Chapter 38: The Regulatory Landscape

"Markets are like water — they find every crack in the regulatory dam. Good regulation channels the flow; bad regulation just makes the flood worse." — attributed to a senior CFTC official, 2023

Prediction markets exist at one of the most complex regulatory intersections in modern finance. They touch commodity law, securities regulation, gambling statutes, tax codes, anti-money-laundering regimes, and — in the era of blockchain-based platforms — an entirely new frontier of crypto-asset regulation. This chapter maps that landscape comprehensively, from the corridors of the CFTC in Washington, D.C., to the European Commission in Brussels, to decentralized protocols operating in regulatory grey zones across the globe.

Understanding regulation is not optional for prediction market participants. Regulation determines which markets exist, who can access them, what fees platforms charge, how contracts are structured, and whether your profits are legal. Whether you are a trader, a platform builder, a researcher, or an investor, the regulatory landscape shapes every aspect of your interaction with prediction markets.

38.1 Why Regulation Matters

38.1.1 The Core Functions of Financial Regulation

Financial regulation serves several fundamental purposes that directly affect prediction markets:

Market Integrity. Regulation exists to ensure that markets are fair, transparent, and free from manipulation. For prediction markets, this means rules about position limits, trade reporting, price manipulation, and insider information. Without these guardrails, prediction market prices would be unreliable as information aggregation tools — undermining their core social value.

Consumer Protection. Retail traders need protection from fraud, misrepresentation, and excessive risk. Regulatory frameworks impose disclosure requirements, suitability standards, and dispute resolution mechanisms. In prediction markets, this translates to clear contract specifications, transparent settlement procedures, and fair pricing.

Systemic Risk Management. While individual prediction market contracts are typically small, the principles of systemic risk management still apply. Regulators worry about interconnections between markets, concentration of positions, and the potential for cascading failures.

Financial Crime Prevention. Prediction markets could theoretically be used for money laundering, terrorist financing, or sanctions evasion. Anti-money-laundering (AML) and know-your-customer (KYC) regulations address these risks.

38.1.2 The Unique Challenge of Prediction Markets

Prediction markets pose a distinctive regulatory challenge because they do not fit neatly into existing categories:

This multi-dimensional classification problem means that prediction markets can face overlapping — and sometimes contradictory — regulatory requirements. A single platform might need to satisfy the CFTC, comply with state gambling laws, implement SEC-grade disclosure, follow FinCEN's AML rules, and navigate state money transmitter licensing, all simultaneously.

38.1.3 Regulation as a Competitive Moat

An often-overlooked aspect of regulation is its role as a competitive advantage. Platforms that successfully navigate the regulatory maze gain:

• Legal certainty that allows them to operate openly
• Institutional trust that attracts larger traders and capital
• Banking relationships that enable efficient deposit/withdrawal
• Media credibility as legitimate information sources
• Barriers to entry that protect their market position

The history of prediction markets is substantially a history of regulatory battles, and the platforms that won those battles — or cleverly avoided them — define the market today.

38.1.4 A Simple Regulatory Risk Model

We can model a platform's regulatory risk exposure as a function of several variables:

$$R = \sum_{j \in J} w_j \cdot \left( P(\text{enforcement}_j) \times L(\text{penalty}_j) \right)$$

where: - $J$ is the set of jurisdictions where users reside - $w_j$ is the weight (proportion of users/volume) in jurisdiction $j$ - $P(\text{enforcement}_j)$ is the probability of enforcement action in jurisdiction $j$ - $L(\text{penalty}_j)$ is the expected loss from enforcement in jurisdiction $j$

This is a simplified model, but it captures the essential trade-offs that platforms face when deciding where to operate and whom to serve.

38.2 US Federal Regulation: The CFTC

38.2.1 The Commodity Futures Trading Commission

The Commodity Futures Trading Commission (CFTC) is the primary federal regulator of prediction markets in the United States. Established by the Commodity Futures Trading Commission Act of 1974, the CFTC oversees derivatives markets including futures, options, and swaps.

The CFTC's jurisdiction is grounded in the Commodity Exchange Act (CEA), which defines "commodity" extraordinarily broadly:

The term "commodity" means wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles, except onions [...] and all services, rights, and interests [...] in which contracts for future delivery are presently or in the future dealt in.

The critical phrase is "all services, rights, and interests." This sweeping language has been interpreted to encompass event contracts — binary options based on the outcome of real-world events.

38.2.2 The Dodd-Frank Act and Event Contracts

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was the most significant overhaul of US financial regulation since the Great Depression. For prediction markets, the key provision is Section 745, which added new Section 5c(c)(5)(C) to the Commodity Exchange Act.

This section gives the CFTC explicit authority over "event contracts" — defined as agreements, contracts, transactions, or swaps based on the occurrence (or non-occurrence) of events. However, Dodd-Frank also empowered the CFTC to determine that certain event contracts are contrary to the public interest and should not be listed for trading.

