Prediction markets: What is their function, and how should we regulate them?
Right now, traders are pricing the odds that a Federal Reserve rate cut happens later this month, whether a particular drug will receive approval from the Food and Drug Administration, and if a nuclear deal with Iran will be reached by a certain date—and it’s all happening on prediction markets.
Prediction markets are straightforward in that they put a price on the probability of a future event rather than the price of a stock or a barrel of oil as in traditional financial markets. While the prevailing conversation on prediction markets pegs them as instruments for fun (or even harm), they do provide value by aggregating information, sharpening forecasts, and driving price discovery. Just like a stock exchange produces and prices a company’s value, prediction markets produce and price information.
Yet prediction markets have drawn scrutiny from lawmakers for a variety of reasons, including newsworthy cases of insider trading like President Trump’s teleprompter operator betting on what words he might say and a member of the U.S. Army wagering on the odds of Nicolas Maduro’s capture in the days before it occurred. While these controversies and concerns must be taken seriously, there’s another conversation to be had: What might these markets do for issues like geopolitical forecasting, macroeconomic policy, public health, and scientific research, and what might it cost us to regulate that value out of existence?
The value of prediction markets
Though prediction markets are new to the mainstream, the theories and research underpinning their existence are decades old. The primary theory is that information is reached more efficiently and more accurately when pooling both opinions and money, rather than opinions alone. The Iowa Electronic Markets (IEM), a small academic exchange at the University of Iowa run under special federal permission since 1992, has produced the best test of this theory. The IEM’s forecasting across five presidential elections and nearly 1,000 comparisons against national polls landed closer to the eventual outcome about three-quarters of the time, and was even more likely to be accurate the further out from Election Day the comparison is made. Beyond the IEM, economists who study these markets point to fairly consistent findings across decades of comparisons: Given the same question at the same time, a betting market is at least as accurate as a poll—and often more so.
The same logic extends elsewhere. Unlike the lag in the Fed’s own dot plot, a prediction market probability on a Fed rate decision updates by the second, granting easy, intuitive access to information that may also be more accurate than competing forecasting methods. Recent internal research from Kalshi, the largest prediction market in the United States, appears to support this theory as well.
But the benefits go beyond improved information aggregation. Because they’re derivatives, prediction markets let people transfer risk they would rather not hold to someone willing to bear it for a price. One argument from proponents is that these markets could be a hedge for businesses with exposure to a regulatory outcome or election in the same way a farmer hedges a wheat crop by selling futures.
What prediction markets get wrong
Despite their potential, certain aspects of prediction markets make lawmakers’ scrutiny understandable. For example, it’s hard to argue that contracts on celebrity gossip or sports outcomes provide much economic or societal value. Concerns surrounding addiction and poor financial choices are only amplified by some of the prediction markets’ advertising strategies.
Of course, this isn’t necessarily the bar for what should and should not be legal. Society allows plenty of things for which individuals must weigh the risk, even when the case for their value is weaker than the case against their harm. It’s essential to liberty and freedom that we hold steadfast to the idea that attempting to protect people from their own choices is not the proper role of government. Yet perception matters too—and it doesn’t do prediction markets any favors as far as credibility and legitimacy are concerned.
How prediction markets are regulated today
The Commodity Futures Trading Commission (CFTC) claims exclusive jurisdiction over prediction-market event contracts as federally regulated derivatives under the Commodity Exchange Act. Their oversight comes from Regulation 40.11, which allows the CFTC to prohibit contracts involving war, terrorism, assassination, unlawful activity, or gaming. However, two major issues prevail. First, gaming is left conspicuously undefined, which has been interpreted by the CFTC to allow sports gambling, resulting in many of the contracts lawmakers are most keen to scrutinize. Second, prediction markets are allowed to “self-certify” their contracts, which means no prior CFTC approval is needed to list a contract or event. The stated purpose of this is to enable the products to reach the market quickly. This retrospective approach produced few denials despite some submissions lacking necessary details, leading the CFTC to update its guidance. Some contracts, like those on mention markets–an event contract which pays out when a specific word or phrase is spoken in a public setting, like the Trump teleprompter incident–have been pulled after facing public scrutiny.
However, the CFTC recently closed an advance notice of proposed rulemaking comment period that seeks to update the 40.11 regulation by replacing the discretionary standard with a structured three-step review, defining what gaming actually means, and establishing retail consumer-protection requirements.
How states and the courts are responding
More than a dozen states have issued cease-and-desist orders, filed lawsuits, and even brought criminal charges against a prediction market. New York is seeking $36 billion from Kalshi in state court, arguing that the company is running an unlicensed gambling operation. The Wisconsin Elections Commission has warned residents that placing a bet on an election could cost them their right to vote in that election under a statute dating to 1849. Whatever the state’s views of prediction markets, infringing on a citizen’s right to vote over a financial position is a dangerous precedent that is sure to be met with legal backlash. The CFTC has already sued nine other states to block their enforcement actions.
Meanwhile, federal courts have split. Most recently, on Aug. 28, a unanimous three-judge Ninth Circuit panel sided with the state of Nevada against Kalshi, ruling that federal commodities law does not preempt the state’s authority to regulate Kalshi’s sports contracts under its gambling laws. This directly contradicts the Third Circuit’s earlier ruling for Kalshi in New Jersey. With two circuits in conflict and roughly 20 states involved in active litigation, federal Supreme Court review is likely.
How states could impact the market
Prediction markets are here, and in today’s digital world, state lawmakers can’t force them out of existence. However, they can harm the market enough to diminish their value. If event contracts are regulated state-by-state as gambling products, the compliance burden alone could push platforms to abandon smaller or lower-margin markets first, such as policy- and science-forecasting contracts, which currently generate less trading volume but more public value.
A patchwork of state regulations will also create a fragmentation problem in what is currently a national market. Compliance under potentially 50 different (and likely conflicting) regulations would diminish the aggregated information and drive away real price discovery, causing distortion in the markets, making them less accurate, less useful, and less fair for users as distortions cloud accuracy.
There’s also the risk of driving prediction markets to overseas exchanges. Pushing these platforms and activities offshore won’t reduce manipulation risk or protect consumers; it just moves both out of the reach of any regulator—state or federal.
But beyond that, there is no reason to believe that a patchwork of state regulations is more capable of providing appropriate guardrails (e.g., no contracts on terrorism) or consumer protections than a single federal standard, which ensures uniformity for all market participants.
An appropriate federal framework
Prediction markets should be regulated under a federal framework that sets clear guardrails and considers the primary issues clouding the markets, thereby preempting a patchwork of inconsistent state rules. But the CFTC must sharpen its own rules to help build market legitimacy; ensure markets are fair and not subject to manipulation; prioritize consumer protections; and consider whether certain contracts invoke a clear, demonstrable societal harm.
A single, credible federal standard would do more for consumer protection and market integrity than 50 separate legal theories and build the public trust these markets need to reach their full potential.
Prediction markets are only the latest in a long history of financial innovation in the United States. Almost every new instrument, such as stock futures and interest rate swaps, drew scrutiny before settling into ordinary use. Mistakes will be made along the way, just like in every market that has ever existed. But mistakes are an expected part of innovation, not evidence that the product should not exist. The question worth considering isn’t whether prediction markets are a perfect product. It’s whether the country will treat them the way it has treated financial innovation in the past—as an opportunity either to build the rules around something useful or to extinguish their value out of fear.