Prediction markets for the future: Navigating the legal landscape to preserve accurate forecasts

Prediction markets are in an unresolvable dilemma. Their ever-expanding popularity with consumers has forced regulators, lawmakers, and courts to grapple with how to define and regulate a new frontier. Opponents consider prediction markets tantamount to gambling and insist this subjects them to state regulation, while proponents are steadfast in their conviction that these financial instruments should be under the sole purview of the federal Commodity Futures Trading Commission (CFTC). There is no clean answer, but whether prediction markets should be immune to conventional gambling regulations comes down to how much we value knowing the future.

The U.S. Third and Ninth Circuit Courts of Appeals currently disagree on whether states or the federal government should regulate prediction markets. This tension will inevitably lead to the Supreme Court of the United States, but how will that case be decided? To contemplate the potential outcomes of such a decision, we must first know what a prediction market is and is not.

Technically, prediction markets are just a specific form of wagering. Consider squares versus rectangles. All squares are rectangles, but not all rectangles are squares. Similarly, every prediction market involves wagers, but not every wager is in a prediction market. However, all wagers are gambling.

As a legal matter, however, prediction markets do not need to be regulated as gambling. Consider the example of premium cigars. Cigars obviously contain tobacco, but under Food and Drug Administration (FDA) regulation, they are not deemed tobacco products. FDA regulates “tobacco products,” but not premium cigars. This sort of arrangement makes sense because the public health concerns surrounding premium cigar use, such as reductions in life expectancy and the raw number of users, are not as severe as those of products like conventional cigarettes. Similarly, if regulators see a societal benefit in treating prediction markets differently than traditional sportsbooks, they can define prediction markets so that they are outside the definition of conventional gambling.

The distinction between prediction markets and other wagers comes down to odds. When a casino sets odds on a professional sports event’s outcome, such as who will win a game, the casino has a preference for who will win. That is because the casino is actually gambling against its customers. An actuarially fair price for a wager depends on who the customers bet on—as more money is cast in support of one team, the payout for those who bet on the other team grows. The amount the odds depart from that price, which is called the overround, is proportional to how much the casino is wagering itself. This leads to an expected profit for the casino, known as the “vig.”

Prediction market companies, like Kalshi, do not care who wins any game. That is because the price of any wager is set to the actuarially fair price, and prediction markets make money on transaction fees rather than betting against their customers. So a prediction market is defined as a wager where the overround is set to zero. Because prediction market companies are indifferent to an event’s outcome, all wagers can be traded at any time for the current market price.

Should prediction markets be regulated differently than other forms of gambling? As eminent Nobel Laureate economists Kenneth Arrow, Robert J. Shiller, Thomas C. Schelling, Vernon L. Smith, Paul Milgrom, and other colleagues wrote in Science, “These markets have great potential for improving social welfare in many domains.” The authors further wrote, “The ability of groups of people to make predictions is a potent research tool that should be freed of unnecessary government restrictions.”

Indeed, every decision we make relies on our understanding of the future, and prediction markets are one of the best ways to predict an event. They are substantially more accurate at predicting games than sports experts and have shown to be 74% more accurate at predicting election results than polling. Among the authors of the aforementioned piece in Science is Robin Hanson, who is a Caltech-trained economist and the foremost expert on prediction markets. As Hanson has written and others have shown, as prediction markets become more popular, they’ll provide larger profit incentives and become more accurate.

Knowing the future is important. Consider the recent Wisconsin gubernatorial primary. When polling showed Democratic Socialist candidate Francesca Hong was poised to win, prediction markets showed that a Republican victory in the general election was imminent. When Francesca Hong suffered her upset defeat, the forecast shifted to favor a Democratic victory in the general election. In this case, prediction markets showed that Hong was not a strong candidate for the general election, and some voters pivoted to pick a stronger, more moderate candidate.

Prediction markets can also serve as financial instruments. For example, if a city counts on funds from an outdoor festival it hosts, it may worry that a storm—and the resulting cancellation—could leave a gap in its annual revenue. To hedge against this risk, the city could wager that a storm occurs, so that if it does, the city still receives a proportion of the revenue it expected. These arrangements are infinitely definable, but require permissive regulations to operate efficiently. That is, prediction markets can serve as a practical way to protect against losses only if the rules are loose enough to allow these sorts of niche bets.

Many prediction market critics are fine with niche financial instruments, but legal challenges mostly target sports wagers. When states seek to regulate prediction markets for sporting events, federal CFTC preemption prevents them from exercising any restrictions. For example, most states that allow gambling require bettors to be 21, but according to CFTC regulations, anyone 18 or older can trade in a prediction market. Such controversies have brought legal challenges from states, with the Ninth Circuit agreeing that Kalshi is subject to the state’s gambling laws on sporting events.

However, there are also many advantages to allowing prediction markets to operate in states, even in sports. Rightly or wrongly, many consider casinos to offer predatory odds that take advantage of bettors, but with prediction markets operating in those states, casinos are often forced to offer fairer odds. At the same time, because prediction markets are more accurate than betting odds, casinos also use prediction markets to set more profitable odds for themselves.

Because prediction markets need collective information across the country to offer informative prices, a strong interstate commerce argument supports separate federal regulation of prediction markets. We can easily define prediction markets as wagers with an overround of 0. The CFTC has considered all such arrangements exempt from state-level regulation, which spurred the legal challenges. What the Supreme Court may decide is which topics are not exempt, which really means which topics the public does not have an interest in being predicted more accurately.

Many opponents do not consider sport predictions to be important, but the economic activity of sports is substantial—about $1 trillion annually, or 3 to 4% of the whole economy. Many businesses are significantly affected by sports performance and could potentially hedge against unanticipated events in prediction markets. For example, a restaurant may lose sales because its local team did not advance far enough in the playoffs and could hedge against that event. Specifically, the restaurant could choose to bet against its local team, and the wager would serve as insurance for lost sales. Such a wager is awkward—betting against the team you want to win—but it is a more efficient way of offering insurance for events that are otherwise difficult to price.

To better predict the future, prediction markets should be regulated as little as possible. Excessive government regulation will create distortions that reduce access to prediction markets and limit their accuracy. As it stands today, the CFTC is the most efficient regulator of prediction markets, so in the short run the agency’s authority should be protected. But with the threat of future presidential administrations having broad authority to change CFTC policy, advocates should consider whether it remains the best regulator in the long term.

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Source: https://reason.org/commentary/prediction-markets-for-the-future-navigating-the-legal-landscape-to-preserve-accurate-forecasts/