🎯Place your bets: Regulators tussle over the future of prediction markets

Predictions markets have seen a huge rise in users with sites like Polymarket and Kalishi raising large funding rounds and experiencing exponential growth. The speed with which these offerings have grown has started to run into regulatory hurdles however, and last Friday, regulators in Tennessee sent a cease-and-desist letter to Polymarkets, Crypto.com and Kalshi, alleging that their predictions markets were in fact unlicensed gambling. The same day Kalshi commenced legal proceedings against the state of Tennessee seeking a temporary restraining order preventing enforcement which would shut down their offering in Tennessee, until their substantive claims had been heard. Polymarkets and Crypto.com have not followed Kalishi in suing the state.

Kalshi hired the former Attorney General of Tennessee and is arguing that it is already regulated under the Commodities Futures Trading Commission (CFTC) and, as such, is not subject to state-level compliance.

The lawsuit reveals that Kalshi has requested "dialogue" with the Tennessee regulators mentioning three other cases which are pending relating to the platform, but those approaches were rejected. Many other states have chosen to wait and see how the other cases against Kalshi are resolved prior to commencing enforcement, according to Kalshi.

Polymarket has faced prosecutions in Canada and previously exited the United States following a settlement with the CFTC. It was ejected from Australia with local ISPs directed to block the site and regulators listing it as an illegal online gambling site.

As matters stand, prediction markets remain in a grey area between regulated financial markets and gambling. Some operators like Kalshi offer prediction markets as derivative contracts under financial services frameworks, and Polymarket is expected to re-enter the US on that basis after acquiring a CFTC regulated derivatives exchange. Robinhood and Coinbase have also announced plans to enter the market.

Under US law, the heart of the dispute relates to where a line will be drawn between what is considered a "swap", and what is considered wagering or gambling. The definition of a "swap" is very broad, including:

any agreement, contract, or transaction ... that provides for any purchase, sale, payment, or delivery that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence

This gives a broad cross-over with wagering, which the Tennessee Sports Wagering Council defines as:

a sum of money risked by a bettor on the unknown outcome of one or more sporting events, including but not limited to: the form of fixed-odds betting, a future bet, live betting, a money line bet, pari-mutuel betting, parlay bet, pools, proposition bet, spread bet... 

The US States each regulate wagering, whereas swaps are federally regulated by the CFTC. Federal law trumps state law, so if Kalishi's sports and other predictions markets are found to be swaps, then despite them appearing very similar to wagers, they would escape state level bans or control, and enjoy greater freedom (and simplicity) under Federal US regulation. Other countries (including Australia) regulate in a similar fashion and derivatives and options are often defined with reference to securities or financial products to draw a demarcation between those products and wagering. Not so the USA, which has historically had strict gambling regulation and focused the venues for gambling into casinos and sports betting venues.

The internet and rise of smart contract powered predictions markets like Polymarket have drawn to the forefront the demand for these products and the difficulty of the state preventing access, due to the manner in which the internet and cryptocurrencies operate.

Polymarket bets, for example, may be created by any users, and operate on a zero-sum basis with anyone able to bet on a peer-to-peer basis. Given this freedom, there has been some suspicious bets with one X user suggesting that the end of a press conference, which had a 98% bet of going over 65 minutes, was ended very abruptly, forcing Kalishi to formally respond and point out there was only $3,400 wagered on that particular bet.

Recently, an anonymous wager on the invasion of Venezuela sparked suspicion of insider trading and a dispute of whether the US operation in Venezuela satisfied the terms of the wager given its limited scope. That wager was ultimately resolved against the anonymous punter by Polymarket, although for some bets, Polymarket permits resolution via a third party oracle and dispute mechanism.

In any event, concerns over insider manipulation of prediction markets are real and have resulted in a proposal before the US Congress to target unfair practices affecting the integrity of these markets.

While in some cases prediction markets look very much like traditional sport betting, these so-called "truth markets" also enable traders to hedge real-world events like elections which can have significant financial implications. For some, the crowd-sourced wisdom of prediction markets offers a superior model to traditional polling or bookmaking models for determining the likelihood of real world events. One thing is for sure, the outcome of the swaps vs bets argument will have significant ramifications over the predictions markets business models, as well as traditional gambling and wagering. First published at www.bitsofblocks.io and reproduced with permission.