CFTC’s Rejection of Kalshi’s Election Listing Application: A Closer Look
Last month, the Commodity Futures Trading Commission (CFTC) dealt a significant blow to
Kalshi
, a digital asset market infrastructure provider, when it rejected the company’s application to list its election-related derivatives on a U.S. exchange. In a
statement
released on October 21, the CFTC explained that it could not find the proposed contracts to be “susceptible to manipulation” and that they did not meet the definition of a “commodity.”
The CFTC’s decision came as a surprise to many in the industry, given that Kalshi had previously received approval from the New York Department of Financial Services (NYDFS) to offer its election-related futures contracts. However, it seems that the CFTC’s concerns were rooted in the unique nature of these derivatives and their relationship to real–world political events.
Kalshi’s election-related futures
are cash-settled contracts that enable investors to speculate on the outcome of specific elections and legislative votes. For instance, a contract might represent a bet on which party will control the Senate after the next election, or whether a particular bill will be passed into law. The value of these contracts is derived from real-world political events and is determined by the outcome of those events.
The CFTC’s rejection of Kalshi’s application raises important questions about the role of regulators in shaping the digital asset industry. It remains to be seen how other regulatory bodies, both in the U.S. and abroad, will approach similar applications. Some observers have suggested that this could mark the beginning of a trend towards greater regulatory scrutiny of digital asset derivatives, particularly those with a close relationship to real-world events.
In the meantime, Kalshi has indicated that it intends to continue offering its election-related futures contracts through its existing regulatory framework with the NYDFS. However, the CFTC’s decision underscores the challenges facing companies operating in this space and highlights the need for clear guidance from regulators on how to navigate the complex regulatory landscape.
Quick Read
Introduction
The Commodity Futures Trading Commission (CFTC), an independent U.S. government agency, was established in 1974 to regulate the futures markets. Its mission is to protect market users and the public from fraud, manipulation, and abusive practices related to derivatives. Derivatives are financial instruments that derive their value from an underlying asset or index. CFTC‘s jurisdiction includes all commodity futures and options, swap agreements, and retail off-exchange foreign currency transactions.
Kalshi: A Fintech Company
Enter Kalshi, a New York-based fintech company that aspires to bring transparency and innovation to the political derivatives market. Founded in 2021, Kalshi aims to list election derivatives based on U.S. elections, public opinion polls, and other political events. The company’s goal is to give investors an opportunity to express their views and hedge risks related to the electoral process.
Application and Rejection by CFTC
In April 2023, Kalshi submitted an application to the CFTC seeking approval to list its election-related derivatives. The proposed contracts were designed to settle based on the outcome of specific elections or electoral events. However, the application was rejected by the CFTC due to concerns about market manipulation and potential violation of federal campaign finance laws.
Market Manipulation Concerns
The CFTC was wary of the potential for market manipulation in the election derivatives market. Given the high stakes and volatility surrounding political events, there is a risk that large traders could influence the price of these contracts through coordinated actions. This could undermine the integrity of the market and create unnecessary risks for unsuspecting investors.
Potential Violation of Federal Campaign Finance Laws
Another concern raised by the CFTC was the potential violation of federal campaign finance laws. Election derivatives could be seen as a form of political contributions, and allowing their trading could create an appearance of impropriety or even facilitate quid pro quo arrangements between traders and politicians.
Implications for the Derivatives Market
The rejection of Kalshi’s application highlights the complex regulatory landscape surrounding derivatives and the importance of balancing innovation with risk management. It also underscores the challenges of applying traditional financial regulations to emerging markets, such as political derivatives. As the fintech industry continues to evolve, regulators will need to adapt and find new ways to ensure that markets remain fair, transparent, and free from manipulation.
Background on Election Derivatives and Regulatory Landscape
Definition of Election Derivatives and Their Purpose
Election derivatives are financial contracts that derive their value from the outcome of an election or a political event. These derivatives are used primarily as hedging tools for investors to manage risks associated with political uncertainty. Historically, election derivatives have been traded over-the-counter (OTC) in private markets due to their complex nature and the regulatory challenges surrounding their listing on regulated exchanges.
Historical Context and Uses
The use of election derivatives can be traced back to the 1980s when political betting markets emerged in the United States. In the late 1990s, PredictIt, a DecisionMarkets, Inc. platform, became one of the first companies to offer political derivatives for trading. However, it was later shut down by the Securities and Exchange Commission (SEC) in 2015 due to regulatory concerns. In 2008, Cantor Fitzgerald launched its election derivatives platform, Cantor Exchange, which was also shut down in 2011 following a legal challenge.
Regulatory Framework for Derivatives Related to Elections and Political Events
The regulatory landscape for election derivatives is shaped by multiple laws and regulatory bodies. Understanding the jurisdiction of the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) is crucial to this discussion.
U.S. Securities and Exchange Commission (SEC) vs CFTC Jurisdiction
The Securities Act of 1933 and the Federal Election Campaign Act (FECA) are two key laws that have been used to justify regulatory intervention in election derivatives. However, there is ongoing debate regarding which agency – the SEC or the CFTC – should regulate these contracts. Traditionally, securities regulations have focused on financial derivatives, while commodity regulations apply to futures and options on tangible commodities. Election derivatives can arguably be classified as both securities (due to their inherent uncertainty) and commodities (as they derive value from political events).
Previous Attempts to List Election Derivatives
Previous attempts to list election derivatives on regulated exchanges have faced numerous regulatory challenges. In 2018, the SEC denied a request by the Chicago Board Options Exchange (CBOE) to list election-related contracts. The SEC’s decision was based on concerns that such products could potentially be used for impermissible manipulation or insider trading, as well as the potential violation of FECA.
