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 “private” 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’ 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’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’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.

Meanwhile, back at the economy, you may have noticed that 2006 ended without a recession. This follows the recessions of 2003, 2004 and 2005, all of which also never occurred, though they were widely warned about in the press and even forecast by many economists at some point during each of those years.

The big economic story going into this New Year is that growth is accelerating. Jobless claims have dipped, as the labor market stays tight amid a low 4.5% unemployment rate and rapidly rising real wages. Corporate profits continue to defy gravity, growing at nearly double-digit rates some five years into this expansion. Economist Ed Hyman’s ISI Group reports that as of last Friday some 57% of companies had beat profit expectations for the fourth quarter.

Then there’s the “trade deficit,” which was supposed to have produced a crisis any day now but is instead contributing to faster growth as American exports soar. Peppier growth abroad is helping, especially in Europe, assuming Germany’s big increase in value-added taxes this month doesn’t get in the way. Oil prices have come down, and even the housing slump seems to have stabilized in some parts of the country.

UPDATE: Apparently, our government revenues are off the charts t00, in light of the capital gains tax cuts. Dan Clifton writes:

The debate about the capital gains tax cut is over. When Congress passed the 15 percent reduction on capital gains all we heard from the naysayers is this will produce massive deficits. When Congress extended the 15 percent rate in 2006 we heard the same tired rhetoric – only louder. Now the new leadership want to repeal this tax cut to generate revenue to the federal government. Based on the new data they may want to reconsider whether repealing this tax cut will generate any revenue to the federal government.Today’s CBO report puts the debate to bed. We were told by the Joint Committee on Taxation (JCT) the capital gains tax cut would “cost” the Federal Treasury $5.4 billion in fiscal years 2003-2006. Thus, the initial CBO forecast (January 2004) forecasted capital gains revenue to be $42 billion in 2003, $46 billion in 2004, $52 billion in 2005, and $57 billion in 2006.Well in what could now be considered the worst forecast in modern times we find out today capital gains tax collections were actually $51 billion in 2003, $72 billion in 2004, $97 billion in 2005, and $110 billion in 2006. For 2005 and 2006 collections nearly doubled the initial forecast.

Translation = total capital gains tax collections over this period were 68 percent higher than forecasted. But even more important, a loss of $5.4 billion is actually a gain of $133 billion. That is a swing of $138 billion in in just short years since the January 2004 forecast. Oops.

Hat tip to Don Luskin. I conclude with the following:

1) Properly structured taxes (and tax cuts) reduce poverty and distribute wealth.

2) Congressional entitlement programs reduce wealth and distribute poverty.

Please remember this when you vote in 2008. Unfortunately, neither Dems nor GOPs understand these principles yet.

I have an idea of which I’m proud (does not happen often): legislators should take a economics and law policy test before they can candidate. The test results will not prevent them from being voted into office–the voters have the final say. But the test results will be listed on the ballots. Think of it as American Legislator: American Idol for congress, without the ratings starved judges skewing the phone-in votes.

Cross-posted from CaveatBettor.

Voting records such as those available at the Washington Post can serve as a simple proxy for how representative members are of their given party. A legislator will be “typical” if their votes nearly always correspond to their party line. Now do the electoral fortunes of legislators who are more typical in this sense in fact exhibit a higher “beta” to general sentiment shifts? If (possibly after trimming special cases) this did not appear to be the case in the last election — if prices were not worse in proportion to how typical the Republican candidate was, then the lack of independence explanation is suspect. In that case, no explanation should be required either, since after all, 70% != 100%.

This is only a first pass, as an issue-level factor analysis should be more enlightening than one that remains at the party-level. This would also allow us to take the challengers’ views into account when modeling individual races.

In terms of the “defense” of prediction markets, apparently it needs to be pointed out ad nauseum that the question is not about their absolute success, but their success relative to alternate tools. Empirical findings confirm the superiority of prediction markets to polls, and the logic of motivation is clearly in their favor. In terms of anecdotal evidence, consider these opinions submitted in response to a television survey on confidence in polls conducted on 11/5/06:

I tell the pollsters the exact opposite of what I’m planning to do. It’s none of their business anyway.
Carole, Columbus, OH

I don’t believe in polls. I keep a penny by the phone. ‘Heads I’m a Democrat, tails I’m a Republican.’ I like to keep them guessing.
Tom, Seattle, WA

Maybe polls should be more emotive and oblique, and ask questions like, “What issues anger you the most?” and “What issues most affect your day-to-day life?”. Prediction markets would then be able to digest this data and better gauge the independence of elections.

In any case, both political factor data and analysis techniques will see development before the 2008 elections. On the latter side, this will include working through ambiguities and accounting for correlations in issue preferences (which constrain party platform “optimization”).

[Cross-posted to Risk Markets and Politics]