What are speculators for in the first place?
Before diving into modern derivatives law, it’s important to understand what financial regulators are protecting. Regulators protect consumers and traders, but the function that speculators perform in markets also demands a careful regulatory balance.
In his book Speculation: A History of the Line Between Gambling and Investing, Stuart Banner explains the dilemma regulators face when managing how much speculation to allow in a market:
“The more we give speculators free rein, the greater the risk that speculators will bring harm to others. But the more we constrain speculators, the smaller the benefits of speculation.”
The banner includes the benefits of speculation as “taking on risks others wish to shed,” which gives some traders the ability to hedge. Speculators also increase market liquidity and can stabilize prices, as they did with agricultural futures.
Too much speculation in a market can lead investors to bankrupt themselves or harm “their families and their creditors.” As the 2008 financial crisis showed, speculators can “even imperil the entire financial system.”
The turn of the century and the fallout from the financial crisis paved the way for prediction markets’ expansion and current regulatory conflicts.
2000: Commodity Futures Modernization Act
As part of an ongoing effort to deregulate American industries in the name of competition, Bill Clinton signed the Commodity Futures Modernization Act (CFMA).
The CFMA allowed derivatives exchanges to self-certify their contracts. Instead of submitting new products to the CFTC, an exchange could file paperwork showing the new product complied with CFTC regulations.
It also shifted the CFTC to regulation based on core principles instead of “prescriptive rules.” The core principles that allow Kalshi the wiggle room – for now – to offer sports contracts are rooted in this piece of legislation.
The CFMA did what it set out to do. By the end of 2004, trading volume of exchange-traded futures grew 164%, compared to 7% in the three years prior to the CFMA’s passage. However, the permissive legislation also kept over-the-counter derivatives off exchanges and exempted some from CFTC regulation.
The consequences of remaining lenient about OTC derivatives would become clear in the fall of 2007.
2010: Dodd-Frank Wall Street Reform and Consumer Protection Act
While the CFMA was focused on removing guardrails, the Dodd-Frank Act was designed to replace them. One of Dodd-Frank’s requirements for derivatives included making firms that trade derivatives use a clearinghouse, which added more oversight than the private OTC trades that subprime mortgages had.
Dodd-Frank also included a special rule for event contracts. Section 745 creates new certification requirements for new derivatives contracts. One subsection created a Special Rule for event contracts that read in part:
“…, the Commission may determine that such agreements, contracts, or transactions are contrary to the public interest if the agreements, contracts, or transactions involve— ‘‘(I) activity that is unlawful under any Federal or State law; ‘‘(II) terrorism; ‘‘(III) assassination; ‘‘(IV) war; ‘‘(V) gaming; or ‘‘(VI) other similar activity determined by the Commission, by rule or regulation, to be contrary to the public interest.”
Crucially, the statute requires the CFTC to find a contract in any of these categories contrary to the public interest for the event contracts to be prohibited. One year later, the CFTC would create its own regulation concerning these categories.
2011: CFTC Rule 40.11
In 2011, the CFTC adopted Rule 40.11, which prohibited all event contracts that Dodd-Frank listed as categories the CFTC should review. The categories became the “enumerated categories” that are at issue in modern prediction market lawsuits.
The CFTC will still conduct a review. Within 90 days, the commission will decide whether the contract belongs to one of the enumerated categories. Despite these public interest reviews, sports contracts have been unsuccessful until December 2024, when Crypto.com self-certified its Super Bowl contracts.
Interestingly, the CFTC pointed out that the definition of “gaming” needed to be clarified:
“The Commission agrees that the term ‘gaming’ requires further clarification and that the term is not susceptible to easy definition. Indeed, in its ‘Concept Release on the Appropriate Regulatory Treatment of Event Contracts,’ the Commission solicited public comments on the best approach for addressing ‘the potential gaming aspects of some event contracts and the potential pre-emption of state laws.’ The Commission received a number of responses to its concept release, including several comments articulating bases for distinguishing trading in contracts linked to the occurrence (or non-occurrence) of events and participation in traditional ‘gaming’ activities.”
Even with a seemingly clear rule to prohibit all “gaming” contracts, the questions the CFTC attempted to settle in 2011 have remained unresolved.
New products, same hard questions
As state gaming commissions fight to prohibit event contracts from circumventing state sports betting laws, federal finance platforms are determined to keep their contracts live in all 50 states until the CFTC or Congress says otherwise.
The self-certification that allowed prediction markets to move into sports and elections so quickly came from an attempt in 2000 to make derivatives markets more competitive. Dodd-Frank and Rule 40.11 reinstalled guardrails on derivatives contracts and created the enumerated categories being challenged in the courts.
Over time, derivatives have become increasingly tailored to individual risks. Contracts that used to be traded over the counter to fit this requirement can now be traded on regulated prediction market exchanges like Kalshi, Crypto.com, and Forecast Ex.
As the line between gambling and finance is resettled for the modern era, courts, regulators, and lawmakers are faced with the same hard questions that jurors in the previous century had to argue among themselves.
