We Need More Money In Politics
Why gambling on politics should be legalized, why it isn't, and how one startup is trying to change that.
We humans are replete with contradictions, often holding two competing opinions or prone to saying one thing while doing another. It’s why nagging parents tritely remind their children to “do as I say, not as I do.” But, try as we might to fight it, we always seem to revert to our most basic human tendencies.
There are countless examples, but some of the clearest can be found in the context of religion—where even the most God-fearing among us at times fail to practice what they preach. Take gambling, for instance. The Bible warns against the love of money and discourages attempts to “get rich quick.” But, even as early as the 1500s, Catholics in Italy were betting the farm vineyard with their fellow church-goers. In fact, it was particularly common to bet on who would be elected as the next pope. So much so that, in 1591, Pope Gregory XIV banned and threatened to excommunicate anyone who placed bets on the outcome of papal elections or the length of the papal reign. (It’s often speculated that Pope Gregory made the announcement after a rough week of losses at the chariot race track, but historians differ on the accuracy of that historical tidbit.)
Point is, despite our best efforts—or, more often, the best efforts of others—to impose “moral” restraints on our conduct, there are some innately human things that we just can’t stop doing. Gambling, it seems, is one of them.
Despite being an act that dates back to before humans could even write, gambling has often been relegated to the dark underbelly of society. In the US, it wasn’t until the 1960s that states started rolling out now-ubiquitous government-run lotteries, and it wasn’t until the Supreme Court’s ruling in Murphy v NCAA in 2018 that states (now 37 in total) would legalize sportsbooks. But, even as Western society increasingly comes to terms with the existence of mainstream gambling within a regulated framework, some areas remain off limits. One of those last bastions of moral absolutism is the very type of gambling that the Italians were doing back in the 1500s: wagering on elections.
When two people (or a person and a bookmaker/broker) agree to wager on a political outcome, a contract is formed between those parties. That contract, under US law, is called an “event contract,” because, well, it’s an agreement by one person to pay the other person based on the outcome of an event (here, a political event). Event contracts are regulated by a federal agency called the Commodity Futures Trading Commission (CFTC). The CFTC isn’t quite as well-known as other federal agencies, like the SEC or FTC (both of which we’ve talked about in the context of activist regulation), but you can basically think of the CFTC as the SEC’s runty little brother—with jurisdiction over almost everything in financial markets other than what the SEC calls dibs on.
The CFTC is maybe best known for regulating commodities—specifically, commodities futures contracts. A “futures contract” is just an agreement to buy or sell something at a predetermined price at a specified time in the future. Commodities futures contracts often involve commodities like wheat and corn (and also frozen orange juice and pork bellies), which buyers and sellers typically use to either (1) speculate on the future price of a commodity or (2) to hedge their exposure to a commodity. Airlines, for example, use oil futures to lock in (through hedging) the price of their oil supply to avoid risking exposure to unexpected spikes in oil prices.
To the extent anyone is wagering on political events today, it probably doesn’t look much different to the way the Italians did it back in the 1500s—which would be considered “speculating” on the future outcome of the political event.
But, you could also imagine a scenario where more formal and sophisticated political event contracts are offered on a legitimate marketplace platform, similar to the way E*Trade and Schwab allow you to buy and sell stocks. The contracts offered on such a platform could—like commodities futures contracts—also be used to hedge exposure to a particular political event.
For instance, a company in Maine whose business involves importing and exporting goods with Canada might purchase an event contract in the lead up to the 2016 presidential election that pays out if the winner withdraws from the Trans-Pacific Partnership (TPP) trade agreement once in office. Alternatively, if the company is simply concerned with the impact that a particular candidate might have on its business more broadly, it might even prefer to purchase a contract that pays out if the candidate of concern wins. Either of these event contracts would serve as a kind of “insurance policy” for the company in Maine to mitigate a potential disruption to its business caused by political events beyond its control.