I Analysis of Kalshi’s Application and CFTC’s Decision
Overview of the Kalshi Application and CFTC’s Decision
Kalshi is a digital marketplace for trading prediction markets on the outcome of political and economic events. The platform structurally
consists
of a decentralized exchange built on Ethereum blockchain,
where users can create and trade derivatives
on a wide range of topics, including US elections.
The features
of the platform include a user-friendly interface,
secure wallets for holding digital assets, and a verified identities system
for maintaining transparency.
Description of the platform and its election derivatives market
The election derivatives market on Kalshi
enables users to buy and sell contracts based on the outcome of specific political events, such as the winner of a primary election or the passage of a legislative bill.
These contracts are settled in US dollars, making them accessible to a broader audience
compared to traditional prediction markets or betting platforms.
CFTC’s justification for rejecting Kalshi’s application
Reasoning based on existing regulations and legal precedents
The Commodity Exchange Act (CEA) section 4c(a)(2)
defines a commodity as any “agricultural product, livestock, meat, and any other commodity (including lumber) that is fungible and acts as a medium of exchange.”
CFTC argues that the election outcomes are not “agricultural products, livestock, meat or any other commodity”
that can be used in commerce, and thus are not considered commodities
under CEA.
Potential risks and implications
However, the CFTC also identified potential risks associated with listing election derivatives
in the United States, such as market manipulation, insider trading, and the potential for harm to the integrity of elections. This concern is based on the belief that allowing such derivatives could influence the outcome of the elections or provide undue advantages to certain parties.
Critics’ perspectives on the CFTC decision and its implications
Views from academia, industry experts, and advocacy groups
The rejection of Kalshi’s application has been met with criticism from various stakeholders. Some academics and industry experts argue
that the decision sets a precedent that may restrict innovation
in the field of political derivatives and prediction markets.
Moreover, advocacy groups argue that the CFTC’s decision undermines
the potential benefits of increased transparency and liquidity in political markets.
Potential consequences for the future of political derivatives trading
The CFTC’s decision could have far-reaching implications for the future of political derivatives trading in the United States. Some argue that the rejection will push innovation to other jurisdictions,
where regulatory frameworks may be more favorable. Others believe that the decision sets a positive precedent for protecting
the integrity of elections and maintaining the separation between financial markets and political processes.
Alternative Solutions:
Regulatory Approaches to Election Derivatives and Political Markets
Overview of alternative regulatory frameworks for political derivatives
Alternative regulatory frameworks for political derivatives have been proposed to strike a balance between promoting market efficiency and transparency, while addressing concerns related to election integrity and potential manipulation. Let’s explore some approaches from other countries that have already implemented such frameworks and consider proposed solutions in the United States.
Approaches from other countries
Switzerland: The Swiss Financial Market Supervisory Authority (FINMA) has taken a permissive stance towards political betting markets. FINMA views political betting as a form of gambling and does not regulate it under financial market law. This approach allows for the development of an unregulated, decentralized market.
New Zealand:
In contrast, the Financial Markets Authority (FMA) in New Zealand considers political derivatives as financial products subject to regulation under the Securities Act. The FMA requires issuers of political derivatives to register with it and comply with disclosure requirements.
Potential benefits and challenges of these alternative approaches
Impact on market efficiency, transparency, and innovation: Alternative regulatory frameworks offer various advantages. For instance, allowing unregulated markets to flourish may spur competition and lead to better pricing and increased liquidity. Conversely, regulations can enhance transparency, ensuring that investors have access to accurate information about market participants and potential risks.
Impact on election integrity and potential manipulation:
Regulatory frameworks can help mitigate the risk of election manipulation by requiring issuers to disclose their trading activities, ensuring market transparency, and mandating adequate internal controls. However, some argue that regulation may restrict innovation and create barriers to entry for new market participants.
Implications for Kalshi and its future plans
As a trailblazer in the political derivatives market, Kalshi‘s future plans will be shaped by regulatory decisions. The success of alternative solutions could impact the company’s growth strategy, potentially leading to expansion into regulated markets or refocusing efforts on non-derivative products.
Conclusion
In this article, we delved into the intricacies of political derivatives trading and the recent landmark decision by the
Commodity Futures Trading Commission (CFTC)
to permit the trading of certain U.S. political derivatives contracts subject to specific regulatory conditions.
Key Points:
The CFTC’s decision came in response to a petition filed by the Chicago Mercantile Exchange and marks a significant shift in regulatory stance towards political derivatives. Previously, such contracts were considered as falling outside the regulatory purview due to their unique nature, being classified as forward contracts rather than futures or options. However, the CFTC recognized the potential benefits of regulating these contracts and outlined specific rules to mitigate risks and ensure market integrity. These rules include limitations on contract size, position limits, and reporting requirements.
Significance of the Decision
The CFTC’s decision to regulate political derivatives is a game-changer in the evolution of this market.
Political derivatives
, as a niche trading instrument, have long been shrouded in controversy due to their potential impact on political outcomes. With this decision, the CFTC aims to bring transparency and regulatory oversight to these markets, making it easier for market participants to engage in political risk management activities. Furthermore, this decision paves the way for more institutional participation in political derivatives trading, which could lead to increased liquidity and market efficiency.
Encouragement for Further Research and Debate
Despite the CFTC’s decision, there are still many unanswered questions surrounding political derivatives trading and its implications for various stakeholders. Further research is required to assess the potential market dynamics, risk management strategies, and regulatory approaches that could be adopted in this emerging market. Moreover, it is crucial to examine the broader implications of regulating political derivatives, including its potential impact on political campaigns and election outcomes. As this field continues to evolve, it is essential that we engage in open and constructive debates to ensure that regulatory frameworks are robust, transparent, and effective while maintaining market integrity and fairness for all participants.