Summary

Situation Overview: On March 12, the Commodity Futures Trading Commission (CFTC) issued an Advanced Notice of Proposed Rulemaking (ANPR) relating to event contracts traded on prediction markets. This ANPR constitutes one of the most significant regulatory actions regarding prediction markets initiated during President Trump’s second term.

What: The ANPR requests public comment on a range of issues, including the application of the Commodity Exchange Act’s (CEA) Core Principles to designated contract markets (DCMs) listing event contracts and how the CFTC should conduct its “public interest” determination for these financial products. Comments are due by April 30.

Who: This rulemaking applies primarily to DCMs and swap execution facilities (SEFs) listing event contracts, though it also has consequences for designated clearing organizations, futures commission merchants, introducing brokers, and swap dealers.

In Depth

The March 12 ANPR follows other actions by the CFTC under Chairman Michael S. Selig intended to assert what he considers to be the agency’s preemptive authority over prediction markets. For example, on February 16 the CFTC filed an amicus brief in the U.S. Circuit Court of Appeals for the Ninth Circuit, which is hearing a case involving Crypto.com’s listing of event contracts. This amicus brief defended the agency’s “exclusive jurisdiction over U.S. commodity derivatives markets, including event contract markets commonly referred to as prediction markets.” This ANPR marks the agency’s first step of actual rulemaking in prediction markets during President Trump’s second term and supports the position the agency has taken in ongoing litigation.

Classification of Event Contracts

The ANPR broadly defines event contracts as “derivative contracts, typically with a binary payoff structure, based on the outcome of an underlying occurrence.” As for their classification under the CEA, the ANPR reiterates the position long maintained by CFTC officials that event contracts may qualify as swaps as defined under CEA section 1a(47)(A)(ii). However, in a surprising footnote, the ANPR also notes that some event contracts may qualify as futures contracts as defined under CEA section 2a(1)(A) but does not engage in further analysis as to when an event contract would fall under the definition of a future. The ANPR also states that event contracts may qualify as security-based swaps, thereby falling under the SEC’s regulatory purview. The SEC and CFTC will likely need to initiate further rulemaking or staff guidance to clarify the categorization of event contracts in addition to their respective regulatory requirements.

CEA Core Principles for Covered DCMs

The ANPR requests public comment on the applicability of several CEA Core Principles for DCMs to prediction markets, including the following:

• Core Principle 2 (Compliance with Rules): Regarding dispute resolution mechanisms, the ANPR inquires as to whether credit default swaps offer a viable model for event contracts.
• Core Principle 3 (Prevention of Market Disruption): The ANPR asks how event contracts with underlying events “under the control of a single individual or small group of individuals” (e.g., unsportsmanlike conduct or injury to a single athlete) should be regulated. The ANPR also asks whether trading by “informed participants” possessing “an asymmetric information advantage on a particular event contract” contributes to public interest utility or leads to “manipulation, unfairness, and the misuse of inside information.”
• Core Principle 5 (Position Limitations or Accountability): The ANPR asks whether event contracts should be subject to different position limitations or accountability standards from other swaps and futures contracts.
• Core Principle 11 (Financial Integrity of Transactions): The ANPR raises the possibility of the margined trading of event contracts, asking about the eligibility of retail versus institutional traders for such trading, possible rules governing cross-margining, and the calculation of initial and daily variation margin, among other things.

Beyond the Core Principles, the ANPR asks broadly about the relationship between blockchain-based prediction markets and DCM Core Principles. The ANPR also requests public comment on whether liquidity and public disclosure requirements should differ for DCM- versus SEF-listed event contracts, as well as the process by which event contracts qualifying as swaps should be reported to a swap data repository (e.g., whether reporting and data availability should be standardized).

The ANPR discusses the “public interest” determination process as described under CEA section 5c(c)(5)(C). This process consists of two steps: (i) an event contract is determined to have fallen within the categories of (a) an activity that is unlawful under any state or federal law, (b) terrorism, (c) assassination, (d) war, (e) gaming, or (f) a similar activity determined by the CFTC to be contrary to the public interest; and (ii) the CFTC determines that the covered event contract is actually contrary to the public interest.

Among other things, the ANPR inquires as to the applicability of an “economic purpose” test to the public interest determination process. This test would determine if an event contract served a legitimate commercial function rather than being used for only speculation or gambling—a test that existed prior to the passage of the Commodity Futures Modernization Act in 2000. The ANPR also asks if the “liquidity and availability of insurance” for a certain event should factor into the public determination process.

Regarding the categories that trigger the public interest review, the ANPR asks the following questions, among others:

• Unlawful under any state or federal law: What if an event contract involves “an activity that is unlawful under some State laws, but not others”?
• Terrorism and assassination: Do assassination and terrorism have self-evident meanings? Should cyberterrorism be included in the definition of “terrorism”?
• War: Does this include all military actions? What about civil unrest?
• Gaming: Should this be considered the same as gambling activities covered by state and federal statutes? Are there characteristics (e.g., element of chance) that distinguish gaming from other activities? Furthermore, should the CFTC take into account “the characteristics of market participants that trade event contracts involving gaming,” such as their age?

More broadly, the ANPR requests public comment on when the public interest determination should be made in the listing process. In addition, it asks if the agency should provide insight into the determination process, such as by providing illustrative examples of prohibited event contracts.

Looking Forward

Comments are due to the CFTC on this ANPR by April 30. It is uncertain how long it will take for the agency to subsequently develop the ANPR into a notice of proposed rulemaking. However, Chairman Selig’s prioritization of prediction markets as well as the industry’s rapid growth may prompt the expediting of relevant rulemaking. Separately, the increasingly close working relationship between the CFTC and the SEC suggests a greater likelihood of similar SEC rulemaking covering event contracts qualifying as security-based swaps.

Concurrent with the CFTC’s increasing regulatory actions in this space, litigation concerning the agency’s jurisdiction over prediction markets continues on both a state and federal level. Multiple state and tribal authorities have undertaken legal action to assert what they consider to be their jurisdictional authority over these financial products, and it remains unclear how the courts will ultimately rule. Barring a Supreme Court ruling that unequivocally denies the CFTC preemptive authority over prediction markets, the agency is likely to continue with relevant rulemaking.

Put Patomak’s Expertise to Work

Patomak has worked with DCMs, derivatives clearing organizations, futures commission merchants, introducing brokers, swap dealers, and other market participants to evaluate their market integrity frameworks against CFTC requirements and to develop compliance, surveillance, and risk management programs designed to address the nuances of prediction markets. To learn more or to discuss how Patomak can support your firm, please contact Pamela Geraghty at pgeraghty@patomak.com, Regine Thoele at rthoele@patomak.com, or Andrew Bonney at abonney@patomak.com.