CFTC, 5th Circuit Upend The Future Of Prediction Markets – Commodities/Derivatives/Stock Exchanges
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CFTC, Fifth Circuit Upend the Future of Prediction
Markets1
The Commodity Futures Trading Commission (CFTC) recently issued
an order disapproving the listing of a political event contract
self-certified by a designated contract market (DCM). This was a
long-awaited decision in an ongoing debate within and outside the
CFTC regarding the future of federally regulated political event
contracts. These issues are not new; they have been present and
before the CFTC for more than a decade. However, this recent CFTC
disapproval comes just after the Fifth Circuit Court of Appeals
issued a related and important opinion regarding the operation of a
political event contract market pursuant to long-standing CFTC
no-action relief.
Taking all this together, the future appears grim for
CFTC-regulated political event contracts. While CFTC staff have
permitted these markets to exist in a semi-regulated environment
for a decade pursuant to a no-action letter relief,2
these recent actions suggest that the CFTC will continue to take
steps to limit—or eliminate—the existence of
CFTC-regulated political event contracts as derivatives, even if
the Fifth Circuit’s recent decision delays the CFTC’s
goals temporarily.
This alert summarizes these two recent developments and their
potential implications for future event contract markets, as well
as the scope of the CFTC’s anti-fraud and anti-manipulation
authority (which comes up frequently in the digital asset spot
market context). We also analyze the potential impact on the
CFTC’s practices with respect to staff no-action letters
after the Fifth Circuit decision.
Kalshi Disapproval of Congressional Control of Political
Event Contracts
On Friday, September 22, 2023, the CFTC issued an order
disapproving a certification by KalshiEX LLC pursuant to CFTC
Regulation 40.2 (the Order).3 The original submission,
filed June 12, 2023, related to a contract that allowed
participants to take positions on which political party would
control the US House of Representatives and which would control the
US Senate (Congressional Control Contracts).
Specifically, the Kalshi contract was a “cash-settled,
binary (yes/no) contracts based on the question: ‘Will be
controlled by for
?’” Upon settlement, the winning side
of the contract would be paid, and no payment would be made to the
counterparty that selected the minority political party.
On June 12, 2023, Kalshi certified that the listing complied
with the Commodity Exchange Act (CEA) and CFTC regulations.
However, a self-certification pursuant to CFTC Regulation 40.2 does
not entail or amount to CFTC approval of that product. On June 23,
2023, the CFTC commenced a review of the Congressional Control
Contracts, which included a public comment period that yielded
1,378 comments. In announcing the review and public comment period,
the CFTC indicated that the Congressional Control Contracts may
involve, relate to or reference an activity enumerated in CFTC
Regulation 40.11 and CEA section 5c(c).
CFTC Regulation 40.11 provides that DCMs “shall not list
for trading or accept for clearing” any contract based on an
excluded commodity, as defined in CEA section 1a(19)(iv), that
“involves, relates to, or references terrorism,
assassination, war, gaming, or an activity that is unlawful under
any State or Federal law.” CFTC Regulation 40.11 also
prohibits contracts that the CFTC determines “to be contrary
to the public interest.”
In disapproving the contracts, the CFTC concluded that:
- the Congressional Control Contracts involve gaming and activity
that is unlawful under State law; and - the Congressional Control Contracts are contrary to the public
interest.
In the Order, the CFTC explains:
- The Congressional Control Contracts “involved”
gaming, which is a prohibited category of commodity under CEA
Section 1a(19) because “taking a position in the
Congressional Control Contracts would be staking something of value
upon the outcome of a contest of others.”The Order includes a lengthy analysis about the use of the word
“involve,” as opposed to “based on” or
“based upon.” The CFTC notes that “involve”
means “to relate to or affect” or “to relate
closely” in connection with an enumerated activity (in this
case, gaming), while “based on” refers to an underlying
reference entity (such as an agricultural commodity). In a
footnote, the CFTC also analyzes the word “involve,”
citing a 2010 Senate floor colloquy between Senator Dianne
Feinstein and Senator Blanche Lincoln, then-chair of the Senate
Agriculture Committee. Senator Lincoln stated that the provision
ultimately enacted as CEA section 5c(c)(5)(C) “was intended
to ‘prevent gambling through futures markets’
and to restrict exchanges from ‘construct[ing] an
‘event contract’ around sporting events such as the
Super Bowl, the Kentucky Derby, and Masters Golf
Tournament.’”4 - The Congressional Control Contracts would involve
“activity that is unlawful under . . . State law,”
pursuant to CEA section 5c(c)(5)(C)(i) and CFTC Regulation
40.11(a)(1) because taking a position in the Congressional Control
Contracts would be staking something of value upon the outcome of
contests between electoral candidates, and in many states such
conduct is illegal.5The CFTC notes that “a common thread throughout the large
majority of definitions of ‘gaming’ and
‘gambling’ is the act of staking something of value on
the outcome of a contest of others.”6 The CFTC
explains that the Congressional Control Contracts involve
