In the wake of US authorities arresting two executives of prominent European online gambling companies, and the surprise passage of the Unlawful Internet Gambling Enforcement Act of 2006, the shares of publicly-traded online gambling firms with large US exposure are down 50% or more. Now these companies are selling off their US operations for as little as $1. And it’s not just offshore gambling execs and shareholders who are worried. Many people are lamenting the seemingly dulled prospects of operating real-money prediction markets in in the United States.

In the previous post, I discussed what is legal in the US and what is not. In this post, I’d like to explore the pros and cons of different strategies for carving out a legal niche for prediction markets.

My personal opinion, and likely the opinion of many readers, is that gambling should be legal in the US as a matter of personal freedom, and that the US should follow the lead of the UK in legalizing, regulating, and taxing online gambling. However, as a practical matter we cannot hope for anything close to blanket legalization anytime in the foreseeable future. Here are four less sweeping approaches to drawing the legal boundaries, some more realistic than others.

1. Economic Purpose Vs. Entertainment
   Robert Hahn and Paul Tetlock have written an excellent op ed in the New York Times calling for special legal distinction for prediction markets apart from gambling laws. They propose an “economic purpose test”, which would legalize prediction markets that have some economic value: either value as an instrument for hedging risk, or “information” value as a predictor of outcomes of significant economic consequence. Hahn and Tetlock argue that presidential betting would pass their economic purpose test, and that sports betting would not pass their test. However, one can argue that sports teams, local sports bars, and even city governments could use sports betting markets to hedge risk. I believe that, as a practical matter, sports betting would simply have to be called out as an exception in any such test.
2. Skill-Based Vs. Chance-Based
   One argument is to draw the legal lines to outlaw pure chance-based games with a proven mathematical house edge that cannot be overcome. Roulette, craps, lotteries, and other common casino games fall into this category. The flipside would be to argue that any game that might allow a mathematical edge to a player with superior information or superior strategy should be allowed. Sports betting, poker, and, of course, prediction markets fall into this category. There is some precedent for allowing skill-based “gambling” games in many US states, as discussed in the previous post.
3. Exchanges Vs. Bookies
   Another argument is to distinguish the new betting exchanges from more traditional bookies. Betting exchanges, like BetFair and TradeSports, simply provide a central marketplace for people to trade bets with one another. They collect transaction fees, but their profit does not depend at all on which side of a bet wins or loses. In contrast, bookies can end up with imbalanced exposure and may stand to gain or lose depending on the outcome of the bet. Also, bookies effectively enforce an artificially large bid-ask spread (often operationalized as a “vig” or tax on winnings) to ensure their profitability, while exchanges do not. Executives at TradeSports argue that these distinctions put them in safer legal territory than more typical online gamling operations. I’m not sure that US prosecutors would agree. The argument can sound like Napster’s argument that they were not directly responsible for users of their service who were violating the law.
4. Investment Caps or Investor Qualifications
   One might argue that by enforcing strict investment limits, say $500 per person, the risk to problem gamblers is sufficiently minimized. This is part of the “no action” agreement between the Commodity Futures Trading Commission (CFTC) and the Iowa Electronic Markets. An almost opposite approach, but with similar motivation, is to limit participation to individuals with a very large net worth (e.g., millions of dollars). This is the legal cover that many hedge funds use: the supposition is that these individuals “know what they’re doing”, understand the risks, and have enough money to survive the inevitable ups and downs. The CFTC weilds a lighter regulatory hand on exchanges that cater only to the super rich.

In my opinion, although all the above arguments make some sense, the only one with any chance of actually gaining ground in the current legal and political environment is the first one (the “economic purpose test”), perhaps with the additional cover of a low investment cap and special exceptions ruling out sports betting and other stigmatized topics. Many people in the US, including lawmakers, still harbor outdated notions that gambling is a religious sin or has the taint of organized crime. If prediction market advocates want to make progress toward legalization, I believe they will have to distance themselves from gambling and sports betting. Although there is no logical distinction between betting on sports and trading contingent contracts, there is a very real social, political, and legal distinction. Though it can seem unpalatable to support gray and illogical distinctions, the unfortunate reality is that gray and illogical distinctions are the only ones with any practical chance of becoming law.