Prediction market regulation: CFTC, offshore, and on-chain

Prediction markets sit at the intersection of three regulatory categories: gambling, securities, and derivatives. Each framework imposes different requirements. Each jurisdiction draws different lines. Operating legally requires navigating this complexity or accepting the consequences of operating outside it.

Why prediction markets face regulatory complexity

The core question: what is a prediction market contract?

If it's gambling, state gambling laws apply. Most states prohibit or heavily regulate gambling. Operating an unlicensed gambling operation carries criminal penalties.

If it's a security, SEC registration requirements apply. Selling unregistered securities violates federal law. Both issuers and platforms face liability.

If it's a derivative, CFTC jurisdiction applies. Derivatives exchanges must register. Contract types must be approved. Retail access faces limitations.

Prediction markets don't fit cleanly into any category. They share features with each.

Gambling parallels: participants wager money on uncertain outcomes. Winners take losers' money. The activity looks like betting.

Securities parallels: shares in outcomes can be bought and sold. Prices fluctuate with information. The instruments look like tradable assets.

Derivatives parallels: contracts reference external events. Settlement depends on outcomes determined by reference sources. The structure looks like event contracts.

Different regulators have claimed jurisdiction at different times. The boundaries remain contested.

The U.S. framework: CFTC and event contracts

The Commodity Futures Trading Commission regulates derivatives markets in the United States.

The CFTC treats prediction market contracts as "event contracts" within its derivatives authority. Event contracts are derivatives whose values depend on the occurrence or nonoccurrence of future events.

Two pathways exist for legal event contract trading:

Designated Contract Markets (DCMs) can list approved event contracts for retail trading. DCMs must register with the CFTC, maintain compliance programs, and submit contract terms for approval.

No-Action Letters provide narrower permission. The CFTC has historically allowed small-scale academic prediction markets (like the Iowa Electronic Markets) through no-action letters that tolerate limited operation without formal approval.

But the CFTC has also prohibited certain event contract types. Contracts on elections, terrorism, assassination, and other events deemed contrary to public interest face explicit bans or strong regulatory resistance.

The Dodd-Frank Act gave the CFTC explicit authority to prohibit event contracts contrary to public interest. Recent court decisions have narrowed this authority, suggesting the public interest standard may be more limited than regulators previously claimed.

Kalshi: operating within the lines

Kalshi registered as a CFTC-designated contract market in 2020. The platform offers event contracts to U.S. retail customers.

Operating as a DCM requires significant compliance infrastructure:

Know-your-customer requirements mean identity verification for all users. Anonymous participation isn't possible.

Position limits cap how much any participant can hold. Large positions require disclosure. Manipulation becomes harder and more detectable.

Contract approval means the CFTC reviews proposed contracts. Some contracts get rejected or modified. The platform can't simply offer any market users might want.

Surveillance obligations require monitoring for manipulation, wash trading, and other market abuse. Kalshi must investigate suspicious activity and report to regulators.

These requirements add operational costs but provide regulatory certainty. U.S. investors can participate without legal concerns about platform legitimacy.

Kalshi's successful litigation over election contracts expanded its offerings but demonstrated ongoing uncertainty. Even a regulated platform faced regulatory resistance to popular contract types.

Polymarket: offshore and decentralized

Polymarket takes a different approach: operate outside U.S. jurisdiction.

The platform is incorporated outside the United States. Terms of service prohibit U.S. users. No CFTC registration exists.

Geographic blocking uses IP detection and terms of service to exclude U.S. users. Enforcement is imperfect. VPNs circumvent IP blocks. Terms of service violations are difficult to police.

Blockchain settlement provides partial decentralization. Trades settle on Polygon. Smart contracts execute without Polymarket's direct involvement in each transaction.

Offshore incorporation places the legal entity beyond easy U.S. regulatory reach. But this doesn't eliminate all exposure. U.S. enforcement agencies have pursued offshore entities with U.S. customer bases.