“wagering” on election outcomes, which is unlawful
activity in a number of states.7 The CFTC dismisses
Kalshi’s argument that CFTC approval would preempt certain
state laws by concluding that permitting this activity on a DCM
“would undermine important state interests expressed in
statutes separate and apart from those applicable to trading on a
DCM.”8 The Order also sets forth why an election
is a “contest” and that “it is common parlance to
refer to elections as contests,” citing an article in the
Washington Post and state gaming statutes.9 - The Congressional Control Contracts could not reasonably be
expected to be used for hedging and/or price basing on more than an
occasional basis, and the Congressional Control Contracts could not
reasonably be expected to be used predominantly by market
participants having a commercial or hedging interest.10The CFTC distinguishes between traditional futures contracts
that “have not been premised on the outcome of a contest of
others” but rather “have served hedging and risk
management functions, and have therefore been designed to correlate
to direct and quantifiable changes in the price of commodities or
other financial assets or instruments.”11The CFTC further explains that other event contracts, such as
Kalshi’s Heating and Cooling Degree Day futures contracts and
real estate index contracts, “generally have more specific
and targeted hedging utility than the Congressional Control
Contracts.” The CFTC also identifies material differences
between those contracts, such as settlement calculation
information.12 - The Congressional Control Contracts are not in the public
interest and could potentially be used in ways that would have an
adverse effect on the integrity of elections or the perception of
integrity of elections—for example, by creating monetary
incentives to vote for particular candidates, even when such votes
may be contrary to a voter’s (or an organized group of
voters’) political preferences or views of such
candidate.13 - Unlike with other “underlying” markets, such as
traditional agricultural or energy markets, in its role as the
regulator of the Congressional Control Contracts, the CFTC would be
required to investigate suspected manipulation in election-related
activities—potentially including the outcome of an election
itself, which is not a role for which the CFTC is
equipped.14
In rejecting the Congressional Control Contracts, CFTC Chairman
Rostin Behnam noted his concern in extending the CFTC’s
authority beyond its mandate. Behnam explained his position, saying
that although the CFTC has the authority to combat fraud and
manipulation, it would be impractical to use such authority for
political events. Specifically, he believes, “The
implications of such authority are vast, and could extend in a
multitude of directions beyond the election itself, [such as to]
political fundraising and polling, to name just
two.”15
Two CFTC commissioners dissented, for very different reasons.
Commissioner Summer Mersinger dissented from the CFTC’s
decision to reject the Congressional Control Contracts because of
her dissatisfaction with the CFTC’s approach to determining
whether to approve or deny the Congressional Control
Contracts.16 Commissioner Caroline Pham abstained from
voting on the Order, citing the CFTC’s ongoing Fifth Circuit
litigation with PredictIt (discussed below). Pham’s concerns
stem from the potential for her vote to be construed as violating
the injunction that enjoins the CFTC from “prohibiting or
deterring the trading” of contracts listed on PredictIt,
which include political event contracts.17
Fifth Circuit Finds That CFTC Staff Action Is Final Agency
Action
The CFTC’s Kalshi disapproval order distinguishes the
Congressional Control Contracts from two markets that operate
pursuant to Division of Market Oversight no-action positions
“on a small-scale, not-for-profit basis for academic
purposes.” These two markets operate with “limitations
on, among other things, the number of market participants and
the number of contracts that each market participant may
hold.”
One of these markets, PredictIt, recently obtained an injunction
from the Fifth Circuit Court of Appeals18 in response to
the CFTC’s Division of Market Oversight’s (DMO) August
2022 attempt to withdraw the 2014 no-action letter issued to
Victoria University of Wellington in Wellington, New Zealand, that
permitted it to operate a political and economic indicator event
contract market without registration as a DCM.
The Fifth Circuit is the first court “to draw the
conclusion that a ‘no-action letter’ constitutes
‘final agency action.’” Judge James. E.
Graves’ dissent notes that he has not “come across any
instance where a court has ruled that a ‘no-action
letter’ constitutes a final action taken by the
agency.”19
In a split 2-1 vote, the panel found that a no-action letter is
agency action under the Administrative Procedure Act (APA), citing
to prior cases where “grants of permission to avoid
compliance with administrative requirements constitute agency
action.”20 Further, the Court of Appeals found
that the no-action letter at issue here is a “license”
within the meaning of the APA.21 Thus, the court found
that withdrawal of the no-action letter constituted agency
action.
In determining whether the withdrawal of the letter is
considered “final,” the Fifth Circuit denoted two
determining factors: (1) the action must mark the consummation of
the agency’s decisionmaking process; and (2) the action must
be one by which rights or obligations have been determined, or
which result in legal consequences.22 The panel found
that both prongs of the “finality” test are met.