The statute identifies specific categories where the CFTC may restrict event contracts:

1. Activity unlawful under state or federal law (e.g., contracts on illegal drug trade volumes)
2. Terrorism (e.g., contracts on terrorist attacks)
3. Assassination (e.g., contracts on the death of specific individuals)
4. War (subject to nuance, as defense-related economic contracts may be permissible)
5. Gaming (overlapping with state gambling law)
6. Other activity the CFTC determines is contrary to the public interest

The sixth category — the catch-all "contrary to the public interest" — has been the most contentious. It was this provision that the CFTC invoked in its attempt to block election event contracts.

38.2.3 Designated Contract Markets (DCMs)

To legally offer event contracts in the US, a platform must register with the CFTC as a Designated Contract Market (DCM). This is the same regulatory status held by the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

DCM registration requires:

• Self-regulatory capability: The exchange must monitor its own markets, enforce rules, and conduct surveillance
• Financial resources: Sufficient capital to operate and meet obligations
• System safeguards: Robust technology infrastructure and cybersecurity
• Compliance programs: AML/KYC compliance, trade reporting, and record-keeping
• Market surveillance: Ability to detect and prevent manipulation
• Customer protection: Segregation of customer funds, fair access, transparent pricing

The DCM application process is rigorous and can take years. As of 2025, only a small number of platforms have successfully obtained DCM status for event contracts:

• Kalshi — Approved in 2020, the first DCM specifically focused on event contracts
• Nadex (North American Derivatives Exchange) — A longer-standing DCM that offered binary options on financial events
• CME Group — The world's largest futures exchange, which has explored event contract products

38.2.4 The CFTC's Evolving Stance

The CFTC's approach to prediction markets has shifted significantly over the decades:

Early Skepticism (2000s). The CFTC initially viewed prediction markets with suspicion, treating them as potential gambling operations that fell outside its traditional commodity markets mandate. The agency took enforcement action against Intrade in 2012 for offering off-exchange options trading to US customers.

Cautious Tolerance (2014-2020). The issuance of no-action letters (discussed in Section 38.4) represented a middle ground — allowing limited prediction market activity for academic purposes without formally endorsing the concept.

Active Engagement (2020-present). The approval of Kalshi as a DCM signaled a fundamental shift. The CFTC began actively engaging with the question of which event contracts should be permitted, rather than avoiding the issue entirely.

The Election Markets Controversy (2023-2024). The CFTC's attempt to block Kalshi from offering congressional election contracts led to landmark litigation that reshaped the regulatory landscape. The D.C. Circuit's ruling in Kalshi v. CFTC affirmed that political event contracts could not be categorically excluded as "gaming" under the CEA.

38.2.5 CFTC Enforcement Actions

The CFTC has brought several significant enforcement actions related to prediction markets:

These enforcement actions establish clear precedent: operating a prediction market accessible to US users without CFTC registration (or a valid exemption) is a violation of federal law.

38.3 The Event Contract Debate

38.3.1 What Qualifies as an Event Contract?

The definition of "event contract" under the CEA is deceptively simple: a derivative whose value is determined by the occurrence or non-occurrence of an event. But the boundaries of this definition are fiercely debated.

Clearly Permissible Events: - Economic indicators (GDP, unemployment, inflation) - Weather events (temperature, rainfall, hurricane landfall) - Corporate events (earnings beats, product launches)

Clearly Excluded Events: - Terrorist attacks or assassinations - Events whose contract creates incentives for illegal activity

The Grey Zone: - Political elections - Geopolitical events (wars, coups, sanctions) - Social outcomes (pandemic severity, crime rates) - Cultural events (Oscar winners, Supreme Court decisions)

38.3.2 The "Contrary to Public Interest" Standard

When the CFTC reviews a proposed event contract, it applies a multi-factor public interest analysis:

1. Economic purpose: Does the contract serve a hedging or price discovery function?
2. Gaming characteristics: Does the contract resemble gambling more than a financial instrument?
3. Market integrity: Can the contract be fairly priced and settled?
4. Manipulation risk: Is the underlying event susceptible to manipulation?
5. Public policy concerns: Does the contract create perverse incentives?

The CFTC proposed a rule in 2023 that would have established a formal framework for evaluating event contracts, but this rulemaking was overtaken by the Kalshi litigation.

38.3.3 The Kalshi Election Contracts Case

The most consequential regulatory battle in prediction market history began when Kalshi sought to list contracts on US congressional elections. The CFTC rejected Kalshi's proposed contracts, arguing they constituted "gaming" and were contrary to the public interest.

Kalshi challenged this determination in federal court. The key legal questions were:

1. Are election contracts "gaming"? The CFTC argued that betting on elections is a form of gambling. Kalshi argued that election contracts serve legitimate hedging and information discovery purposes.

2. Does the CFTC have authority to categorically exclude event types? The court examined whether the CEA's exclusion categories gave the CFTC blanket power to prohibit entire categories of contracts or only specific contracts that meet the exclusion criteria.

