Chapter 38 Quiz: The Regulatory Landscape

Question 1

What is the primary federal agency in the United States with jurisdiction over prediction market event contracts?

(a) The Securities and Exchange Commission (SEC)
(b) The Commodity Futures Trading Commission (CFTC)
(c) The Federal Trade Commission (FTC)
(d) The Financial Crimes Enforcement Network (FinCEN)

Answer: (b)

Explanation: The CFTC has primary jurisdiction over event contracts under the Commodity Exchange Act, as amended by the Dodd-Frank Act Section 745. The CFTC oversees derivatives markets including futures, options, swaps, and event contracts. While the SEC may have jurisdiction over certain tokenized prediction market products that qualify as securities, and FinCEN oversees AML compliance, the CFTC is the primary regulator for the contracts themselves.

Question 2

Which section of the Dodd-Frank Act specifically addresses event contracts?

(a) Section 619 (the Volcker Rule)
(b) Section 745
(c) Section 929
(d) Section 1502

Answer: (b)

Explanation: Section 745 of the Dodd-Frank Act added new Section 5c(c)(5)(C) to the Commodity Exchange Act, giving the CFTC explicit authority over event contracts and the power to determine that certain event contracts are contrary to the public interest.

Question 3

Which of the following is NOT one of the specific categories where the CFTC may restrict event contracts under Dodd-Frank?

(a) Terrorism
(b) Assassination
(c) Sports outcomes
(d) Activity unlawful under state or federal law

Answer: (c)

Explanation: The statute specifically identifies terrorism, assassination, war, gaming (overlapping with gambling law), activity unlawful under law, and a catch-all "contrary to public interest" category. Sports outcomes are not specifically listed, though they might fall under the "gaming" category or state gambling law restrictions.

Question 4

What regulatory status must a platform obtain from the CFTC to legally offer event contracts in the US?

(a) Money Services Business (MSB) registration
(b) Broker-Dealer registration
(c) Designated Contract Market (DCM) registration
(d) Swap Execution Facility (SEF) registration

Answer: (c)

Explanation: To legally offer event contracts in the US, a platform must register as a Designated Contract Market (DCM). This is the same regulatory status held by major exchanges like CME and ICE. DCM registration requires self-regulatory capability, financial resources, system safeguards, compliance programs, and market surveillance capabilities.

Question 5

What was the key outcome of the Kalshi v. CFTC case regarding election event contracts?

(a) The court ruled that all event contracts are unconstitutional
(b) The court ruled that the CFTC has unlimited discretion to ban any event contract
(c) The court ruled that political event contracts could not be categorically excluded as "gaming"
(d) The court ruled that prediction markets are gambling and should be regulated by states

Answer: (c)

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

Question 6

PredictIt's CFTC no-action letter was issued to which entity?

(a) PredictIt, Inc.
(b) Aristotle International, Inc.
(c) Victoria University of Wellington
(d) The University of Iowa

Answer: (c)

Explanation: The CFTC no-action letter was issued to Victoria University of Wellington, a New Zealand academic institution, reflecting the academic research framing of the platform. The letter was not issued to PredictIt directly, which had important legal implications.

Question 7

Which prong of the Howey test is most likely to prevent traditional prediction market contracts from being classified as securities?

(a) Investment of money
(b) Common enterprise
(c) Expectation of profits
(d) Derived from the efforts of others

Answer: (d)

Explanation: The "efforts of others" prong is the weakest for prediction market classification as securities. In a prediction market, profit or loss depends on the occurrence of an external event, not on the managerial efforts of a third party. This distinguishes prediction market contracts from traditional investment contracts.

Question 8

Under the "predominant purpose test" for gambling classification, what must be shown?

(a) That any element of chance is involved
(b) That the outcome is determined predominantly by skill or by chance
(c) That chance is a material element of the outcome
(d) That the activity is licensed by a state gambling commission

Answer: (b)

Explanation: The predominant purpose test, used by a majority of states, asks whether the outcome is determined predominantly by skill or by chance. Under this test, prediction markets have a reasonable argument for skill predominance, since successful trading requires information analysis, probability assessment, and risk management.

Question 9

What is MiCA?

(a) A US federal law regulating cryptocurrency
(b) The EU's Markets in Crypto-Assets Regulation
(c) A CFTC rule on market integrity and compliance assessment
(d) A Japanese cryptocurrency exchange licensing framework

Answer: (b)

Explanation: MiCA (Markets in Crypto-Assets Regulation) is the European Union's comprehensive crypto-asset regulatory framework, which came into full effect in December 2024. It establishes licensing requirements for crypto-asset service providers, stablecoin regulation, white paper requirements, and market abuse provisions.

