The term “bet” or “betting” is frequently used in reporting about the trading of commodity futures contracts. For example, “Wheat Climbs as Bearish Investors Trim Bets Among Crop Woes,” the headline of a July 19 article in Bloomberg. Translation for the general reader: Wheat futures prices increased as investors who bought contract positions anticipating that wheat futures prices would fall reduced their price shorting positions due to concerns about reported wheat supply reductions that would drive up wheat prices. “Bet” is not only intuitively understood by readers but also aids the headline writer’s need for brevity.
However, in Commodity Futures Trading Commission (CFTC, Commission) regulations, buying, selling or holding a futures contract position is not a bet in the sense of a stake taken in a game of chance with a binary output, win or lose. The CFTC has proposed a rule that would prohibit the trading of event contracts based on the results of gaming, e.g., of gambling on the results of elections or any aspect of elections, such as the withdrawal of a candidacy. IATP sent to the CFTC an August 8 letter in support of the proposed rule. Because the trading of some event contracts resembles betting in the vernacular sense, our letter interprets the CFTC’s reasons for prohibiting contracts based on gaming as “contrary to the public interest.”
Background in brief
One reason for the proposed rule is to enable exchanges that create new contracts to understand which kind of event contracts would be prohibited by a finalized rule. In footnote 9, the agency summarizes some of the subjects of recent event contract trading:
These have included event contracts based on the occurrence or nonoccurrence of international events, natural disasters in specific U.S. cities, heating/cooling degree days and cumulative average temperature in specific cities, the timing of video game and album releases, Oscar award winners, COVID–19 case levels and restrictions, the outcome of cases pending before the Supreme Court of the United States, the passage of specific laws by the U.S. Congress, U.S. Presidential approval ratings, confirmation of U.S. executive branch officials, National Football League (“NFL”) television ratings, the discovery of exoplanets, and the occurrence of a National Aeronautics and Space Administration moon landing before a certain date.
Such contracts are designed to attract retail investors who can post the full collateral required to buy a $25,000 contract position or fraction thereof. The CFTC has allowed such event contracts to be traded because they are consistent with CFTC Core Principles criteria, such as prohibiting contracts that may be susceptible to price manipulation or fraud. One $25,000 position or several $25,000 positions are unlikely to affect the data underlying a contract and contract positions taken on those event outcomes.
KalshiEX LLC (Kalshi Exchange), founded in 2019 and designated in November 2020 by the Trump CFTC as a contract market, proposed a contract oriented to institutional investors with a position limit of up to $100 million, if Kalshi determined, according to a confidential methodology, that the investor had justified its economic need for taking such a position. In September 2023, the CFTC disapproved a contract proposed by the Kalshi Exchange based on electoral results determining the political party control of each chamber of the U.S. Congress, which allowed investors to take up to $100 million positions. IATP, which had urged disapproval, supported the Commission’s 3-2 vote decision. The Kalshi Exchange sued the agency in November 2023, arguing that it had no legal authority to prohibit the Congress Controls contract.
The CFTC commissioners and chair voted in May to release for comment the proposed rule to amend and clarify a 2011 rule on event contracts. Whether investors take a $25,000 or $100 million position, the “public interest” criteria of derivatives (futures, options and swaps) contracts should be delineated to clarify to exchanges and market participants which event contracts are “contrary to the public interest.” Here we outline the proposed rule in terms of our responses to some of the questions posed by the CFTC staff.
Commodities excluded as the basis for derivatives contracts
The proposed rule amends an existing rule that stipulates the “excluded commodities” that must not be involved as the underlying assets of event contracts. For example, the existing rule bans using an assassination as the underlying asset of a binary options contract such as “Leader X will/ will not be assassinated by Y date.” The reasons that the CFTC bans such a contract as “contrary to the public interest” might seem self-evident. No exchange has proposed an assassination binary options contract because such a contract would be morally repugnant, even though the contract could be profitable for some investors. An assassination may have economic consequences, but there is no standardized and reliable underlying cash market data for assassinations comparable to the cash market data for wheat that informs the “public interest” in managing price risks in wheat derivatives contracts.