3. What standard of review applies? Kalshi argued for heightened scrutiny; the CFTC sought deference under the Chevron doctrine (though Chevron deference was significantly curtailed by the Supreme Court's 2024 Loper Bright decision).

The D.C. district court ruled in Kalshi's favor in September 2024, finding that the CFTC had not adequately demonstrated that election contracts fell within the statutory exclusions. The court's opinion emphasized the informational value of prediction markets and rejected the broad "gaming" characterization.

38.3.4 Implications for Future Event Contracts

The Kalshi ruling has profound implications for the scope of permissible prediction markets:

• Election markets are now legally available through registered DCMs
• Other political event contracts (legislation outcomes, executive orders, judicial confirmations) are likely permissible
• Social event contracts (pandemic metrics, demographic trends) have a stronger legal foundation
• Entertainment event contracts remain uncertain — contracts on sports outcomes face additional scrutiny under gambling laws

However, the ruling does not eliminate CFTC oversight. The agency retains authority to evaluate individual contracts and can still prohibit specific contracts that clearly fall within the statutory exclusions (terrorism, assassination) or that present manipulation risks.

38.4 No-Action Letters and PredictIt

38.4.1 The No-Action Letter Mechanism

A CFTC no-action letter is a written statement by the agency's staff that it will not recommend enforcement action against a specific party for a specific activity. No-action letters are not formal approvals — they do not create legal precedent, can be withdrawn at any time, and apply only to the named recipient.

No-action letters serve as a regulatory safety valve, allowing limited experimentation with novel activities that might otherwise violate the CEA. For prediction markets, they provided a crucial bridge between the era of prohibition and the era of formal DCM registration.

38.4.2 The PredictIt Story

PredictIt's history is the defining narrative of prediction market regulation in the United States:

2014: The No-Action Letter. Victoria University of Wellington, a New Zealand academic institution, received a CFTC no-action letter permitting it to operate a small-scale prediction market for research purposes. The letter was issued to Victoria University, not to PredictIt directly, reflecting the academic research framing.

Key Conditions of the Letter: - Markets limited to 5,000 traders (later informally treated as 5,000 per contract) - Individual positions capped at $850 - Not-for-profit operation with any revenues directed to academic research - Only certain categories of political and economic event contracts - Victoria University must maintain oversight of the platform

2014-2022: Growth and Tension. PredictIt grew far beyond what many believed the no-action letter contemplated. The platform became a widely cited source of political forecasting data, with millions of dollars in trading volume. Critics argued that PredictIt had exceeded the spirit (if not the letter) of its exemption by operating as a de facto commercial exchange.

2022: Withdrawal of the No-Action Letter. In August 2022, the CFTC's Division of Market Oversight informed Victoria University that it was withdrawing the no-action letter, effective February 15, 2023. The withdrawal required PredictIt to wind down operations — settling existing contracts but not listing new ones.

Legal Challenge. PredictIt users and operators challenged the withdrawal in federal court, arguing that the CFTC acted arbitrarily and that the withdrawal harmed traders who had relied on the platform's continued operation. The litigation raised important questions about reliance interests and the CFTC's discretion in managing no-action relief.

38.4.3 Lessons from PredictIt

The PredictIt episode offers several critical lessons:

1. No-action relief is inherently precarious. Building a business on a no-action letter is building on sand — the relief can be withdrawn with limited process.

2. Academic framing has limits. Presenting a commercial platform as academic research creates tension as the platform grows.

3. Regulatory relationships matter. PredictIt's relationship with the CFTC deteriorated as the platform's activities diverged from what the agency believed it had authorized.

4. Path dependency shapes markets. Many traders and researchers built workflows around PredictIt, and its disappearance created a gap that other platforms rushed to fill.

5. Political dynamics are real. The timing of the no-action letter withdrawal, coinciding with broader political debates about election markets, suggests that regulatory decisions are not made in a political vacuum.

38.5 Securities Law Considerations

38.5.1 When Is a Prediction Market Contract a Security?

The Securities and Exchange Commission (SEC) has jurisdiction over "securities," which include a broad category of "investment contracts." The foundational test for whether something is an investment contract comes from the Supreme Court's 1946 decision in SEC v. W.J. Howey Co.:

The Howey Test — An investment contract exists when there is: 1. An investment of money 2. In a common enterprise 3. With a reasonable expectation of profits 4. Derived from the efforts of others

Applying Howey to prediction markets:

For most traditional prediction market contracts, the Howey test probably does not classify them as securities. The critical weakness is the "efforts of others" prong — in a prediction market, your profit or loss depends on the occurrence of an external event, not on the managerial efforts of a third party.

