Prediction Markets: Who Regulates a Bet on the Future?

The rapid growth of prediction markets, and the equally rapid multiplication of disputes concerning their regulation, have revived a question that is far older than the platforms on which such contracts are now traded, namely whether an agreement whose payoff depends upon the occurrence or non-occurrence of a future event is to be regarded as a financial instrument or, rather, as a wager. The issue is not merely taxonomic. Upon its answer depend the identity of the competent authority, the applicability of the rules on market abuse, investor protection and cross-border provision of services, and, ultimately, the legitimacy of an industry whose turnover now runs into billions of dollars. In a recent working paper, Prediction Markets between the United States and the European Union: A Comparative Analysis of the Legal Classification of Event Contracts, available on SSRN, we examine how the two principal regulatory systems of the Western world classify what is, in economic substance, the same product. We seek to show that the divergence between them is at once narrower and more instructive than is commonly assumed.

The starting point of the analysis is that the two systems have approached the problem from opposite ends. In the United States, the Commodity Exchange Act (CEA), as amended by the Dodd-Frank Act, defines a ‘swap’ in terms so broad as to encompass expressly any contract whose payment depends upon ‘the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence’. Event contracts were thus written into the statutory definition from the outset. Once a product qualifies as a swap, it falls within the jurisdiction of the Commodity Futures Trading Commission (CFTC) and must be traded on a designated contract market. According to the argument consistently advanced by the platforms, it also enjoys the protection of a federal regime that pre-empts the gambling statutes of the several States. The paper retraces the construction of this architecture and the tensions that have accompanied it: the CFTC’s long-standing ambivalence towards contracts on electoral outcomes; the special rule which permits the Commission to prohibit event contracts that involve gaming or are otherwise contrary to the public interest; the litigation concerning Kalshi’s election contracts; and, more recently, the wave of enforcement actions brought by State authorities against contracts on sporting events. The American debate has accordingly been framed, almost without exception, in terms of pre-emption, that is, of whether federal derivatives law, once it reaches a product, displaces the gambling legislation of the States.

The European Union proceeds, by contrast, from a (tendentially) closed enumeration of underlyings. The Markets in Financial Instruments Directive (MiFID II) contains no general category of event contracts. A derivative is a financial instrument only insofar as it relates to one of the underlyings enumerated in Section C of Annex I: transferable securities, currencies, interest rates, commodities, emission allowances and, under the first limb of point (10), climatic variables, freight rates, inflation rates or other official economic statistics. What unites this enumeration is that each of its items is a magnitude, that is, a quantity which can be observed, quoted and measured, so that the value of the contract may be derived from it. A contract whose outcome turns upon a bare binary fact, such as the election of a candidate or the victory of a team, has no underlying of this kind: it does not track a variable but resolves a question. Under EU law such a contract is not a financial instrument at all, and it therefore falls outside MiFID II, outside the Market Abuse Regulation (MAR) and outside the passporting regime, to be governed instead by the gambling legislation of the Member States, which remains almost entirely unharmonised. The paper examines the few points at which these two spheres come into contact, including the case law of the Court of Justice of the European Union on the limits that the freedom to provide services places on national gambling regimes, the treatment of binary options and the product intervention measures adopted by the European Securities and Markets Authority (ESMA), the questions raised by platforms that settle event contracts in crypto-assets and must therefore be assessed in the light of the Markets in Crypto-Assets Regulation (MiCAR), and ESMA’s recent statements on the application of the product intervention measures on binary options to event contracts.

The conventional account of the transatlantic divide holds that the United States treats prediction markets as a matter of financial regulation, whereas the European Union relegates them to the law of gambling. The central thesis of the paper is that this account, while not inaccurate, obscures the more significant point, which is that the true dividing line runs within the category of event contracts rather than between the two legal systems, and that it is, in substance, the same line on both sides of the Atlantic: the line which separates contracts referenced to a measurable quantity from contracts referenced to a mere yes-or-no outcome. A contract on the forthcoming inflation figure, on the closing level of an index or on the number of hurricanes in a given season possesses a measurable underlying, and both systems are able to accommodate it as a derivative, with the familiar consequences in terms of market integrity and investor protection. A contract on the winner of an election or of a football match possesses no such underlying; EU law excludes it from the financial perimeter by construction, whereas American law includes it only by virtue of the unusually expansive drafting of the swap definition, and even there, as the paper documents, the inclusion has been persistently contested, by the CFTC itself no less than by the States. Properly understood, therefore, the comparative question is not whether prediction markets are financial in nature, but which contracts traded on them deserve that characterisation, a question whose answer determines the competent authority, the availability of a passport, the qualification of informed trading as market abuse rather than as a mere breach of gambling rules, and the very possibility of retail access.

Developments in the United States since the paper was published have lent this thesis further support. The paper discusses the decision of the Court of Appeals for the Third Circuit, in KalshiEX v Flaherty, rendered in April, which endorsed the position of the platforms, holding that sports-related event contracts are swaps subject to exclusive federal regulation and that State gambling laws are accordingly pre-empted. At the end of August, however, the Court of Appeals for the Ninth Circuit, in KalshiEX v Assad, unanimously rejected that reading at the preliminary-injunction stage, on the ground that the definition reaches contracts on financial and economic variables such as rates, prices or indices, whose function is to transfer financial risk, whereas a contract on the outcome of a sporting contest creates risk rather than transferring it. Having regard to the substance of the product, which permits wagers on the winner and on the margin of victory and their combination into parlays, the court concluded, with a nod to Shakespeare, that a sports bet re-labelled as a contract remains a sports bet. According to the judgment, therefore, federal financial law does not displace State law, and States such as Nevada may enforce their gambling regimes, including licensing, against the platform. With two federal courts of appeals now in open conflict, the final word will likely belong to the Supreme Court. 

From a European standpoint, what is remarkable is that a court applying a statute wholly unrelated to MiFID II has drawn the line very close to where European law draws it, between magnitudes and facts. The comparison proposed by the paper has therefore become even more actual.

The authors’ paper is available here.

Filippo Annunziata is Professor of Financial Markets and Banking Legislation at Bocconi University.

Thomaz De Arruda is an advogado (established lawyer) at Annunziata & Conso in Milan.