from the scope of gambling regulations, a prudent firm could help to ensure that result by:
• Forbidding traders from investing their own funds in the market- and
• Requiring its agents to participate in its market.

As should perhaps go without saying (but as hereby will not), any firm implementing these legal strategies should back them up with ample record-keeping. Each person who trades on a firm&#8217-s market should, for instance, receive clear notification that the market does not deal in CFTC- or SEC-regulated instruments, and that it does not offering services subject to oversight by any state gambling commission. Better yet, traders should be required to access the market only through a click-through agreement in which, among other things, they consent to that stipulation. So go only a few of the provisions that ought to appear in such an agreement- any reasonably competent attorney will think of many worthwhile provisions to add.

Private prediction markets will almost certainly escape the legal uncertainty that now clouds their prospects in the U.S. Even if no legislator, judge, or regulator ever notices them, private prediction markets will come to win de facto legality simply by merit of their widespread use and acceptance. With reflection —perhaps aided by papers such as this one— and practical experience, attorneys will learn how to structure private prediction markets to accommodate the laws that rightfully apply to them and to dodge the effect of laws written for other, materially different markets. There remains some risk, granted, that the CFTC will crush private prediction markets under new regulations. With luck though —and perhaps also with some persuasion— the CFTC will instead allow prediction markets to choose from among several different tiers of regulations. And even in the worse-case scenario, private prediction markets will not disappear- they will simply flee the U.S. for other, freer homes.

The CFTC safe-harbor option for event markets

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The recommendation for safe-harbor of a group of influential economists to the CFTC aims squarely at the 4(c)3(K)* clause of the Commodity Exchange Act. The CFTC may approve a public interest exemption under 4(c) provided that the affected contracts are traded only between &#8220-appropriate persons&#8221-. 4(c)3(k) is the only qualification that would accommodate &#8220-retail&#8221- trading in the style of IEM, allowing, &#8220-Such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections.&#8221- Regarding &#8220-other qualifications&#8221-, the economists recommend:

&#8220-that three types of entities be eligible for safe harbor treatment. The first would be not-for-profit research institutions, including universities, colleges, and think tanks wishing to operate exchanges similar to the Iowa Electronic Markets. The second would be government agencies seeking to do research similar to that of nongovernmental research institutions. The third group would consist of private businesses and not-for-profits that are not primarily engaged in research, which would only be allowed to operate internal prediction markets with their employees or contractors.

Regarding the applicability of regulatory protections, the economists recommend that such markets should be limited to small-stakes, low-fee contracts. This limitation addresses consumer protection because the CFTC is typically much less interested in non-levered transactions, and there is little chance of being able to manipulate a market with a small-stakes account. Possibly, consumer protection measures could completely satisfy 4(c)3(K).

The safe-harbor proposal looks like an expedient option that would avoid the problems of treating event markets as excluded commodities (or exempt commodities), which were touched on last time. One problem the CFTC faces is selecting a principle that would include only markets that pass an economic purpose test within their jurisdiction, and the safe-harbor proposal avoids this problem. Although there doesn&#8217-t seem to be anything in the CEA to indicate that an exempted market could possibly lie outside the agency&#8217-s jurisdiction, Congress has determined – significantly – that, &#8220-Rather than making a finding as to whether a product is or is not a futures contract, the Commission in appropriate cases may proceed directly to issuing an exemption.&#8221-

Arguably, if someone were to set-up non-profit small-stakes exchanges similar to the ones the economists describe, they would not need CFTC safe-harbor anyway – especially if they restrict trading to States where the predominant factor test applies. Safe-harbor would, however, allow for exchange profits.

I believe that a combined approach would work best. Treating event markets as excluded commodities would not contradict granting some exchanges public interest safe-harbors, which would especially be appropriate if they wanted to host markets like research science claims, where a trader might be in control of the outcome. Exchanges seeking to host larger stake markets useful for hedging could do so with a trading prohibition for people who might be in control of the outcome. From the CFTC&#8217-s perspective, the safe-harbor would be a less complicated option with regard to their jurisdictional scope. Ultimately, statutory clarification is needed.

* This section is listed as USC Title 7, Chapter 1 6(c) here.

Cross-Posted from RM&amp-P