However, certain prediction market structures may trigger securities concerns:

• Tokenized shares in prediction market outcomes that trade on secondary markets
• Liquidity provider tokens that represent fractional ownership of market-making pools
• Platform governance tokens that give holders voting rights and fee revenue

38.5.2 The SEC's Position

The SEC has not issued definitive guidance on prediction markets specifically, but several statements and enforcement actions provide context:

• The SEC has indicated that binary options offered to retail customers may constitute securities depending on their structure
• Token offerings by prediction market platforms have been scrutinized under securities law
• The SEC's "Framework for Investment Contract Analysis of Digital Assets" (2019) provides guidance applicable to prediction market tokens

38.5.3 Dual Registration Concerns

The overlapping jurisdictions of the CFTC and SEC create a significant compliance challenge. A platform that offers event contracts on economic indicators (CFTC jurisdiction) and tokenized outcome shares (potentially SEC jurisdiction) might need to register with both agencies — a costly and complex undertaking.

The ongoing debate about SEC/CFTC jurisdictional boundaries, particularly in the crypto space, adds further uncertainty. Congressional efforts to clarify these boundaries through legislation like the Financial Innovation and Technology for the 21st Century Act (FIT21) could eventually resolve this ambiguity, but as of early 2026, the lines remain blurry.

38.6 State Gambling Laws

38.6.1 The Gambling Classification Problem

The most persistent regulatory challenge for prediction markets is the question of whether they constitute gambling. This is primarily a state law issue in the United States, as gambling regulation is traditionally a state responsibility under the Tenth Amendment.

State gambling statutes typically define gambling using three elements:

1. Consideration (something of value is wagered)
2. Chance (the outcome depends on chance rather than skill)
3. Prize (the winner receives something of value)

Prediction markets clearly involve consideration (you must pay for a contract) and prize (you receive a payout if your contract is in the money). The battleground is chance versus skill.

38.6.2 The Skill vs. Chance Debate

Prediction market proponents argue that trading on prediction markets is a skill-based activity:

• Successful traders must analyze information, assess probabilities, and manage risk
• Over time, skilled traders consistently outperform the market
• Prediction market trading is more similar to stock trading than to roulette

Gambling regulators counter that:

• The underlying events are uncertain and outside the trader's control
• Many prediction market participants treat the activity as entertainment
• The binary outcome structure resembles traditional sports betting

Different states apply different legal tests:

Predominant Purpose Test (majority of states): Is the outcome determined predominantly by skill or by chance? Under this test, prediction markets have a reasonable argument for skill predominance.

Any Chance Test (minority of states): If any element of chance is involved, the activity may constitute gambling. Under this strict test, prediction markets are more vulnerable.

Material Element Test: Is chance a material element of the outcome? This intermediate standard considers whether chance plays a meaningful role, even if not the predominant one.

38.6.3 State-by-State Variation

The regulatory landscape varies dramatically across states:

The federal preemption question is critical: if a prediction market is registered with the CFTC as a DCM, does federal law preempt state gambling laws? The CEA contains a broad preemption provision, but its application to event contracts specifically is untested in most states.

38.6.4 State Attorney General Actions

Several state attorneys general have taken action against prediction market platforms:

• State AG offices have issued cease-and-desist letters to platforms operating without state gambling licenses
• Some states have specifically exempted CFTC-regulated platforms from state gambling laws
• The patchwork of state responses creates significant uncertainty for platforms with nationwide user bases

38.6.5 The Wire Act and Federal Gambling Law

The Federal Wire Act of 1961 prohibits the use of wire communications (including the internet) for transmitting bets or wagers in interstate or foreign commerce. The Department of Justice's interpretation of the Wire Act has fluctuated:

• A 2011 DOJ opinion limited the Wire Act to sports betting
• A 2018 DOJ opinion reversed course, applying it to all forms of online gambling
• A 2019 First Circuit decision sided with the 2011 narrow interpretation

For prediction markets, the Wire Act creates additional risk if the markets are classified as gambling. However, CFTC-registered platforms likely benefit from the argument that their products are regulated financial instruments, not wagers.

38.7 European Regulation: MiCA and Beyond

38.7.1 The Markets in Crypto-Assets Regulation (MiCA)

The European Union's Markets in Crypto-Assets Regulation (MiCA), which came into full effect in December 2024, is the world's most comprehensive crypto-asset regulatory framework. For prediction markets — particularly blockchain-based platforms like Polymarket — MiCA has significant implications.

Key MiCA Provisions Affecting Prediction Markets:

1. Crypto-Asset Service Provider (CASP) Licensing: Platforms that facilitate trading in crypto-assets must obtain CASP authorization from the competent authority in at least one EU member state. This authorization can then be "passported" across the EU.

2. Stablecoin Regulation: Many prediction markets use stablecoins (like USDC) as collateral. MiCA imposes strict requirements on stablecoin issuers, including reserve requirements, redemption rights, and market cap limitations for non-euro-denominated stablecoins.

3. White Paper Requirements: Issuers of crypto-assets must publish a white paper containing detailed information about the asset, the issuer, and the risks. Prediction market outcome tokens may trigger this requirement.

4. Market Abuse Provisions: MiCA includes market abuse rules similar to those in traditional securities regulation — prohibitions on insider trading, market manipulation, and unlawful disclosure of inside information.

