Legal difference between Binary Options regulated by CFTC and gambling regulated by U. S. member states

Question

I have trouble to understand the exact (legal) difference between binary options and gambling. Binary options are regulated in the United States by the CFTC and gambling is regulated by each U.S. state individually. Some U. S. state have allowed pari-mutuel betting while a few have not, and some other states allow online gambling. [Ref 1]

Example from my understanding:

Binary Option: Is Facebook trading over $ 300 on 30. January 2022 appears to be a binary option regulated by the CFTC.

Gambling: Will Donald Trump be the next U. S. president? Appears to be regulated by the local gambling authority.

Polygon.com, a prediction market for YES and NO questions has been fined by the CFTC by $1.4m on the 4th January 2022. They announced, they have to removed some markets, and continued to operate until now although a fine has been spoken out by the CFTC.

This is basically the part, which I don't understand. It appears the question decides the type of regulation. The type of regulation makes a fair difference. While a banking license requires million of assets a gambling license can be obtained for fairly low amounts.

As part of the settlement deal, Polymarket has agreed to pay a $1.4 million civil monetary penalty and to wind down all markets displayed on Polymarket.com that do not comply with the Commodity Exchange Act (CEA) and applicable CFTC regulations. [Ref 2]

Summa summarum, does it mean that if a company creates a question (Yes/No) on financial assets (like an option traded on an exchange) will be considered as a binary option regulated by the CFTC while a non-related financial question is considered as gambling?

[Ref 1] https://en.wikipedia.org/wiki/Gambling_in_the_United_States#Legality

[Ref 2] https://financefeeds.com/cftc-fines-polygon-powered-binary-options-platform-polymarket-1-4-million/

Answer 1

Gambling and speculation

The difference between gambling and financial speculation is notoriously unclear. See Lynch, Gambling by another name; the challenge of purely speculative derivatives (2011) 17:1 Stanford Journal of Law, Business and Finance 67 (p 94):

Numerous commentators have previously noted the similarity between what is commonly referred to as derivatives trading [eg. stock options, commodity futures …] and what is commonly referred to as gambling [eg. sports betting, card games …]. Too often, however, they have shied away from concluding that the purely speculative form of what are known as derivatives and what is known as gambling are indeed identical.

Lynch defines purely speculative derivatives as those in which “neither counterparty hedges a pre-existing risk” (p 82) and, after accounting for transaction costs, “the expected value for any counterparty to a purely speculative derivatives contract is less than zero” (p 85). According to Lynch, purely speculative derivatives (such as binary options) are “identical” to gambling.

The CFTC’s jurisdiction

If binary options are just gambling, then why are they regulated by the Commodity Futures Trading Commission? 7 U.S.C. § 2 grants the CFTC:

exclusive jurisdiction … with respect to … transactions involving swaps or contracts of sale of a commodity for future delivery … traded or executed on a contract market … or a swap execution facility … or any other board of trade, exchange, or market …

The recent settlement between Polymarket and the CFTC was recorded in an order dated 3 January 2022. The basis of the settlement was that Polymarket (p 2):

has been operating an unregistered facility … for the online trading of event-based binary options contracts, known as “event markets” … Such event contracts, each of which is composed of a pair of binary options, constitute swaps under the CFTC’s jurisdiction, and therefore can only be offered on a registered exchange in accordance with the Act and Regulations.

Specifically, the CFTC argues that Polymarket executed “commodity options transactions” and operated “a facility for the trading or processing of swaps” (order p 6). So, the short answer to the question is that binary options are swaps and swaps are regulated by the CFTC. According to 7 U.S.C. § 1a(47), “swap” includes:

any … transaction … that provides for any … payment … that is dependent on the occurrence … of an event or contingency associated with a potential financial, economic, or commercial consequence.

Contrary to a premise of the question, the CFTC cites “Will Trump win the 2020 presidential election?” as an example of a binary option (order p 3). Presumably, the CFTC would say that presidential elections have potential economic significance.

Conditional tokens as swaps

By 14 January 2022, Polymarket was required to “cease offering access to trading in markets displayed on Polymarket.com, unless such offering, solicitation or trading complies with the Act and applicable Commission Regulations” (order p 10).

As of 31 January 2022, the @PolymarketHQ Twitter account says “Trading unavailable in US.” It is unclear if Polymarket claims that any of its activities are outside the CFTC’s jurisdiction.

However, it is notable that binary options are generally defined by reference to the strike price of an underlying financial asset. In contrast, the conditional tokens traded on the Polymarket smart contract (known as Yes and No shares) generally do not have a strike price. The value of a conditional token can depend on the outcome of any event, and need not be “derived” from the price of a commodity or other financial asset.

Was the Commodity Exchange Act intended to regulate such bets? This is a question to be worked out in the case law, which seems to depend on whether the events bet on have “financial, economic, or commercial consequences.”

Answer 2

The primary distinction between gambling and non-gambling is whether something is a game of chance, and usually, the statutes of a state prohibiting gambling will expressly define it in those terms.

The mere fact that there is some element of chance or probability involved, however, is not sufficient to make something gambling, and the fact that there is some skill involved in a game does not automatically prevent it from being gambling.

Generally speaking, if the activity serves some commercial or economically useful purpose, like an insurance contract entered into by someone with an insurable interest in the outcome, or a contract regarding a security or commodity price, it will not be treated as gambling under U.S. law (Britain and Ireland draw the line differently).

The status of prediction markets is still unresolved, but since many of them call upon the application of skill and knowledge, rather than random chance, to make predictions, and since their use, for example, by the CIA, has given them an air of legitimacy, more often than not, they are not treated as gambling.

Binary options are regulated in the United States by the CFTC and gambling is regulated by each U.S. state individually.

This isn't entirely true. But it does appear that the CFTC asserted jurisdiction over this particular prediction market type activity, and did not consider it to be gambling subject to state law regulation.

Also, there is some federal regulation of gambling even though it is primarily a matter of state law.

Indeed, this ruling was quite helpful in the long run to the prediction market industry. The case held that Polygon.com was subject to CFTC jurisdiction, which would take it out of state law gambling jurisdiction and it provided a road map to come into regulatory compliance:

The platform offered off-exchange event-based binary options contracts and failed to obtain designation as a designated contract market (DCM) or registration as a swap execution facility (SEF).

All it has to do is register with the CFTC as a DCM or SEF and it is in regulatory compliance (these aren't trivial undertakings and could require months of interactions with the agency and $100,000+ of legal work to accomplish, but there is a clear path to doing so).

does it mean that if a company creates a question (Yes/No) on financial assets (like an option traded on an exchange) will be considered as a binary option regulated by the CFTC while a non-related financial question is considered as gambling?

No.

The case held that the questions, for example, about who would win the next Presidential election, constituted a "swap" regulated by the CFTC and not gambling. It simply said that since the CFTC has jurisdiction and since Polygon.com had not complied with CFTC rules for conducting that activity, that it had violated the law.