Who would have predicted it? Polymarket Decides to Operate Unregistered Swap Execution Facility – Fin Tech

On January 3, 2022, the Commodity Futures Trading Commission (CFTC) announced an order and settlement with Polymarket, a blockchain-enabled prediction market that allows users to “bet” on the occurrence of certain future events to offer over-the-counter events – based binary options contracts that constituted “swaps” and failure to obtain designation as a Designated Contract Market (DCM) or registration as a Swap Execution Facility (SEF).

Polymarket describes itself as a “decentralized information market platform” that allows users to bet on their beliefs. Users build a portfolio based on forecasts and buy and sell “stocks” based on the development of a future event, such as whether Bitcoin will be worth more than a certain amount on a certain date or whether a certain candidate would win a political election . The CFTC determined that these stocks are instead binary options contracts that constitute swaps and are therefore subject to the jurisdiction of the CFTC and the associated regulatory obligations. Pursuant to the U.S. Commodity Exchange Act (CEA), as amended by the derivatives regulatory reform provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, swaps generally may only be offered on a bilateral basis between eligible contracting participants or over a one-year platform, which is registered as DCM or SEF. In particular, the CFTC noted the use of an algorithmic “automated market maker” (AMM) to value options premiums based on relative demand for each position, with trading volume and liquidity automatically adjusting based on demand and other factors . Market participants were charged a 2% fee on each transaction, which served as compensation for liquidity providers, although Polymarket itself claimed to have made no profits.

The definition of “swap” as a category of regulated products under the CEA is very broad and could be understood to include most financial contracts that provide for an exchange of value based on an external reference such as the occurrence of an event or the price of one asset or index, even if these contracts are not commonly referred to as swaps by market participants. The principal exclusions from the definition of “swap” are products subject to an alternative regulatory regime, such as options on securities, which are subject to the jurisdiction of the U.S. Securities and Exchange Commission (SEC). Therefore, any offering of financial contracts whose value is tied to the occurrence of an event or the price of an asset or index, unless already subject to an alternative regulatory regime, is at risk of enforcement action by the CFTC.

The SEC has taken similar action against providers of financial contracts tied to the price of securities. In 2015, the SEC launched an enforcement action against the Sand Hill Exchange, which was touted as a platform for investors to purchase contracts tied to the pre-IPO price of technology companies, arguing that the contracts were ” Security-based swaps are the responsibility of the SEC and the associated regulatory requirements. Accordingly, there is also risk of SEC enforcement against issuers of financial contracts tied to the price of digital assets that the SEC has classified as securities.

Because the betting contracts were considered swaps, the CFTC found that Polymarket violated Section 5h(a)(1) of the Commodity Exchange Act and Regulation 37.3(a), which prohibit the operation of an entity that offers a trading system or trading platform more than one other market participant has the ability to execute or trade swaps with more than one other market participant, unless that entity is registered as a SEF or DCM. Pursuant to the order, Polymarket is required to cease offering access to trading in non-compliant markets and to liquidate those markets unless the offer, solicitation or trading on those markets complies with CFTC regulations. Polymarket was also ordered to pay a civil penalty of $1.4 million. Although Polymarket has neither admitted nor denied the findings in the Order, Polymarket is required to cooperate with the CFTC on an ongoing basis and is prohibited from making any statement disputing the findings or conclusions of the Order or creating the impression that the order objectively is the basis.

The CFTC has previously granted limited inaction relief to operators of prediction markets. For example, in CFTC Letter No. 14-130, the CFTC granted inaction relief to Victoria University of Wellington, New Zealand, to operate a submarket for binary contracts on political elections and economic indicators. Importantly, no one should receive compensation for operating the market, which was used for educational purposes, with strict limits on the number of contract participants, the size of the contracts, the maximum “stake” and the way the site was advertised would be. including prominent disclaimers that the proposed market is unregulated, experimental and operated for academic purposes. Similar relief was granted to the University of Iowa in 1993 to operate Iowa Electronic Markets.

This could result in significant regulatory burdens for a provider that, as a commercial entity, wishes to launch a platform for trading event contracts, whether linked to cryptocurrencies or other events. Providers could operate under an existing regulatory model, such as the CFTC’s futures and options regulatory regime, the CFTC’s swaps regulatory regime or, potentially for securities-related contracts, the SEC’s securities or security-based swaps regulatory regime. Both would subject the platform to conditions and criteria imposed by respective regulators and require regulatory approval before launch. See, for example, the current CFTC review of Eris Exchange, LLC’s proposal to offer sporting event contracts on a futures exchange registered with the CFTC, or the CFTC’s rejection in 2012 of a proposal by the North American Derivatives Exchange to list event contracts in connection with certain political events .

The CFTC’s order continues its trend of taking enforcement actions against crypto industry participants. For example, in September 2021, the CFTC filed charges against 14 cryptocurrency options exchanges, many of which falsely claimed to be regulated by the CFTC, and settled charges with cryptocurrency exchange Kraken for allegedly offering U.S. customers margined retail transactions in digital assets that were not authorized Contract participants.

According to public statements, the CFTC is also apparently reviewing more conventional DeFi swap facilities such as Uniswap and Sushiswap. Consideration could also be given to whether the mere presence of an AMM within a DeFi protocol could be considered the operation of a swap execution facility (or an alternative trading system if the digital assets in question are securities and not commodities), and whether to pledge or lend these tokens in liquidity pools could be viewed as completing a regulated commodity option. Additionally, this raises questions about other prediction-based platforms and Decentralized Autonomous Organizations (DAOs) that attempt to prove the governance theory of futarchy (a theoretical form of government in which decisions are made by prediction markets to determine which actions are the most positive would have an effect). .

The settlement could also allow the CFTC to take enforcement action against those who participate in, rather than operate, certain DeFi swap markets as they are considered key swap participants. On the other hand, the CFTC’s order goes into detail about how Polymarket was not decentralized, but decided the outcome of each bet internally and resolved any disputes. The order states: “Polymarket’s market solution terms and conditions are determined solely by Polymarket. Any disputes or ambiguities regarding the market solution – i.e. which consists entirely of Polymarket employees.” This focus on centralization raises the question of whether the outcome might have been different with a fully decentralized platform.

Going forward, other operators of blockchain-based prediction markets will likely pay close attention to whether Polymarket is able to continue to operate a prediction market in the United States and, if so, how it complies with the terms of its settlement with the CFTC.

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