38.7.2 How MiCA Applies to Prediction Markets

The application of MiCA to prediction markets depends on how the platform's tokens are classified:

A critical unresolved question is whether prediction market outcome tokens are "financial instruments" under MiFID II rather than "crypto-assets" under MiCA. If they are financial instruments, they fall under the more stringent MiFID II framework, which would require the platform to operate as a regulated investment firm.

38.7.3 Country-Specific European Regulation

Within the EU, individual member states retain some discretion in implementing MiCA and may impose additional requirements:

France. The Autorite des Marches Financiers (AMF) has been proactive in regulating crypto-assets and has taken enforcement actions against unregistered platforms offering binary options to French users.

Germany. BaFin (Federal Financial Supervisory Authority) classifies certain crypto-assets as financial instruments, potentially subjecting prediction market tokens to securities-grade regulation.

Malta. The Malta Financial Services Authority (MFSA) has created a relatively friendly regulatory environment for crypto-assets through its Virtual Financial Assets Act, potentially providing a favorable jurisdiction for prediction market platforms.

Netherlands. The Dutch Authority for the Financial Markets (AFM) has been aggressive in enforcing gambling regulations against prediction market-like products.

38.7.4 The UK Approach

Post-Brexit, the UK operates outside MiCA and has developed its own crypto-asset regulatory framework:

• The Financial Conduct Authority (FCA) regulates crypto-assets that qualify as "specified investments" under the Financial Services and Markets Act 2000
• The FCA has banned the sale of crypto-derivatives (including binary options) to retail consumers
• The UK Gambling Commission may have jurisdiction over prediction markets that are classified as gambling
• The UK is developing a comprehensive digital assets regulatory framework expected to be finalized by 2026

The UK's approach creates a challenging environment for prediction market platforms. The FCA's binary options ban likely encompasses many prediction market products, and the overlap with gambling regulation adds further complexity.

38.8 Global Regulatory Patchwork

38.8.1 Australia

The Australian Securities and Investments Commission (ASIC) regulates financial products, including derivatives. ASIC has taken enforcement actions against platforms offering binary options to Australian consumers, imposing a product intervention order that bans the issuance and distribution of binary options to retail clients.

For prediction markets, this ban is significant because most prediction market contracts are structured as binary options. Platforms seeking to serve Australian users would need to: - Obtain an Australian Financial Services Licence (AFSL) - Comply with the binary options product intervention order (which may preclude retail access) - Meet ASIC's design and distribution obligations

38.8.2 Singapore

The Monetary Authority of Singapore (MAS) regulates securities, futures, and payment services through a comprehensive framework:

• The Securities and Futures Act (SFA) regulates capital markets products, potentially including prediction market contracts
• The Payment Services Act (PSA) regulates digital payment tokens
• MAS has issued guidelines on digital token offerings that may apply to prediction market tokens

Singapore's approach is generally more open to innovation than many jurisdictions, and MAS has created a regulatory sandbox that could potentially accommodate prediction market experimentation.

38.8.3 Japan

Japan's Financial Services Agency (FSA) has one of the world's most detailed crypto-asset regulatory frameworks:

• The Payment Services Act regulates "crypto-assets" (previously "virtual currencies")
• The Financial Instruments and Exchange Act (FIEA) regulates securities tokens
• Japan's gambling laws are strict, with limited exceptions for certain forms of gambling

For prediction markets, Japan presents a particularly challenging environment because of the strong cultural and legal presumption against gambling combined with strict crypto-asset regulations.

38.8.4 Canada

Canada's regulatory landscape is fragmented across federal and provincial authorities:

• The Canadian Securities Administrators (CSA) coordinate securities regulation across provinces
• Individual provincial securities commissions (e.g., OSC in Ontario) have enforcement authority
• The CSA has issued guidance treating crypto-asset trading platforms as securities dealers

Several crypto-asset trading platforms have registered as restricted dealers in Canada, providing a potential pathway for prediction market platforms. However, provincial gambling laws may independently restrict prediction market activity.

38.8.5 India

India's regulatory approach to prediction markets is evolving:

• The Securities and Exchange Board of India (SEBI) regulates securities and derivatives
• The Reserve Bank of India (RBI) has expressed concerns about crypto-assets
• Indian gambling laws vary by state, with most states restricting betting

Despite regulatory challenges, India has seen significant growth in "opinion trading" platforms (platforms like Probo and MPL Opinio) that structure prediction market-like products within the framework of Indian law. These platforms often argue they offer games of skill rather than gambling, leveraging India's legal distinction between the two.

38.8.6 Offshore Platforms and Regulatory Arbitrage

The global patchwork of regulations has driven significant activity to offshore platforms that operate from jurisdictions with minimal or no regulation of prediction markets:

• Polymarket operates from outside the US, serving non-US users after its 2022 CFTC settlement
• Betfair operates under UK gambling regulation but restricts access in many jurisdictions
• Various DeFi protocols operate without geographic restrictions from decentralized infrastructure

Regulatory arbitrage — the practice of locating in a jurisdiction with favorable regulations while serving users globally — is a defining feature of the prediction market landscape. This creates a tension:

$$\text{Regulatory Strictness} \uparrow \implies \text{Platform Migration Offshore} \uparrow \implies \text{Consumer Protection} \downarrow$$

This dynamic gives regulators a difficult choice: regulate too strictly and lose oversight entirely as activity moves offshore, or regulate too lightly and risk consumer harm.

