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.

The gambling laws in the United States, as in many other countries, are a hodgepodge of inconsistent and hypocritical provisions. First, most of the laws are at the state level, not the federal level, so a true understanding requires familiarity with fifty different sets of rules. But even at the federal level, the picture is murky, convoluted, and full of seemingly nonsensical exceptions.

So what is currently legal?

Here are some forms of gambling that are legal in the US:

• Betting on horse races
• Betting on Jai Alai in Florida
• Betting on other sports (e.g., professional football, college basketball, …) in Nevada
• Betting on roulette, craps, slot machines, and other “unwinnable” casino games in Nevada, Atlantic City, riverboat casinos, Detroit, American Indian reservations, and other specially designated places
• Betting in state-run lotteries (which, incidentally, usually have a much larger “house edge” than any casino game)
• Betting in “skill-based money tournaments” in most states (see below)
• Betting in financial markets: Betting on stocks, options, futures, derivatives, “hedgelets”, and other financial instruments officially sanctioned by either the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC)
• Betting on presidential elections in the Iowa Electronic Markets
• Betting for insurance purposes: Betting on death, injury, theft, etc.

Yet casino gambling and sports betting are illegal in most of the country, and gambling on the Internet is illegal — well, sort of. MSNBC has an “oldie but goodie” special report on online gambling, which includes an article about the murky legal waters of online gambling.

The central question — whether Internet gambling is legal, illegal or exists in a legal nether world where no rules apply — is as gray as lawyers can make it.

(Aside: The same special report also includes articles on the rise of betting exchanges, and opportunities for arbitrage.)

Examples: Companies surviving on the edge

Here are some examples of US-based companies that are successfully navigating the murky legal waters. Some of these companies’ operations seem to teeter on the edge of what the gambling laws say is legal and what is not.

The Ticket Reserve and YooNew both allow sports fans to purchase tickets to important playoff games (e.g., the US NFL Super Bowl) contingent on their favorite team making it to the game. So, for example, a “Steelers Super Bowl ticket forward” entitles its owner to a ticket to the Super Bowl if and only if the Steelers are one of the two final teams that play in the Super Bowl, but is worthless if the Steelers do not make it to the Super Bowl. This is a brilliant idea: most fans value attending a big playoff game much more highly if their favorite team is playing in the game. Once a “ticket forward” is purchased, it can be sold via an exchange back to another fan at a profit or loss. The price of a “Steelers Super Bowl ticket forward” of course is intimately related to the odds of the Steelers making it to the Super Bowl, so in theory a gambler can use the TicketReserve or YooNew as an alternate betting exchange, without any intention of keeping the ticket and going to the game. These two companies have very carefully and (so far) successfully distanced themselves from the stigma and legal headaches of US gambling laws. Still, they are sufficient close to “the edge” that I doubt many large companies would take such a risk; both The Ticket Reserve and YooNew are small startups. (Aside: rumor has it that YooNew uses Robin Hanson’s logarithmic market scoring rule market maker for pricing.)

WorldWinner is another company that has successfully navigated the legal boundaries. WorldWinner was originally a US-based company, now owned by the international company Fun Technologies, and at least at one point was featured on Yahoo! Games (Internet Archive of Y!Games circa 2004). WorldWinner collects entry fees from players and pays out money to winners of various tournament-style games, including some clearly designed to resemble common casino games, like “Catch-21” (resembles blackjack) and “Royal Flush” (resembles poker). So how do they operate legally in the US? They work hard to be able to claim that their games are games of skill, not games of chance or luck. Most US states allow these “skill-based money tournaments”, but not all. Another interesting special case are companies that insure challenge prizes like those often featured at halftime of major sporting events.

HedgeStreet is one of the few companies that has trudged down the lengthy, costly, and arduous path of obtaining official sanction from the US Commodity Futures Trading Commission (CFTC). This is the safest route for any new prediction market company, as a CFTC license immediately overrides the fifty states’ varied and convoluted gambling laws. But HedgeStreet often seems to emphasize speculation as opposed to hedging in their advertisements, information collateral, and choice of contracts (e.g., short-term instead of long-term housing prices). Reportedly InTrade (the non-sports arm of TradeSports) is attempting to go down the same path toward CFTC approval. I wonder if the new anti-gambling climate will adversely effect their chances of approval. The Iowa Electronic Markets have a “no action” letter from the CFTC allowing them to operate, but that is a special case unlikely to be repeated having to do with the university’s academic status and a $500 max investment limit. US-based Cantor Fitzgerald is the parent company of UK spread betting firm Cantor Index (which in turn owns the play-money Hollywood Stock Exchange). The main difference (legally speaking) between Cantor Index, BetFair, and TradeSports, is that while Cantor Index and BetFair appear to take pains to lock out US-based bettors, TradeSports seems to specifically target the US audience by listing US-centric contracts and actively seeking exposure in US press outlets. Certainly there are other companies I’ve missed that are interesting test cases for US gambling laws.

What’s the lesson? Although the waters are murky, there are some innovative companies that are so far successfully staying on the good side of the myriad prosecutors, regulators, and lawmakers putting up barriers. Let’s encourage and support these companies, and thank them for blazing trails for the rest of us. At the same time, let’s push for clearer, saner, and less restrictive laws. More on this last point in the next post.