Building Exits into CFTC Regulation

Much of my draft paper, Private Prediction Markets and the Law, focuses on nuts-and-bolts fixes for the legal uncertainty that currently afflicts private prediction markets under U.S. law. I’ll say more about those in later posts to Agoraphilia and Midas Oracle. The paper also dicusses a more theoretical and general issue, though: The benefits of designing regulatory schemes to include exit options.

The Commodity Futures Trading Commission recently issued a request for comments about whether and how it should regulate prediction markets. In earlier papers, I explained why the CFTC cannot rightly claim jurisdiction over many types of prediction markets. I recap that view in my most recent paper, but add some suggestions about how the CFTC might properly regulate some types of prediction markets. In brief, I suggest that the CFTC build exit options into any regulations it writes for prediction markets, allowing those who run such markets the same sort of freedom of choice that U.S. consumers already enjoy, thanks to internet access to overseas markets like Intrade, with regard to using prediction markets. Here’s an excerpt from the paper:

Those practical limits on the CFTC’s power should encourage it to write any new regulations so as to allow qualifying prediction markets to operate legally, and fairly freely, under U.S. law. . . . Ideally, the CFTC would offer prediction markets something like these three tiers, each divided from the next with clear boundaries.

• Designated Contract Markets. Regulations designed for designated contract markets, such as the HedgeStreet Exchange, would apply to retail prediction markets that offer trading in binary option contracts and significant hedging functions.
  
• Exempt Markets. Regulations for “exempt” markets, which impose only limited anti-fraud and manipulation rules, would apply to prediction markets that:
  
  
  • offer trading in binary option contracts;
    
  • thanks to market capitalization limits or other CFTC-defined safe harbor provisions do not primarily support significant hedging functions; and
    
  • offer retail trading on a for-profit basis.
  
  
• No Action Markets. A general “no action” classification, similar to the one now enjoyed by the Iowa Electronic Markets, would apply to any market that duly notifies traders of its legal status and that is either:
  
  
  • a public prediction market run by a tax-exempt organization offering trading in binary option contracts but not offering significant hedging functions;
    
  • a private prediction market offering trading in binary option contracts, but not significant hedging functions, only to members of a particular firm; or
    
  • any prediction market that offers only spot trading in conditional negotiable notes.

Notably, regulation under either of the first two regimes would definitely afford a prediction market the benefit of the CFTC’s power to preempt state laws. It remains rather less clear whether the third and lightest regulatory regime would offer the same protection, though the cover afforded by its two “no action” letters has allowed the Iowa Electronic Markets to fend off state regulators. Markets that by default qualify for the third regulatory tier described above thus might want to opt into the second tier, so as to win a guarantee against state anti-gambling laws and the like. So long as they satisfy the first two conditions for such an “exempt market” status, public prediction markets run by non-profit organizations or private prediction markets that offer trading only to members of a particular firm should have that right. Why offer this sort of domestic exit option? Because it would, like the exit option already open to U.S. residents who opt to trade on overseas prediction markets, have the salutatory effect of curbing the CFTC’s regulatory zeal.

The footnotes omitted from the above text includes this observation: “Because they fall outside the CFTC’s jurisdiction, markets offering only spot trading in conditional negotiable notes could not opt into the second regulatory tier.”

Please feel free to download the draft paper and offer me your coments.

[Crossposted at Agoraphilia, Technology Liberation Front, and Midas Oracle.]