Yesterday, an online prediction market platform announced that it has been actively investigating potential insider trading activity on its platform. To shed let on how it identifies violations and enforces its rules, it shared details from two cases it recently closed.

With prediction markets taking off, there has been a decent amount of commentary lately on whether there are guardrails to keep things fair. Analytical tools are even popping up to find unusual activity – not unlike how the SEC uses data analytics to flag suspicious trades. And with our members being so on top of things, it was only a matter of time before someone asked about it in our Q&A Forum. Here’s Question #12,966:

I had a question regarding the rise of the predictions market and possible interaction with the federal securities laws. Specifically, I am thinking about a public company’s Insider Trading Policy and whether we should be suggesting any changes to these policies to consider actions by employees/actors in predictions markets.

Of course, we know that SEC Rule 10b-5 requires a trade “in connection with the purchase or sale of any security”. I am pretty sure that participation in a predictions market is not a security.

I am thinking of CFTC’s Rule 180.1 which is modeled directly after Rule 10b-5, and prohibits “any manipulative device, scheme, or artifice to defraud” in connection with any swap or contract of sale of a commodity. Do you think there is reason to believe that prediction market contracts are classified as “commodity interests” rather than securities, that they may technically fall outside the SEC’s reach, and may be within the reach of the CFTC?

Indeed, the prediction market that made yesterday’s announcement about insider trading is regulated by the CFTC and referred the cases to that agency. Bloomberg’s Matt Levine explained it this way:

There is, perhaps, a three-tiered system of insider trading enforcement on prediction markets:

1. Kalshi itself bans insider trading, more strictly than the US stock market does; if you trade with any insider knowledge at all, and they catch you, they can ban you from the site and confiscate some of your money.

2. The CFTC bans insider trading on prediction markets, but less strictly than the stock market; the CFTC will only come after you if you have “misappropriated confidential information in breach of a pre-existing duty of trust and confidence to the source of the information.” But if they do come after you, they can probably do more to you than Kalshi can. (Bigger fines, banning you from exchanges other than Kalshi, etc.)

3. The US Department of Justice has some obvious interest in nontraditional insider trading, and has brought wire fraud cases against insider sports gamblers and insider nonfungible token traders. If the DOJ comes after you, they can put you in prison, which Kalshi can’t. I don’t know exactly what makes prediction-market insider trading a crime, though. In the sports gambling case, the DOJ argued that the insider bettors committed wire fraud by violating online sportsbooks’ terms of service, which seems like a stretch to me. But if that is the rule, then betting $200 on your own political candidacy, in violation of Kalshi’s rules, might also be a crime? It’s possible that the criminal insider trading rules cover more than the CFTC’s rules; it’s possible that the Justice Department would prosecute some trades that the CFTC would allow.

Here’s how John responded to our member’s question (in part):

That’s an interesting question. I’m far from an expert in commodities regulation, but it strikes me that some adjustment to existing insider trading policies may be advisable (or at least worth thinking about) in order to address insider trading in prediction markets. While the CFTC generally has jurisdiction over prediction markets, if they are used to manipulate securities markets, it’s my understanding that the SEC has the authority to get involved.

John also noted that the SEC has pursued “shadow trading” enforcement theories in the recent past, so perhaps there could be some tie-in to securities enforcement there (keep in mind that practice varies in terms of whether to prohibit shadow trading in company policy). At this point, though, it seems like the connection to securities trading is more indirect. So, for most companies, it may just be a matter of corporate policy – i.e., prohibiting employees from misusing confidential information. On the other hand, Bloomberg also recently reported this:

Roundhill Investments has asked the US Securities and Exchange Commission for permission to launch six ETFs that would let investors wager on US election outcomes through standard brokerage accounts — the most ambitious attempt yet to bring prediction markets into mainstream finance.

I’m not sure whether that changes things. This is a complex and evolving area, and I’ll look forward to hearing from someone who’s analyzed it more closely!

– Liz Dunshee