Building Exits into CFTC Regulation

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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&#8217-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&#8217-s an excerpt from the paper:

Those practical limits on the CFTC&#8217-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 &#8220-exempt&#8221- 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 &#8220-no action&#8221- 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&#8217-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 &#8220-no action&#8221- 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 &#8220-exempt market&#8221- 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&#8217-s regulatory zeal.

The footnotes omitted from the above text includes this observation: &#8220-Because they fall outside the CFTC&#8217-s jurisdiction, markets offering only spot trading in conditional negotiable notes could not opt into the second regulatory tier.&#8221-

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

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

Previous blog posts by Tom W. Bell:

  • Let’s Tell the CFTC Where to Go.
  • Let Prediction Markets Fight Terrorism.
  • Protecting Private Prediction Markets
  • Insider Trading and Private Prediction Markets
  • Getting from Collective Intelligence to Collective Action
  • Quake Markets
  • Presentation of Private Prediction Markets’ Legality Under U.S. Law

9 thoughts on “Building Exits into CFTC Regulation

  1. Jason Ruspini said:

    Regarding the Zelener case, if the traders had the right to offset their positions (that is, exit them before settlement) the forwards would have been considered futures contracts and within the CFTC’s jurisdiction. So in order to escape CFTC jurisdiction by qualifying as “spot” otc for retail traders, those traders can’t exit their positions. I.e. they can’t trade.



    The CFTC and NFA are working to close the Zelener loophole and will probably do so by 2010 although they seem to be doing it in such a way that will only affect margined/levered traders. [5/23 Update: It was already in.. somehow I missed this on the first time.]


    Also I think you technically mean “excluded” instead of “exempt” commodities, which is the reason for the scare quotes there?

  2. Tom W. Bell said:

    jsalvati: How can I disagree?

    Jason: I draw a different, more general lesson from Zelener. It stands for the proposition that parties can avoid CFTC jurisdiction by carefully stepping outside what ought to be clearly defined boundaries. That’s true even if the transactions in question function much like the sorts of transactions the CFTC properly regulates. As the Zelener court noted, after all, the Forex transactions in question *did* typical resolve in offsets. The contracts did not expressly promise to allow for offsets, however, saving them from the CFTC’s reach.

    My suggestion for dodging the CFTC’s jurisdiction operates on a different principle: By not dealing in contracts but rather in notes. Those are distinct legal entities, ones that competent attorneys and courts have no trouble keeping apart. And, importantly, the CFTC has no jurisdiction over transactions in notes.

    Thanks for asking, but I really did mean to say “exempt markets.” Some such markets deal in “excluded” commodities, which must be what you were thinking of.

  3. Jason Ruspini said:

    If someone wants to jump through hoops to evade the CFTC in order to then have the joy of dealing with gambling laws, they can be my guest.  Heck, if someone has a real legal plan, I might even invest.


    Yes, I just meant to point out that you weren’t using “exempt” in the sense that the CEA uses it.. that is, a non-agricultural, non-statutory commodity.



  4. Tom W. Bell said:

    Jason: You evidently presume that prediction markets offer gambling. I rather doubt that a court would agree, leastwise so long as a market steers clear of sports claims. But I’ll agree that some risk of prosecution remains; so goes life in general and the law in particular.

    I still don’t understand what you’re getting at with regard to “exempt,” given that I’m talking only about a certain regulatory classification–exempt markets–and not about commodities of any particular type. So I think my usage comports with that of the CEA and the CFTC. There is no such thing as a “excluded market,” after all.

  5. Jason Ruspini said:

    I’m not presuming that. I’m just saying that you will have to jump through a second set of hoops, including some state-level hoops engulfed in flames. The example of Hedgestreet is very disturbing but would CFTC jurisdiction really be THAT awful? There would be other benefits too such as anti-manipulation and anti-fraud enforcement.


    I do appreciate the several reasons and principles that inform your opinion and the work you’ve done on this topic, but I guess I have a different sense of the cost/benefit analysis, and find CFTC regulation to be a more natural and robust option compared to a basket of legal “hacks”. I’m sick of legal ambiguity and I view a basket of hacks (even if I agree with them in principle) as just perpetuating that ambiguity, leading me to trade at lower levels than I want to, if at all.


    Also I am just referring to the definitions of “excluded” and “exempt” commodities in the CEA, but I guess you are using exempt in a less technical sense, which is what i thought originally.

  6. Tom W. Bell said:

    Jason: You present a very sound approach to the problem of figuring out the legal status of prediction markets. I support both that *and* other approaches. I think we need competition between different regulatory regimes in order to discern which works best. If the CFTC pulls a Hedgestreet on us, I want to make sure we can escape. Hence the title and theme of this post.

    I see what you mean about *commodities,* but I am not talking about those. I’m talking about *markets*–”exempt markets,” to be precise. As there are no such things as “excluded markets,” so that usage would err.

  7. Jason Ruspini said:

    Yes, these approaches could be complementary.

  8. COMMENTS TO THE CFTC: What to expect from Tom W. Bell and Jason Ruspini | Midas Oracle .ORG said:

    […] By doing so, he will tell the CFTC to go fugging themselves —since the CFTC is allegedly about “contracts”, not about “notes”. […]

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