In 2022, Polymarket settled with the CFTC for $1.4 million over operating an unregistered derivatives platform. The settlement required Polymarket to block U.S. customers and wind down U.S.-facing operations.

The settlement established that offshore operation doesn't provide complete protection. U.S. regulators can pursue platforms that serve U.S. customers, even from abroad.

Global regulatory approaches

Other jurisdictions take different approaches to prediction market regulation.

United Kingdom: The Financial Conduct Authority regulates spread betting and contracts for difference. Prediction markets structured as spread bets face FCA oversight. Binary options are banned for retail customers.

European Union: MiFID II governs derivatives markets. Member states implement varying approaches. Some treat prediction markets as gambling, others as financial instruments.

Asia: Most jurisdictions restrict prediction markets alongside gambling. Singapore, Hong Kong, and Japan generally prohibit or limit event contract trading.

Jurisdictions of convenience: Some smaller jurisdictions provide regulatory homes for prediction market platforms. Curacao, Malta, and similar locations host gambling-licensed operations that may include prediction-market-like products.

Regulatory shopping exists. Platforms choose jurisdictions based on regulatory friendliness. But serving customers globally while domiciled locally creates legal complexity.

Financial market implications

Regulatory status shapes prediction market utility for financial markets.

Institutional participation requires regulatory clarity. Pension funds, endowments, and regulated financial institutions cannot use products with unclear legal status. Until prediction markets gain clear regulatory frameworks, institutional capital stays away.

This limits market depth. Retail-only markets have less liquidity than markets with institutional participation. Price discovery quality suffers.

Hedging applications face compliance barriers. A company wanting to hedge regulatory risk using prediction markets faces questions from compliance, legal, and audit functions. Is this transaction legal? How do we account for it? What disclosure is required?

Without clear answers, hedging use cases remain theoretical.

Information value depends on market quality. Thin, retail-dominated prediction markets produce noisier signals than deep, institutionally-populated markets. Regulatory barriers to institutional participation reduce prediction market information value.

Economic implications

Prediction market regulation extends beyond financial markets.

Precedent for crypto regulation. How regulators treat prediction markets signals broader approaches to crypto assets. If event contracts face stringent regulation, other crypto derivatives may follow. If prediction markets gain clarity, it may ease paths for related innovations.

Democratic implications of restricting information markets. Prediction markets produce information about public events. Restricting them limits a form of public discourse. The debate involves First Amendment considerations alongside financial regulation.

Global regulatory competition. Jurisdictions that provide clarity may attract prediction market innovation. Those that maintain ambiguity push activity elsewhere. Regulatory approaches affect where economic activity locates.

Manipulation concerns cut both ways. Regulators worry prediction markets could be manipulated to influence events or deceive the public. But regulated markets with surveillance are more resistant to manipulation than offshore alternatives. Prohibition may worsen the problem it tries to solve.

What regulatory clarity would change

Imagine prediction markets gain explicit, permissive regulatory status.

Institutional money arrives. Market makers, hedge funds, and asset managers could participate openly. Liquidity would deepen substantially. Spreads would tighten.

Contract diversity expands. With clear approval pathways, platforms could offer contracts on more events. Political, economic, scientific, and corporate events could all have liquid markets.

Integration with traditional finance accelerates. Prediction market signals could feed into risk models, trading algorithms, and economic forecasts. Banks might offer prediction-market-linked products.

Information quality improves. Deeper, more diverse markets produce better probability estimates. Society gains access to higher-quality forecasts on important questions.

The cost would be compliance overhead. Platforms would need registration, surveillance, and reporting infrastructure. Some current participants would be excluded by KYC requirements. The permissionless character of decentralized prediction markets would diminish.

Whether clarity arrives depends on regulatory decisions that remain uncertain. The current ambiguity serves some participants (those comfortable with legal risk) while excluding others (those requiring regulatory certainty).

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