38.9 DeFi and Regulatory Challenges

38.9.1 The Decentralization Spectrum

Decentralized prediction markets present fundamental challenges to traditional regulatory frameworks. These platforms exist on a spectrum of decentralization:

Fully Centralized (e.g., Kalshi): - Central operator controls all functions - Clear regulatory entity - Traditional enforcement tools apply

Hybrid (e.g., early Polymarket): - Decentralized settlement but centralized order book - Identifiable operator but decentralized infrastructure - Regulatory grey zone

Highly Decentralized (e.g., Augur v2, Gnosis conditional tokens): - Smart contracts execute autonomously - No single operator - Governance may be distributed across token holders

Fully Autonomous: - Immutable smart contracts - No governance or upgradeability - No identifiable operator

The degree of decentralization directly affects regulatory enforceability. For fully centralized platforms, existing regulatory tools work well. For highly decentralized protocols, regulators face novel challenges.

38.9.2 Can You Regulate Smart Contracts?

The question of whether and how governments can regulate smart contracts is one of the most debated issues in crypto-asset regulation:

Arguments That Smart Contracts Cannot Be Effectively Regulated: - Code deployed on public blockchains is immutable and cannot be "shut down" - Decentralized protocols have no central operator to serve with legal process - Users can access protocols through any internet connection, making geofencing impractical - The global, borderless nature of blockchain technology makes jurisdictional claims difficult

Arguments That Smart Contracts Can Be Regulated: - The humans who write, deploy, and govern smart contracts are subject to law - Front-end interfaces that make protocols usable can be regulated - DNS registrars, cloud hosting providers, and other infrastructure can be compelled to restrict access - On-chain analytics can identify users despite pseudonymity - Economic incentives (token value, exchange listings) create leverage for regulators

In practice, regulators have pursued a multi-pronged approach:

1. Direct enforcement against identifiable developers and operators
2. Infrastructure pressure on front-end hosts, DNS providers, and RPC endpoints
3. Financial chokepoints at fiat on-ramps and stablecoin issuers
4. Sanctions against specific smart contract addresses (as in the Tornado Cash case)

38.9.3 The Tornado Cash Precedent

The US Treasury Department's Office of Foreign Assets Control (OFAC) sanctioned the Tornado Cash smart contracts in August 2022, marking the first time a government sanctioned a piece of software rather than a person or entity.

For prediction markets, this precedent has enormous implications:

• OFAC could potentially sanction prediction market smart contract addresses
• US persons interacting with sanctioned contracts could face severe penalties
• Stablecoin issuers (like Circle for USDC) can freeze assets in sanctioned addresses
• The legal challenges to the Tornado Cash sanctions (the Van Loon v. Department of the Treasury case) will establish important precedent

38.9.4 DeFi-Specific Compliance Challenges

Decentralized prediction markets face unique compliance challenges:

38.10 Compliance Best Practices

38.10.1 KYC/AML Requirements

For centralized prediction market platforms operating in the US, compliance with the Bank Secrecy Act (BSA) and FinCEN regulations is mandatory. Key requirements include:

Know Your Customer (KYC): - Verify the identity of all customers at account opening - Maintain customer identification programs (CIP) - Conduct ongoing due diligence on customer activity - Apply enhanced due diligence (EDD) for higher-risk customers

Anti-Money Laundering (AML): - Implement a written AML compliance program - Designate a compliance officer - Conduct independent audits of AML controls - File Suspicious Activity Reports (SARs) for transactions that raise red flags - File Currency Transaction Reports (CTRs) for transactions exceeding $10,000

38.10.2 Geofencing

Platforms must restrict access from jurisdictions where they are not authorized to operate. Effective geofencing requires:

• IP address-based blocking: Block connections from IP addresses geolocated to restricted jurisdictions
• VPN detection: Identify and block connections from known VPN and proxy services
• Identity verification: Verify user identity documents to confirm jurisdiction of residence
• Ongoing monitoring: Continuously monitor for circumvention attempts

38.10.3 Record-Keeping

Regulatory compliance requires extensive record-keeping:

• All customer identification information (5-year retention minimum)
• Transaction records (5-year retention)
• Communications related to trading activity
• SAR and CTR filing records
• Compliance program documentation and audit results

38.10.4 Compliance Program Design

A well-designed compliance program for a prediction market platform includes:

1. Risk Assessment: Identify and evaluate risks specific to prediction markets (manipulation, insider information, gambling law exposure)
2. Policies and Procedures: Written policies covering KYC, AML, sanctions screening, market surveillance, and record-keeping
3. Training: Regular training for all employees on compliance obligations
4. Monitoring and Testing: Automated transaction monitoring, periodic compliance testing, and independent audits
5. Reporting: Procedures for filing SARs, CTRs, and other required reports
6. Governance: Clear reporting lines, compliance committee oversight, and board-level engagement