These event contracts are seemingly simple solutions for market participants to get direct exposure to the very political event that they’re concerned with. Without them, a company wanting to take out the sort of “insurance policy” on the 2016 election that a simple political event contract would afford it would have to buy complicated and expensive financial instruments from some fancy investment bank in New York in an effort to get indirect exposure to the political event through the financial markets. So, the political event contract clearly seems like the winning option for our little company in Maine.
The problem, however, is that the CFTC currently prohibits most political event contracts—leaving it deliberately unclear as to what event contracts cross the line into the impermissible. For example, while it’s clear that a contract that pays out if Donald Trump wins the 2016 election is illegal, it’s likely, but far from certain, that the CFTC would allow the TPP event contract in the example above. Nevertheless, the ambiguous regulatory regime hasn’t stopped a handful of companies from trying to navigate it.
In 2012, the CFTC issued an Order Prohibiting the Listing or Trading of Certain Political Event Contracts, in which it banned certain binary (yes/no) political events contracts that would have paid out based upon the outcome of the 2012 US federal elections (e.g., “Will there be a Republican Majority in the U.S. House of Representatives?”).
In making its determination, the CFTC pointed to a congressional act called the Commodities Exchange Act (CEA) that grants the agency its power and entrusts it with the right to determine that a contract is “contrary to the public interest” and, as a result, illegal, if the contract “involve[s] . . . (I) activity that is unlawful under any Federal or State law; (II) terrorism; (III) assassination; (IV) war; (V) gaming; or (VI) other similar activity determined by the [CFTC], by rule or regulation, to be contrary to the public interest.” Without giving much in the way of legal reasoning, the CFTC determined that the political event contracts at issue “involved gaming and were contrary to the public interest.”
Ten years later, Kalshi, a startup founded by a pair of ex-investment banking analysts, decided to challenge the CFTC’s longstanding position on political events contracts. Kalshi, which is overseen by the CFTC, is the first federally regulated exchange in the US that allows both retail and institutional customers to trade on event contracts like annual COVID-19 numbers to whether a bill will pass in Congress.
As one of the founders explained:
The simple idea behind event contracts came about during my time at Goldman Sachs in 2016. At the time, clients were looking to get direct exposure to Brexit and the 2016 US elections. Our desk would structure and sell complex financial bundles that included options, swaps, and a number of other instruments. However, these products have a clear problem: they are proxies and thus imprecise. Also, they're super expensive (we were charging 40% premiums to some of these counterparties).
Event contracts are [in my opinion] elegant trading instruments because they allow traders to get direct exposure to the event itself, rather than trading on the market reaction to the event and trying to figure out what's priced in or not.
Of course, political event contracts such as the ones prohibited in the CFTC’s 2012 order remain off limits for Kalshi. Nevertheless (in all likelihood knowing full well that the request was futile) Kalshi submitted a proposal to the CFTC in June 2023 for the approval of various binary political event contracts taking the form of: “Will [House of Representatives/Senate] be controlled by [Republicans/Democrats] for [term]?”
Unsurprisingly, the CFTC rejected Kalshi’s submission in September, finding that the political event contracts at issue involve gaming, activity that is unlawful under state law, and are contrary to the public interest. Just over a month later, Kalshi sued the CFTC in federal court in Washington, DC, alleging that the CFTC’s decision was “arbitrary, capricious, and otherwise contrary to law.” The lawsuit sets up what may well be a multi-year battle over a market worth hundreds of millions of dollars. It also puts pressure on the typically low-profile CFTC to avoid being the next administrative agency to lose a court battle against a fast-moving player in the private sector.
Here are the three key issues in the battle over political event contracts:
1. Political Event Contracts “Involve Gaming”
The CFTC argues that Kalshi’s political events contracts are illegal because they “involve gaming” (one of the prohibited items listed in the CEA as being contrary to the public interest). But because the CEA defines neither “involve” nor “gaming,” the lawyers for both Kalshi and the CFTC have, naturally, spent a considerable amount of brain damage arguing about what exactly constitutes “gaming” and what it means to say that a contract “involves” gaming.
