Prediction Market Policing Will Test Insider Trading Law Limits

The US agency charged with overseeing derivatives might face difficulty rooting out alleged insider trading and misconduct on prediction markets given the outlines of federal law, even if it succeeds in elbowing out state regulators, attorneys say.

The CFTC wants to exclusively police the emerging prediction markets. For tackling insider trading, it’s bound by anti-fraud rules that parallel federal securities laws. And the burdens of proof, including a breach of a duty of confidentiality, may be a significant hurdle for trades that face public scrutiny.

“I think the government will find that it’s actually very, very difficult to apply the law as it currently exists to capture some of those cases,” said Morrison Cohen LLP’s Jason Gottlieb. “Not all of them. Some of them, people really are using material, nonpublic information, violation of duties of confidentiality, and the usual law applies.”

“But I think people will be surprised when they learn just how much of the stuff that they’re seeing is actually not illegal and it’s not covered by insider trading law,” he said.

Prediction markets allow people to wager on a wide range of binary outcomes, such as whether the US accepts a new nuclear deal with Iran before July or whether Oklahoma City will repeat as NBA champions. The Commodity Futures Trading Commission, Kalshi Inc., Crypto.com, and other platforms are grappling in court with states over who can regulate their event contracts, particularly sports ones.

States say sports prediction markets are gambling sites subject to their laws. Companies counter that their offerings are a hedging derivative traded on federally regulated markets, under the CFTC’s exclusive jurisdiction per the Commodity Exchange Act.

The agency is also aggressively taking that position through lawsuits, proposed rulemaking, and enforcement promises.

“Because the more they do, the more credibility they have as the enforcers, as the correct regulator for this type of market,” Troutman Pepper Locke LLP’s Stephen Piepgrass said. “And the more it feels like the Wild West, the more arguments the states have that, ‘hey, wait a minute, we’re the ones that have this great body of enforcement law around wagering, and it should apply here.’”

Materiality

For typical insider trading, the line of what’s “material” is often clearer than for prediction markets, said Boies Schiller Flexner LLP’s Alison Anderson—such as a merger only a few people know about.

On prediction markets, “people may bet on something like whether or not the US is going to strike another country where you may have hundreds of military members, other defense contractors, who have some information that public does not have,” she said. “But if it’s anything less than the strike will happen tomorrow at 12:42 p.m., where is the line of what is material, nonpublic information? It’s going to be a real struggle figuring that out.”

Classic insider trading appears easier to investigate since fewer actual actors make the trades, she said. But so many people have at least some information related to a prediction market.

In at least the Second Circuit, home to the Southern District of New York, prosecutors would need “a duty of confidentiality under a wire fraud misappropriation theory, and it’s got to be involve commercially valuable information,” said Crowell & Moring LLP’s Anand Sithian.

Recent criminal charges indicate some belief inside the DOJ that that theory is viable to prosecute trading on government information, he said.

The CFTC declined to comment on the record. The DOJ didn’t respond to an email seeking comment.

Much of insider trading law has developed in courts, potentially pressuring Congress to act, Sithian said. “It’s unclear how courts might address criminal wire-fraud theories of insider trading based on the alleged misuse of government information to trade on prediction markets.”

Government Trading

Many cases will be clear cut, and attorneys expect the CFTC and DOJ to bring more charges, putting their money where their mouth is on exclusive jurisdiction.

The agencies brought civil and criminal charges against a US Army soldier for allegedly using classified information concerning the capture of Venezuela’s Nicolás Maduro through trading on Polymarket.

“It is a very powerful case in a few dimensions: the swiftness with which it’s been brought after the Maduro action, the fact that it involves government information, the fact that it’s a parallel matter between the criminal authorities and the CFTC,” said Debevoise & Plimpton LLP’s Charu Chandrasekhar. “It’s absolutely a shot across the bow and should really cause market participants to sit up and take notice that the government is very serious about rooting out insider trading in this marketplace.”

The CFTC said it used for the first time in that case the “Eddie Murphy rule"—referencing the 1983 comedy “Trading Places"—that bars trading on material, nonpublic information misappropriated from government sources. The special forces master sergeant pleaded not guilty April 28.

The rule might give the CFTC an edge over the DOJ in prediction market insider trading cases, said Pallas Partners LLP’s Josh Naftalis. “The CFTC says it’s illegal to trade based on government information on the commodity side. But on the securities side, the DOJ side is actually narrower in a way.”

“So I think that this is where the CFTC sort of comes back to life.”

Gambling Claims

Exchange participation too will sway what the CFTC and DOJ can do, attorneys say, as insider trading cases are most commonly derived from tips and companies reporting from their compliance programs.

Polymarket, seeking to return its main exchange to the US, worked with federal officials on the Maduro action. Kalshi already publicized some enforcement work, recently banning three political candidates who traded on their races.

“These companies had to pick and choose their poison,” Anderson said. By implementing anti-money laundering, know your customer, and insider trading surveillance, “Kalshi has chosen to push the narrative that they are subjected to the CEA instead of being treated as gambling.”

Because if prediction market offerings are considered gambling instead, she said, “that will tie their hands significantly.”