Question 10

Under MiCA, what license must platforms facilitating trading in crypto-assets obtain?

(a) EMI (Electronic Money Institution) license
(b) CASP (Crypto-Asset Service Provider) authorization
(c) MiFID II investment firm license
(d) PSD2 payment institution license

Answer: (b)

Explanation: Under MiCA, platforms that facilitate trading in crypto-assets must obtain CASP (Crypto-Asset Service Provider) authorization from the competent authority in at least one EU member state. This authorization can then be passported across the EU.

Question 11

What action did OFAC take against Tornado Cash in August 2022 that has implications for decentralized prediction markets?

(a) Issued a cease-and-desist letter to the developers
(b) Sanctioned the smart contract addresses themselves
(c) Froze all USD stablecoin reserves
(d) Imposed personal sanctions on all users

Answer: (b)

Explanation: OFAC sanctioned the Tornado Cash smart contract addresses, marking the first time a government sanctioned a piece of software rather than a person or entity. This precedent has enormous implications for decentralized prediction markets, as OFAC could potentially sanction prediction market smart contract addresses.

Question 12

What is the favorable tax treatment available for Section 1256 contracts?

(a) Tax-free treatment for the first $10,000 of gains
(b) 60% long-term / 40% short-term capital gains split regardless of holding period
(c) Flat 15% tax rate on all gains
(d) Gains are tax-deferred until withdrawal

Answer: (b)

Explanation: Section 1256 contracts receive the 60/40 split: 60% of gains are taxed at the long-term capital gains rate and 40% at the short-term rate, regardless of how long the contracts were actually held. This produces a maximum effective rate of approximately 26.8%, compared to 37% for ordinary income.

Question 13

If prediction market gains are classified as gambling income, how are losses treated for tax purposes?

(a) Losses are fully deductible against all income
(b) Losses are deductible only to the extent of gambling winnings
(c) Losses are not deductible at all
(d) Losses can be carried forward for 5 years

Answer: (b)

Explanation: Under gambling treatment, losses are deductible only as itemized deductions and only to the extent of gambling winnings. This is less favorable than investment treatment, where losses can offset gains plus up to $3,000 of ordinary income, with excess losses carried forward indefinitely.

Question 14

What was the outcome of the CFTC's 2022 enforcement action against Polymarket?

(a) Polymarket was shut down permanently
(b) Polymarket paid a $1.4M settlement and blocked US users
(c) Polymarket was granted a no-action letter
(d) Polymarket registered as a DCM

Answer: (b)

Explanation: In 2022, Polymarket settled with the CFTC for $1.4M for operating an unregistered facility. As part of the settlement, Polymarket blocked US users and restructured its operations to serve non-US users from outside the United States.

Question 15

Which Australian regulator imposed a product intervention order banning binary options for retail clients?

(a) APRA (Australian Prudential Regulation Authority)
(b) ASIC (Australian Securities and Investments Commission)
(c) ACCC (Australian Competition and Consumer Commission)
(d) RBA (Reserve Bank of Australia)

Answer: (b)

Explanation: ASIC imposed a product intervention order banning the issuance and distribution of binary options to retail clients. Since most prediction market contracts are structured as binary options, this ban has significant implications for prediction market platforms seeking to serve Australian users.

Question 16

What is the primary argument for federal preemption of state gambling laws for CFTC-registered prediction market platforms?

(a) The First Amendment protects prediction markets as free speech
(b) The Commerce Clause gives Congress exclusive authority over interstate markets
(c) The Commodity Exchange Act contains a broad preemption provision
(d) The Supremacy Clause automatically preempts all state financial regulation

Answer: (c)

Explanation: The CEA contains a broad preemption provision that may preempt state gambling laws for CFTC-registered platforms. The argument is that if a platform is operating as a registered DCM under federal law, state gambling restrictions should not apply to its federally regulated activities. However, this application to event contracts specifically is largely untested.

Question 17

Which of the following is a requirement for DCM registration with the CFTC?

(a) Minimum $1 billion in assets under management
(b) Self-regulatory capability including market surveillance
(c) Approval from the Federal Reserve
(d) Listing on a major stock exchange

Answer: (b)

Explanation: DCM registration requires self-regulatory capability (the exchange must monitor its own markets, enforce rules, and conduct surveillance), along with financial resources, system safeguards, compliance programs, market surveillance, and customer protection measures including segregation of customer funds.