I don’t want to spend too much time on this point, mainly because it’s silly, boring and not likely to be of any consequence (which also generally describes the sort of activities that many lawyers fill their days doing), but there are a few issues here worth mentioning.
First, the CFTC’s interpretation of the CEA is just wrong. It makes no sense to say that these political event contracts “involve gaming” just because a person is staking money on the outcome of the event (here, a political event). If that were the case, then every event contract, as well as futures contracts more broadly (including futures contracts involving commodities like grain and wheat), would be illegal, because in every case money is being staked on a future event occurring or failing to occur. Just as the CEA empowers the CFTC to prohibit contracts that “involve assassination,” the underlying activity in the contract needs to “involve gaming” for it to be prohibited (like where two parties are betting on the outcome of a coin toss or a spin of the roulette wheel). The underlying content of the contract at issue here is politics, not a game of chance. And there is no enumerated category prohibiting contracts that involve “politics.”
Even if, for the sake of argument, we accept the CFTC’s broad and contorted reading of the statute as true, there’s a strong case to be made that political event contracts are much more akin to fantasy sports—which several states, including New York, have found to be games of skill, rather than chance. While there’s certainly an aspect of fortuitousness that goes along with any real world event, politics is a domain that one can study and develop domain expertise in. As one user of PredictIt—an earlier, non-profit version of Kalshi that was granted a limited exemption by the CFTC to operate strictly for educational research purposes— described it:
PredictIt is an object lesson in epistemology. . . learning the dance of political communication, its tactics and strategy, and how we, the voters, know what we know. PredictIt answers a lot of questions about what you do to get beyond the cynicism of institutional modes of knowledge, the cynicism of reporters and journalists. It provides an organic and anonymized way of understanding data.
[This sort of trading on political event contracts is more than] mere gambling, something driven merely by chance or chaos. It is driven. . . by empirics and careful study.
2. Activity That Is Unlawful Under State Law
The CFTC also argues that Kalshi’s political event contracts are illegal because they involve activity that is unlawful under state law, which is another one of the prohibited categories of contracts listed in the CEA. In support of this assertion, the CFTC cites to more than a dozen state laws that, in so many words, say it’s illegal to wager on the result of an election. At a surface level, this seems bad for Kalshi. But a deeper dive uncovers a few fatal flaws with the argument.
First, these are all, obviously, state laws, which means that the CEA—a federal statute passed by Congress to empower the CFTC, a federal agency—can trump state law on issues where Congress intended for the federal government to have exclusive jurisdiction, as it did with the CFTC and the derivatives markets (including futures contracts). This is called the doctrine of preemption, and there’s a lot of merit to this argument. It’s also further bolstered by the fact that, although states are empowered by the Constitution to regulate the “time, places and manner” of elections within their jurisdiction, it is well settled that the Elections Clause grants Congress the power to override state regulations by establishing uniform rules for federal elections binding on the States.
There’s also the argument that one of the CFTC commissioner’s made in her dissent to the CFTC’s order rejecting Kalshi’s political event contract: that, even without preemption, the state laws cited by the CFTC don’t technically cover Kalshi’s proposed contracts. Each one of the state laws cited by the CFTC prohibits wagering on an election. Kalshi’s proposed political event contracts, on the other hand, would pay out based on which party takes control of the House or Senate, which necessarily involves many individual elections across the country.
Finally, and maybe most importantly (given that neither the dissenting members of the CFTC, in their dissents, nor Kalshi, in its lawsuit, made mention of it), not one of the state laws cited by the CFTC in its order have actually ever been applied in the context of federal elections. This, I think, was a fairly significant missed opportunity on Kalshi’s part that should have been highlighted in their complaint filed against the CFTC.
