Risk Markets And Politics

Wednesday, May 28, 2008

The CFTC safe-harbor option for event markets

The recommendation for safe-harbor of a group of influential economists to the CFTC aims squarely at the 4(c)3(K)* clause of the Commodity Exchange Act. The CFTC may approve a public interest exemption under 4(c) provided that the affected contracts are traded only between "appropriate persons". 4(c)3(K) is the only qualification that would accommodate "retail" trading in the style of IEM, allowing, "Such other persons that the Commission determines to be appropriate in light of their financial or other qualifications, or the applicability of appropriate regulatory protections." Regarding "other qualifications", the economists recommend:
"that three types of entities be eligible for safe harbor treatment. The first would be not-for-profit research institutions, including universities, colleges, and think tanks wishing to operate exchanges similar to the Iowa Electronic Markets. The second would be government agencies seeking to do research similar to that of nongovernmental research institutions. The third group would consist of private businesses and not-for-profits that are not primarily engaged in research, which would only be allowed to operate internal prediction markets with their employees or contractors.

Regarding the applicability of regulatory protections, the economists recommend that such markets should be limited to small-stakes, low-fee contracts. This limitation addresses consumer protection because the CFTC is typically much less interested in non-levered transactions, and there is little chance of being able to manipulate a market with a small-stakes account. Possibly, consumer protection measures could completely satisfy 4(c)3(K).

The safe-harbor proposal looks like an expedient option that would avoid the problems of treating event markets as excluded commodities (or exempt commodities), which were touched on last time. One problem the CFTC faces is selecting a principle that would include only markets that pass an economic purpose test within their jurisdiction, and the safe-harbor proposal avoids this problem. Although there doesn't seem to be anything in the CEA to indicate that an exempted market could possibly lie outside the agency's jurisdiction, Congress has determined - significantly - that, "Rather than making a finding as to whether a product is or is not a futures contract, the Commission in appropriate cases may proceed directly to issuing an exemption."

Arguably, if someone were to set-up non-profit small-stakes exchanges similar to the ones the economists describe, they would not need CFTC safe-harbor anyway - especially if they restrict trading to States where the predominant factor test applies. Safe-harbor would, however, allow for exchange profits.

I believe that a combined approach would work best. Treating event markets as excluded commodities would not contradict granting some exchanges public interest safe-harbors, which would especially be appropriate if they wanted to host markets like research science claims, where a trader might be in control of the outcome. Exchanges seeking to host larger stake markets useful for hedging could do so with a trading prohibition for people who might be in control of the outcome. From the CFTC's perspective, the safe-harbor would be a less complicated option with regard to their jurisdictional scope. Ultimately, statutory clarification is needed.

* This section is listed 7 USC 1, section 6(c) here.


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