38.10.5 Python Compliance Checking Tools

A basic compliance checking framework can automate many routine compliance tasks. See code/example-01-compliance-checker.py for a full implementation that includes:

• Jurisdiction screening against a restricted list
• Sanctions screening against OFAC's SDN list
• Transaction monitoring for suspicious patterns
• KYC verification status tracking

The following pseudocode illustrates the core logic:

def check_compliance(user, transaction):
    """
    Multi-factor compliance check for a prediction market transaction.
    Returns (approved: bool, flags: list[str]).
    """
    flags = []

    # 1. Jurisdiction check
    if user.country in RESTRICTED_JURISDICTIONS:
        flags.append(f"BLOCKED: User in restricted jurisdiction {user.country}")
        return False, flags

    # 2. Sanctions screening
    if sanctions_match(user.name, user.identifiers):
        flags.append("BLOCKED: Potential sanctions match")
        return False, flags

    # 3. KYC status
    if not user.kyc_verified:
        flags.append("BLOCKED: KYC not completed")
        return False, flags

    # 4. Transaction monitoring
    if transaction.amount > LARGE_TRANSACTION_THRESHOLD:
        flags.append("FLAG: Large transaction - enhanced review required")

    if is_structuring_pattern(user.recent_transactions):
        flags.append("FLAG: Potential structuring detected")

    # 5. Position limits
    if exceeds_position_limit(user, transaction):
        flags.append("BLOCKED: Position limit exceeded")
        return False, flags

    return len([f for f in flags if f.startswith("BLOCKED")]) == 0, flags

38.11 Tax Implications

38.11.1 US Tax Treatment

The IRS has not issued specific guidance on the tax treatment of prediction market gains and losses. However, the general principles of tax law provide a framework:

Classification of Gains/Losses:

Prediction market contracts are most likely classified as Section 1256 contracts (regulated futures contracts) if traded on a CFTC-registered DCM, or as ordinary income/loss if classified as gambling winnings.

The Section 1256 classification is favorable for traders because it provides a blended tax rate: 60% of gains are taxed at the long-term capital gains rate (currently 20% for the highest bracket) and 40% at the short-term rate (up to 37%). This produces an effective maximum rate of approximately 26.8%, compared to the 37% maximum ordinary income rate.

Mark-to-Market. Section 1256 contracts are subject to mark-to-market taxation: unrealized gains and losses are recognized at year-end as if the contracts were sold at their fair market value on December 31. This means you may owe taxes on unrealized gains.

38.11.2 The Gambling vs. Investment Distinction

The tax treatment depends critically on whether prediction market activity is classified as gambling or investment:

If gambling: - Winnings are reported as "other income" on Line 8 of Schedule 1 - Losses are deductible only as itemized deductions and only to the extent of winnings - The Tax Cuts and Jobs Act of 2017 eliminated miscellaneous itemized deductions, making gambling loss deductions less valuable - Professional gamblers may deduct losses as business expenses on Schedule C

If investment: - Gains are capital gains (short-term or long-term) - Losses are deductible against gains plus up to $3,000 of ordinary income - Excess losses can be carried forward indefinitely - Section 1256 treatment provides the favorable 60/40 split

38.11.3 International Tax Considerations

For non-US participants, tax treatment varies significantly:

United Kingdom: Gambling winnings (including spread betting) are generally tax-free. If prediction markets are classified as gambling, UK users face no tax liability. However, if classified as financial derivatives, capital gains tax applies.

European Union: Tax treatment varies by member state. Some countries (e.g., Germany) tax capital gains on financial instruments at a flat rate. Others may classify prediction market gains as gambling income with different treatment.

Australia: Gambling winnings are generally not taxable for recreational gamblers. Professional gamblers may be subject to income tax on gambling profits.

38.11.4 Crypto-Specific Tax Issues

Blockchain-based prediction markets introduce additional tax complexity:

• Token conversion events: Converting fiat to crypto, crypto to outcome tokens, and outcome tokens back to crypto may each be taxable events
• DeFi interactions: Providing liquidity, claiming rewards, and governance participation may have tax implications
• Cost basis tracking: Tracking the cost basis of tokens across multiple platforms and wallets is challenging
• Foreign account reporting: Crypto held on foreign platforms may trigger FBAR (FinCEN Form 114) and FATCA (Form 8938) reporting requirements

38.11.5 Record-Keeping for Tax Purposes

Regardless of classification, meticulous record-keeping is essential:

• Date and time of every trade
• Contract description and market
• Entry price and exit price (or settlement value)
• Fees and commissions paid
• Running profit/loss calculations
• Deposits and withdrawals

See code/example-02-tax-calculator.py for a Python tool that calculates tax obligations under different classification scenarios.

