May 15, 2008
UI researchers among those calling for legal clarification of prediction markets
New federal rules are needed to protect futures prediction markets from excessive regulation so they can continue to develop as innovative planning tools, according to an article co-written by two University of Iowa business professors and prediction markets pioneers.
George Neumann and Forrest Nelson, professors of economics in the Tippie College of Business, are among 19 co-authors of "The Promise of Prediction Markets," which appears in the May issue of the journal Science. Neumann and Nelson were two of the co-founders of the Iowa Electronic Markets, one of the first event prediction futures markets, in 1988.
In the article, the authors suggest the Commodities Futures Trading Commission (CFTC) establish safe-harbor rules that allow for unregulated small-stakes event prediction markets. The CFTC is the federal agency that regulates futures exchanges, and letting it establish the safe harbor will let those who want to develop such markets do so without unwittingly violating a state or federal law.
"Current federal and state laws limiting gambling create significant barriers to the establishment of vibrant, liquid prediction markets in the United States," they write. "We believe that regulators should lower these barriers by creating a legal safe harbor for specified types of small-stakes markets, stimulating innovation in both their design and their use."
The IEM, which runs markets that seek to predict such events as political elections, influenza outbreaks and hurricane land-falls, operates under a "no-action letter"-or waiver from regulation- it received from the CFTC in 1992. However, the article notes that it's not clear if the waiver reduces the chances of legal action under state and federal laws. To fully protect the IEM and other similar markets, the CFTC could establish formal rules or guidance.
Without these rules, the authors suggest a possible chilling effect on the continued development of markets as predictors of future events. The markets work by using the "wisdom of crowds" theory that many people know more as a collective than each member knows as an individual. Investors on the market purchase contracts about future events using money, credits or some other form of currency, and the price of the contract is the probability that the event will occur.
Those figures, supporters say, can improve the decision-making process and help manage risk. However, their development may be stunted by a patchwork of state and federal regulations that leave their legal status up in the air. CFTC waivers, they say, would clear up that legal status and encourage the further development of event prediction markets.
"The first step in helping prediction markets deliver on their promise is to clear away regulatory barriers that were never intended to inhibit socially productive innovation," the article says.
The authors suggest that waivers would be granted only to not-for-profit research institutions such as universities and think tanks; government research agencies; and private businesses and non-profits operating the market for research purposes.
They suggest other limitations, as well, such as a relatively small-stakes maximum investment (the IEM limits investments to $500) and only nominal fees to pay for administration and regulatory costs. Brokers and paid advisers would be barred from the market to reduce the risk of contracts being sold to inappropriate or vulnerable customers, and the markets would have the responsibility to regulate themselves.
The authors also call on Congress to specify that a no-action letter from the CFTC pre-empts federal and state laws and explore other legal protections for the markets.
STORY SOURCE: University of Iowa News Service, 300 Plaza Centre One, Suite 371, Iowa City, Iowa 52242-2500.
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