Prediction Markets Have Arrived. Here's What Advisors Should Know

Nevertheless, the regulatory outlook for prediction markets remains uncertain. Several U.S. states dispute the CFTC's jurisdiction over sports markets and have sued Kalshi and Polymarket for violating state gambling laws. The CFTC has intervened to argue that the Commodity Exchange Act preempts state law, but legal experts do not see a certain outcome for these cases and Supreme Court review is not expected until 2027 or 2028. This uncertainty puts a question mark over the long-term prospects for prediction markets, which derive a substantial portion of their revenues from sporting event contracts.

An Emerging Tool for Portfolio Management

Some investment advisers have begun to use the prediction markets to understand portfolio risks. A discussion paper by two U.S. economists recently published by the Federal Reserve supports this use case. The paper concludes that prediction markets can serve as a valuable complement to existing forecast tools and, in the case of forecasts for the federal funds rate and the consumer price index, provide statistically significant improvements over fed funds futures and professional forecasters.

The success of prediction markets has inspired traditional securities and commodities firms to develop similar products using traditional structures and trading on traditional exchanges.

● Intercontinental Exchange has invested up to $2 billion to sell Polymarket data to its institutional base and build investor trust in prediction markets as a new asset class.

● Nasdaq has applied to the SEC to list binary (yes/no) options that allow traders to make yes-no bets on index moves.

● The Chicago Board Options Exchange is developing an option offering an all-or-nothing payout for a fixed yes/no event.

● Three investment advisers are awaiting approval from the Securities and Exchange Commission to launch exchange-traded funds that would offer investors the opportunity to participate in prediction markets for political events using the ETF wrapper.

We expect investment advisers to be a target market for many of these products.

Compliance Issues

Investment advisers should consider how participating in prediction markets could implicate their regulatory obligations and impose appropriate controls to ensure compliance.

Personal Trading. As an initial matter, investment advisers should consider whether to permit their employees to trade in prediction markets for their own accounts. This trading implicates the adviser's fiduciary duty to the extent that it creates an opportunity for employees to exploit the firm's proprietary information and information developed for clients. Firms should work with their legal and compliance professionals to consider what controls will ensure that this trading complies with the adviser's fiduciary duty and what amendments to their codes of ethics may be advisable to prevent even the appearance that employees are misusing the firm's information.

For example, firms may wish to expressly require employees to:

● conduct their trading in prediction markets consistently with their fiduciary obligations and the rules of the prediction market

● refrain from trading in event contracts that relate too closely to the firm's investment process or client holdings, such as contracts in single stocks

● preclear prediction market trading in markets where proprietary information could be relevant

● submit account statements for review

● certify they have conducted their trading in accordance with the code

To the extent that the firm allows prediction market trading, it must also develop a process for compliance monitoring that is resourced to manage the manual nature of account statement review, as prediction markets are not yet positioned to offer automated trading feeds.

Insider trading. Prediction markets also raise the specter of insider trading. Kalshi offers an entire category of contracts that focus on companies, including public companies. A person who possesses material nonpublic information about a public company has a duty to refrain from trading on that information in the prediction markets and the SEC will expect investment advisers to implement controls to prevent that trading.

Jay Clayton, the current U.S. attorney for the Southern District of New York, has said he will use his criminal authority to pursue insider trading and other types of fraud in the prediction markets, using the federal wire fraud statutes. Kalshi has also imposed sanctions on participants trading on inside information.

To prevent insider trading, investment advisers should consider which event contracts may relate to companies about which it possesses MNPI and add those contracts to its restricted list, along with a process for trade preclearance that confirms the person requesting the trade does not possess MNPI. The SEC will also expect to see post-trade monitoring for evidence that trading reflected knowledge of MNPI.

Update disclosure and compliance policies and procedures. Advisers that wish to purchase contracts in the prediction markets to hedge investment risk should consult their legal and compliance professionals to determine how their disclosure and compliance policies and procedures should be amended to reflect those practices. In particular, firms should examine client guidelines for liquidity and SEC expectations for valuation and custody, as well as related disclosures. Firms that use information from prediction markets should also consider what additional disclosure may be advisable regarding their investment process.

Training. Perhaps most important, advisers should consider meeting with employees to explain how trading in prediction markets could breach the firm's fiduciary duties to its clients and alert them to their compliance obligations.

Prediction markets are here, and compliance officers will need to be proactive and vigilant to ensure they are implementing effective compliance practices and protecting their firms.

Carlo di Florio is President of ACA Group, a provider of compliance, risk, and technology solutions for financial services firms.

Carlo di Florio: Courtesy Photo