38.12 The Future of Regulation

38.12.1 Trends Toward Acceptance

Several converging trends suggest that prediction market regulation is moving toward greater acceptance:

Demonstrated Social Value. The performance of prediction markets during the 2024 US presidential election cycle — where Polymarket and Kalshi provided more accurate forecasts than traditional polls — generated significant public attention and goodwill.

Academic Support. A growing body of academic research supports the informational value of prediction markets, including studies showing their superiority over polls, expert forecasts, and statistical models for many types of events.

Institutional Interest. Financial institutions, media organizations, and policy researchers increasingly cite prediction market prices as authoritative forecasts, creating institutional constituencies that favor legal prediction markets.

Bipartisan Political Support. Prediction markets have attracted support from both sides of the political aisle, with free-market advocates emphasizing market freedom and policy advocates emphasizing information quality.

38.12.2 CFTC Modernization

The CFTC is likely to continue modernizing its approach to event contracts:

• Formal rulemaking on event contract standards, including clear criteria for permissible and impermissible contracts
• Streamlined DCM applications for platforms focused on event contracts
• Technology-neutral regulation that accommodates both centralized and decentralized platforms
• International coordination with foreign regulators to address cross-border issues

38.12.3 Potential Federal Legislation

Congress has shown increasing interest in prediction market regulation:

• Bills have been introduced to create explicit legal frameworks for prediction markets
• The FIT21 legislation addresses CFTC/SEC jurisdictional boundaries
• Potential standalone prediction market legislation could provide regulatory certainty

A comprehensive federal prediction market statute might include:

1. Clear definition of permissible event contracts
2. Explicit federal preemption of state gambling laws for registered platforms
3. Consumer protection standards tailored to prediction markets
4. Tax treatment clarification
5. Safe harbors for academic and research use

38.12.4 Regulatory Sandboxes

Several jurisdictions have established or are considering regulatory sandboxes for innovative financial products:

• The UK's FCA sandbox has hosted fintech experiments, potentially including prediction market structures
• Singapore's MAS sandbox provides a controlled environment for testing novel financial products
• The US has no formal federal sandbox, but the CFTC's LabCFTC initiative serves a similar function

Regulatory sandboxes could accelerate prediction market innovation by allowing platforms to test new contract types and market structures under regulatory supervision without full compliance burdens.

38.12.5 The Path Forward

The future regulatory landscape for prediction markets will likely feature:

Short-term (2025-2027): - Expansion of Kalshi and other DCMs into new event categories - Implementation of MiCA for European crypto prediction markets - Continued enforcement against unregistered platforms - Initial regulatory sandbox experiments

Medium-term (2027-2030): - Potential federal legislation in the US - Greater international regulatory harmonization - Maturation of DeFi compliance tools (decentralized identity, zero-knowledge proofs) - Entry of traditional financial institutions into prediction markets

Long-term (2030+): - Prediction markets as an established asset class with comprehensive regulation - Integration with traditional financial markets infrastructure - Global regulatory standards for event contracts - Prediction market data formally recognized as a public good

38.13 Chapter Summary

This chapter has mapped the complex, multi-layered regulatory landscape governing prediction markets across the globe:

1. Regulation fundamentally shapes prediction markets — determining what markets exist, who can trade, and how platforms operate.

2. The CFTC is the primary US regulator of prediction markets, with jurisdiction grounded in the Commodity Exchange Act and the Dodd-Frank Act's event contract provisions.

3. The Kalshi election contracts case established that political event contracts are permissible under federal law when offered through a registered DCM.

4. PredictIt's rise and fall illustrates the precariousness of no-action relief and the importance of formal regulatory approval.

5. Securities law may apply to certain prediction market structures, particularly tokenized outcome shares and governance tokens.

6. State gambling laws present a patchwork of risk, with the skill-vs-chance debate remaining unresolved for prediction markets.

7. European regulation through MiCA creates a comprehensive framework for crypto prediction markets, with significant compliance requirements.

8. The global regulatory patchwork varies dramatically across jurisdictions, driving regulatory arbitrage and offshore platform migration.

9. Decentralized prediction markets present fundamental challenges to traditional regulatory frameworks, but regulators are developing new tools and approaches.

10. Compliance best practices include robust KYC/AML programs, geofencing, record-keeping, and proactive regulatory engagement.

11. Tax treatment remains uncertain, with different classifications (Section 1256, capital gains, gambling income) producing significantly different tax outcomes.

12. The future trend is toward greater acceptance, with CFTC modernization, potential federal legislation, and international harmonization on the horizon.

What's Next

In Chapter 39: Ethical Dimensions of Prediction Markets, we will examine the ethical questions that prediction markets raise — from the morality of profiting from tragedy to the social implications of commodifying uncertainty. While this chapter focused on what the law permits, the next chapter explores what prediction market participants should do, even when the law is silent.

Chapter 38 is part of Part VII: Regulation, Ethics & the Future. For the foundational concepts referenced in this chapter, see Chapter 5: Market Microstructure.