3. Contrary to the Public Interest
The third and final argument made by the CFTC in its order rejecting Kalshi’s political event contracts is that they’re “contrary to the public interest.” The CFTC wasn’t convinced that sophisticated parties would use these contracts for hedging, and found that any potential utility these contracts might serve is outweighed by their “inconsisten[cy] with ideals of democracy and the sanctity of the electoral process.” Fundamentally, the CFTC is concerned that, if they allow event contracts based on elections, then they’d be responsible for policing the integrity of the actual elections underlying those event contracts.
At a basic level, the CFTC, again, misinterprets the statute. The CEA requires the CFTC to determine “by rule or regulation” that a contract is contrary to the public interest. The CEA does not allow the CFTC to make that determination retroactively and on an ad hoc basis through an order.
From a substantive standpoint, although the CEA fails to define what “public interest” even means, it’s clear that, however you slice it, political event contracts do, in fact, have significant pro-social value.
Setting aside the relatively esoteric but real hedging value that these contracts provide to institutional players, the undeniable benefit to the public interest through sheer speculation alone sufficiently outweighs any remote downsides. Indeed, the weight of the empirical evidence on the topic clearly suggests that, by leveraging the law of large numbers and the wisdom of the crowds, the real-time results of these sort of political event contracts are far better predictors of political outcomes than even some of the most seasoned pollsters, journalists, and pundits.
There’s also a more qualitative value derived from retail investors studying the political landscape. As one user of the non-profit PredictIt said, “PredictIt cultivates civic literacy. It provides checks on how to interpret media, how to not just go by a soundbite, how to not allow a headline to take on a life of its own.”
The CFTC’s concerns of things like moral hazard, election tampering, strategic manipulation of these markets are also unfounded. As the foremost scholars on this niche world of political contracts put it, these concerns have been present throughout history, including at times when the markets for political event contracts were much more robust than they are today. The researchers suggest that, even back then, these arguments didn’t carry “much bite,” concluding that “current concerns about the appropriateness of prediction markets are not well founded in the historical record.”
Finally, it’s also unclear where the CFTC draws the line in its concern with “policing elections.” We know that a political event contract tied to the outcome of the US presidential election is prohibited in the CFTC’s eyes. So, too, apparently, is Kalshi’s version where the contract pays out based on which party controls the House or Senate. But, Kalshi’s site currently offers event contracts on everything from “Who will be confirmed as the next Treasury Secretary?” (a position nominated by the president, not elected by the people) to “Will a bill that raises the capital gains tax become a law by December 31, 2023?” (an event that is almost certainly dependent upon which party controls the chambers of Congress). The CFTC has presumably OK’d these contracts. But can’t the same “contrary to the public interest” arguments be leveled against those?
Whether the DC federal court presiding over Kalshi’s case will see the issues in the same light remains to be seen. It will definitely be an uphill battle for the scrappy startup, as decisions made by federal agencies like the CFTC are afforded considerable deference by courts. But what has been even more helpful to the CFTC up to this point has been the general approach of strategic ambiguity that it and other administrative agencies have taken to regulating novel companies and trends in the private sector.
Rather than offering up a clearly defined roadmap for how to comply with federal rules and regulations, agencies like the CFTC have time and time again abrogated their responsibilities and opted to provide as little information as possible to the public in order to preserve the status quo. These agencies do this because they want to preserve their option value—unable to keep up with the fast-moving private sector because of the capital asymmetries, regulatory agencies hold their cards close to their chest to ensure that, when the next novel trend or startup comes around, they’re able to tackle it on an ad hoc basis, despite the clarity and efficiency that broad-based rules would otherwise afford society.
But the tide is certainly shifting, and Kalshi may be poised for an upset. After the CFTC unexpectedly revoked the exemption it had granted to the non-profit PredictIt so that it could conduct academic research on the political event contracts market, the Fifth Circuit Court of Appeals issued a decision in July finding the CFTC’s conduct to be “likely arbitrary and capricious.”
After a year of legal blows to the administrative state, here’s hoping that, if Kalshi is indeed the next David to land a blow on Goliath, regulators will slowly but surely begin to realize that it may be high time to change tactics.