Jason Ruspini:

Unfortunately, election contracts and ALL event contracts appear to be prohibited by CFTC regulation 40.11, released in July 2011 as part of Dodd-Frank:

“(a) Prohibition. A registered entity shall not list for trading or accept for clearing on or through the registered entity any of the following:

(1) An agreement, contract, transaction, or swap based upon an excluded commodity, as defined in Section 1a(19)(iv) of the Act, that involves, relates to, or references terrorism, assassination, war, gaming, or an activity that is unlawful under any State or Federal law”

“… involves, relates to … an activity that is unlawful under any State or Federal law” is very broad. Not only does it include election outcomes, which several States have explicit laws against, but Massachusetts, Mississippi, Nebraska, North Dakota and South Carolina have laws against bets on “events”.

This is not the only reading of 40.11 and is certainly not the one Nadex holds. In the short term, it seems that any argument for this sort of contract has to address the broad interpretation above all.

We are academic researchers who study prediction markets. We are writing in favor of allowing NADEX, or a similar entity, to offer a broad range of political and policy event futures, including the three they are currently proposing.

There are four broad reasons for our support:

1. Existing political event futures have proven useful. Political event futures have been offered in small quantities by the onshore Iowa Electronic Markets (IEM), and by offshore exchanges such as Intrade. Prices from these markets have made possible a broad range of academic research.

2. Political event futures facilitate price discovery in other asset markets. One of the findings of this research is that firms and industries are exposed to political and policy risk. Political event futures provide investors with a market-based assessment of outcome probabilities, which reduces investors’ uncertainty when trading other assets. In addition, if allowed to operate onshore, political event futures markets might eventually grow to the point where they might provide useful hedging opportunities for firms. The currently proposed position limits are likely sufficient for most individuals to hedge their personal exposure to election outcomes.

3. The full potential of political event futures cannot be realized in academic-scale markets or offshore. Despite the utility of the IEM and Intrade, both markets are hampered by the current regulatory environment. An onshore exchange that allowed positions of the size NADEX is suggesting could ultimately reach a scale where it could attract liquidity to contracts that currently do not succeed on Intrade. There are many exciting potential applications of such markets, in research and policy making. Offering contracts on questions of great popular interest (such as Presidential elections) is crucial to attracting investors to an exchange. Once there, they face lower costs of participating in other markets, such as those currently offered by NADEX.

4. Concerns about gambling and manipulation are misplaced. Trading securities whose payoffs depend on political outcomes is no more “gaming” than trading securities whose payoffs depend on commodity or equity prices. Clearly, one can trade any security out of gambling motives, so the key question is whether the subject of these contracts is a “game,” or an economically important event. It is hard to argue that elections are not economically important events.

One might be concerned with two forms of manipulation: outcome and price manipulation. Many individuals have already large stakes in election outcomes; for example, a top executive in a public company will have will have a significant exposure via their equity holdings, as well as through any impact of the election on policies such as tax rates. Many individuals also have substantial exposure to election outcomes via their careers. Given the position limits proposed by NADEX, the market is likely to make at most a small contribution towards the number of individuals with meaningful stakes in election outcomes. One might be concerned with trading by those involved in supervising elections, and it might be reasonable for policy to prohibit trading by those individuals.

Turning to price manipulation, there have been a couple episodes that appeared to be attempt by traders to influence perceptions of an election by manipulating prediction market prices. The evidence suggests that effects on prices are relative short-lived, and effects on perceptions are often counter-productive for the manipulator (e.g., through media stories mentioning the manipulation). Onshore election markets will likely be significantly more liquid, making price manipulation even less attractive. A further protection comes from the fact that the outcomes of interest (election winners) will be linked to prediction market prices only through perceptions. Concern about price manipulation might be better devoted to cash-settled futures, where contracts settle based on other financial market prices.

To summarize, we view markets in securities contingent on economically-relevant events as an innovation that generate positive externalities (by aggregating information) as well as benefits to participants. Innovations with positive externalities should be encouraged by policy makers, not limited. If the Commission has questions about any of the statements made or research mentioned in this letter, it should feel free to contact any of the undersigned.

The latest developments. (audio)

I am skeptical, since the US Congress has just outlawed movie prediction markets, but I wish good luck to Chris Rabelais et al. Maybe the political scene will be different next year, who knows.

UPDATE: As you’ve understood, I was talking about CFTC-approved real-money prediction markets, here.

CNBC: The End of the Box Office Futures Business

The Wrap

In its approval of Trend Exchange and preceding statements, the CFTC has confirmed a very broad definition of “commodity” that includes “event” contracts. The old debate about whether or not the CFTC has jurisdiction over “prediction markets” has been decided for now. Yet, there is considerable dissent within the Commission. Commissioners Chilton and Sommers have expressed disapproval that the Commission did not first address the general questions raised in the 2008 Concept Release. To this point, given the very broad definition of “commodity,” it now seems that Intrade and online sports exchanges could be in violation of the Commodity Exchange Act. The Commission does not consider an “economic purpose test” in the contract review process, and there is no statutory basis for such a test being used in jurisdictional determinations. Perhaps as a matter of practice, in accordance with the spirit of the Act, the Commission is considering such a test for jurisdicitional questions as I suggested in my Concept Release comments (surprisingly cited by the MPAA group). Otherwise, it seems inconsistent that exchange-traded sports bets, for example, would not also be considered commodities and be subject to the Act.

As a whole, the Commission has apparently decided to defer such questions and focus on specific techniques for ensuring that the new contracts fulfill the Act from the standpoints of manipulation and fair trading. To these ends, the CFTC will require, “entities and individuals who control a film’s marketing budget, release date or opening screen number to provide the Exchange with information regarding such decisions whenever that entity or individual holds a position of 1,000 or more contracts.” Additionally, the Commission will require a “firewall” within studios and distributors, and has restricted certain employees from trading altogether. These are procedures that I had recommended for event contracts, but they are relatively novel mechanisms in the commodities world. Whether or not the CFTC would agree to support special trading restrictions was the pivotal question in whether the contracts would be approved. I applaud the principled, politically independent thinking of the Commission and the can-do attitude of the Market Oversight Division — though some headline risk has been assumed here if something should eventually fall through the cracks.

UPDATE:

- NYT

- WSJ

- Felix Salmon

- “If we approve these types of things on the arguments posed in favor of them, we could be approving things like death pools or terrorism contracts, something Congress surely never intended.”

- Hollywood Reporter

- AP

- CNBC

- AFP