The first condition is that the DMO decision to issue or
withdraw the no-action letter cannot be appealed within the agency,
and also that CFTC regulations state that a beneficiary “may
rely” on DMO issuing a no-action letter.23 Second,
the panel cited its previous 2019 decision in Data Marketing
Partnership v. U.S. Department of Labor, in which the Fifth
Circuit determined “where agency action withdraws an
entity’s previously held discretion, that action alters the
legal regime, binds the entity, and thus qualifies as final agency
action.”24 Further, the Fifth Circuit found that
the relevant regulation stated that requesters may
“rely” on an advisory opinion, thereby binding the
Department of Labor and withdrawing its previously held
discretion.25 Thus, the panel found
that Victoria’s no-action letter withdrew some of the
CFTC’s discretion because a beneficiary may rely on it, and
legal consequences resulted from the no-action
letter.26
Second, on the question of agency discretion not subject to
judicial review, the Fifth Circuit disagreed with the CFTC’s
argument that no-action letters are like agency discretion to not
prosecute or enforce and thus are unreviewable. The panel
determined that the withdrawal of a “regulatory
instrument” (the no-action letter) is what is being
challenged here, not the CFTC’s discretion to not enforce the
law.27
Lastly, the Fifth Circuit addressed the issue of whether the
plaintiffs have standing considering Victoria University is not
included in the lawsuit. The panel found that the standing
requirements are easily satisfied in this case, saying that
“market operators, traders, and academics claiming to be
impacted by the no-action letter’s rescission” have
shown numerous injuries that are traceable to the withdrawal of the
no-action letter.28 The panel therefore concluded that
the District Court for the Western District of Texas erred in not
issuing a preliminary injunction and remanded the case to enter the
injunction and hear the merits of claims in this case.
The Fifth Circuit PredictIt decision will result in the CFTC
(and other regulatory agencies) likely reviewing requests for
no-action relief more carefully and taking greater steps to clarify
that a staff no-action letter does not constitute final agency
action.
What the Kalshi and PredictIt Actions Mean for the Future
of Event Contract Markets
Many of the CFTC’s concerns in the Kalshi determination
remain the same as those that were raised when the North American
Derivatives Exchange (Nadex) attempted to list political control
contracts in 2011, which the CFTC denied in 2012. The CFTC has
consistently focused on the issue of election prediction markets as
a form of gaming. Those fears may be heightened given the
preexisting concerns surrounding US election integrity that have
grown over the past election cycle.
The Kalshi denial order and the CFTC’s pursuit to revoke
the PredictIt no-action letter suggest the CFTC may continue to
take steps to dissociate itself from political event contract
markets. The CFTC may, in the future, engage in a
notice-and-comment rulemaking on the issue, as Mersinger suggests.
Until then, however, the impact of these two events is to raise the
barriers to entry in the event contract marketplace and, at the
same time, make it more difficult to obtain staff no-action letter
relief in all areas subject to CFTC regulation.
Footnotes
1. 2023 Summer Associate Evan Goldsholle contributed to
this alert.
2. CFTC Letter No. 14-130 (Oct. 29, 2014), available
at https://www.cftc.gov/csl/14-130/download.
3. In the Matter of the Certification by KalshiEX LLC of
Derivatives Contracts with Respect to Political Control of the
United States Senate and United States House of Representatives,
available at https://www.cftc.gov/sites/default/files/filings/documents/2023/orgkexkalshiordersig230922.pdf.
4. Id. n. 17.
5. Id. at 12.
6. Id. n. 25.
7. Id. at 11.
8. Id. n. 28.
9. Id. n. 25.
10. Id. at 19.
11. Id. at 18.
12. Id. n. 35.
13. Id. at 20.
14. Id. at 22.
15. Statement of Chairman Rostin Behnam Regarding CFTC
Order to Prohibit Kalshi Political Control Derivatives Contracts
(Sept. 22, 2023), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement092223.
16. Dissenting Statement of Commissioner Summer K.
Mersinger Regarding Order on Certified Derivatives Contracts with
Respect to Political Control of the U.S. Senate and House of
Representatives (Sept. 22, 2023), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/mersingerstatement092223.
17. Statement of Commissioner Caroline D. Pham Regarding
Political Event Contracts (Sept. 22, 2023), available
at https://www.cftc.gov/PressRoom/SpeechesTestimony/phamstatement092223.
18. Clarke et al v. CFTC, No. 22-51124 (5th Cir.
2023).
19. Id. at 25.
20. Id. at 8-9. Citing Atl. Richfield Co. v.
United States, 774 F.2d 1193, 1200 (D.C. Cir. 1985)
(discussing one such “temporary license”);
Gallagher & Ascher Co. v. Simon, 687 F.2d 1067,
1072–76 (7th Cir. 1982) (reviewing withdrawal of a special
permit exempting customs brokers from ordinary
requirements).
21. Id. at 9.
22. Id. at 9. Citing Data Mktg. P’ship v. U.S.
Dep’t of Lab., 45 F.4th 846, 853 (5th Cir. 2022);
Bennett v. Spear, 520 U.S. 154, 177–78
(1997).
23. Id.
24. Id.
25. Id.
26. Id. at 10-11.
27. Id. at 12.
28. Id. at 13.
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