Question 18

How does the UK FCA's approach to crypto-derivatives affect prediction markets?

(a) The FCA encourages crypto-derivative innovation
(b) The FCA has banned the sale of crypto-derivatives to retail consumers
(c) The FCA has no authority over crypto-derivatives
(d) The FCA requires only basic registration for crypto-derivatives

Answer: (b)

Explanation: The FCA has banned the sale of crypto-derivatives (including binary options) to retail consumers. This ban likely encompasses many prediction market products, creating a challenging environment for prediction market platforms in the UK.

Question 19

What is a no-action letter in the CFTC context?

(a) A formal approval to operate as a DCM
(b) A written statement that staff will not recommend enforcement action for a specific activity
(c) A permanent exemption from the Commodity Exchange Act
(d) A court order prohibiting the CFTC from taking enforcement action

Answer: (b)

Explanation: 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, do not create legal precedent, can be withdrawn at any time, and apply only to the named recipient.

Question 20

In the context of DeFi prediction markets, which of the following is NOT a viable regulatory enforcement strategy?

(a) Direct enforcement against identifiable developers
(b) Pressure on front-end hosting providers
(c) Shutting down the underlying blockchain network
(d) Sanctions against specific smart contract addresses

Answer: (c)

Explanation: Shutting down a public blockchain network like Ethereum is not a viable enforcement strategy because these networks are decentralized and operated by thousands of independent nodes globally. However, regulators can pursue direct enforcement against developers, pressure front-end hosts and DNS providers, use financial chokepoints at fiat on-ramps, and sanction specific contract addresses.

Question 21

Under Indian law, how have "opinion trading" platforms positioned their products?

(a) As regulated financial derivatives under SEBI oversight
(b) As games of skill rather than gambling
(c) As insurance products regulated by IRDAI
(d) As peer-to-peer lending products

Answer: (b)

Explanation: Indian opinion trading platforms (like Probo and MPL Opinio) often argue they offer games of skill rather than gambling, leveraging India's legal distinction between the two. This classification allows them to operate in states where games of skill are permitted, even when gambling is restricted.

Question 22

What is "regulatory arbitrage" in the context of prediction markets?

(a) Using prediction markets to bet on regulatory outcomes
(b) Locating in a jurisdiction with favorable regulations while serving users globally
(c) Exploiting price differences between regulated and unregulated markets
(d) Arguing that multiple regulations apply to avoid any single one

Answer: (b)

Explanation: Regulatory arbitrage is the practice of locating a platform in a jurisdiction with minimal or favorable regulations while serving users globally. This has driven significant prediction market activity to offshore platforms, creating a tension where stricter regulation leads to more offshore migration, which reduces consumer protection.

Question 23

Which of the following best describes mark-to-market taxation for Section 1256 contracts?

(a) Taxes are deferred until the contract expires
(b) Unrealized gains and losses are recognized at year-end as if contracts were sold at fair market value
(c) Only realized gains are taxed, at a flat rate
(d) Taxes are calculated based on the average market price over the holding period

Answer: (b)

Explanation: Section 1256 contracts are subject to mark-to-market taxation, meaning 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 traders may owe taxes on unrealized gains even if they have not closed their positions.

Question 24

What key condition of PredictIt's no-action letter limited individual investment amounts?

(a) $100 per contract
(b) $500 per market
(c) $850 per contract position
(d) $5,000 total account balance

Answer: (c)

Explanation: PredictIt's no-action letter capped individual positions at $850. This low limit, combined with the trader cap (originally 5,000), was designed to ensure the platform operated at a small scale consistent with its academic research purpose.

Question 25

Which of the following trends is NOT identified in the chapter as supporting greater regulatory acceptance of prediction markets?

(a) Demonstrated accuracy of prediction markets relative to polls in the 2024 elections
(b) Growing academic research supporting their informational value
(c) Universal agreement among state attorneys general that prediction markets are legal
(d) Bipartisan political support for prediction markets

Answer: (c)

Explanation: There is no universal agreement among state attorneys general about the legality of prediction markets. In fact, state-level enforcement actions have been taken against some platforms. The other three factors (demonstrated accuracy, academic support, and bipartisan political support) are all identified in the chapter as trends supporting greater acceptance.