The CFTC does not propose to further define “assassination,” “war” or “terrorism” as excluded commodities in the rule because those activities are unlawful under state and federal law. However, in a footnote in the preamble to the proposed rule, the CFTC acknowledges that cyberattacks on computer networked infrastructure could be construed as acts of war or terrorism. Preambles to rules provide an agency’s reasoning for a rule, but they are not legally binding. To prevent the possibility that an event contract be based on the failure of critical infrastructure, e.g., an electrical grid failure, that might result from a cyberattack, we suggested including the footnote in the binding text of the rule.
Reviewing proposed event contracts: a two-step CFTC methodology
The CFTC is greatly understaffed to closely review the hundreds of new contracts that the exchanges self-certify annually as consistent with its Core Principles and rules. However, under the proposed rule, the staff will be able to determine efficiently whether a proposed new contract involves an excluded commodity and if so whether that contract is likely to be “contrary to the public interest.” The preamble to the rule concedes that some proposed event contracts may have characteristics that will require a staff review of certain individual contracts whenever an automated review of a contract’s terms and conditions indicates that the contract may not comply with the Commission’s public interest criteria. (Federal Register (FR), p. 48974) IATP characterized the proposed rule as “pragmatic but not inflexibly dogmatic.”
The preamble explains that event contracts involved with physically backed and financial commodity derivative contracts will not be affected by the proposed rule. The trading of such contracts has a price-basing utility based on standardized and reliable data consistent with the public interest criteria of the existing event contract rule. So, for example, an event contract involved with an interest rate change set by the Federal Reserve Board of Governors will comply with the amended event contract rule.
A proposed definition of “gaming” and public interest criteria
The current event contract rule includes “gaming” as an excluded commodity but does not define “gaming.” The preamble notes that the only event contracts that have been presented for the Commission’s formal review and approval are contracts involved with “gaming.” The proposed definition “includes, but is not limited to, the staking or risking by any person of something of value upon: (i) the outcome of a political contest, including an election or elections; (ii) the outcome of an awards contest; (iii) the outcome of a game in which one or more athletes compete; or (iv) an occurrence or nonoccurrence in connection with such a contest or game, regardless of whether it directly affects the outcome.” (FR, p. 48975) The definition is accompanied by a non-exhaustive list of examples. IATP supports this definition and the reasoning for it.
Contracts involved with gaming are susceptible to price manipulation in violation of the Commission's Core Principle 3 prohibition of such contracts. IATP’s letter to the Commission stated,
For example, an event contract investor could produce a [Artificial Intelligence generated] deep fake that disrupts political contributions and make a High Frequency Trading killing on the contract involving the candidate benefiting from the deep fake. IATP strongly agrees with the preamble’s statement that “The lack of price forming information for contracts involving ‘gaming,’ or the availability of only opaque and/or unregulated sources of price forming information, may increase the risk of manipulative activity relating to the trading and pricing of such contracts, while decreasing the ability of the offering exchange, or the Commission, to detect such activity.” (FR, p. 48982)
An election or elections disrupted by deep fakes or by the refusal of election supervisors to certify election results are just two of the sources of manipulative price forming information in election event contracts that substantiate the Commission’s decision to include such event contracts within its definition of “gaming.” A Better Markets organized letter signed by IATP and 20 other organizations states, “By prohibiting these contracts from being listed for trading or accepted for clearing [post-transaction trade completion] on CFTC-regulated markets, the CFTC is taking an appropriately strong stance to protect the public interest.” How does the proposed rule define the “public interest” in derivatives trading and clearing?
The preamble notes that although “public interest” is not defined in the existing event contract rule, components of the public interest, other than price-basing utility, are enumerated in the Commodity Exchange Act, the underlying statute for CFTC rulemaking: “protection of market participants and the public; efficiency, competitiveness, and financial integrity of the markets; price discovery; sound risk management practices; and other public interest considerations.” (FR, p. 48991) Additionally, the Commission intends to include an appendix to the final rule of other factors that may be considered to determine whether an event contract is contrary to the public interest. (FR, p. 48994)
A crucial Commission vote
The CFTC staff is reviewing and summarizing 822 comments on the proposed rule. A summary of the comments pertaining to each provision in the proposed rule will be an important part of the preamble for the voting copy of the rule. To judge by the vote to release the proposed rule for comment, the final rule will be approved by 3-2, with the two Democratic Commissioners and the Democratic Chair voting in the affirmative. If so, the CFTC will not only have robustly defended its Core Principles, but will have clarified that event contracts, including those based on election results, are prohibited in CFTC-regulated markets. That will be a final rule in the public interest worth celebrating and publicizing.
