United States: Did you Predict This? Why Prediction Markets may be Your Next Compliance Headache.

By: Thoreau A. Bartmann, Lance C. Dial, Todd S. Fishman, Pablo J. Man, and Sarah V. Riddell

Prediction markets and event contracts have gone mainstream. Prediction market platforms offer contracts on virtually any event you can imagine, and increasingly advisers and their personnel, including portfolio managers, are signing up. If your compliance program hasn’t caught up to the issues that prediction markets raise, you may have a problem you don’t know about yet.

Code of Ethics / Personal Trading Policies

Most codes of ethics were written before event contracts existed as an asset class. An access person who trades a political outcome contract tied to an FDA advisory committee vote — or a merger arbitrage event — could be transacting on exactly the kind of information your MNPI controls are designed to wall off, but in a way you might not be able to easily monitor.

What about event contracts tied to financial market outcomes (or even earnings of single stocks)? Should access persons be reporting these trades even though these contacts are not “securities”?

Event contracts can also raise questions about whether adviser personnel are taking positions that are different or contrary to trading they are engaged in on behalf of clients. While this risk is typically disclosed in offering documents and Form ADV, the underlying fiduciary duty analysis remains important, as does compliance monitoring.

Direct Investments and Research Tools

Some portfolio managers are already trading event contracts directly or using prediction market pricing as a research signal. Neither is inherently problematic, but both require careful thought. Are event contracts within your investment mandate? How are they valued for NAV purposes? If you are using event contract prices to inform investment selections, has the firm disclosed the strategy accurately in its Form ADV? Does trading such contracts (which are generally listed as swaps) implicate CFTC registration?

Training

Training employees is also critical. Many may think that event contracts are just “bets” and completely out of scope of compliance rules. But are they?

If you are interested in learning more about our perspective on the evolving prediction market space, please use this link to access our analysis or feel free to reach out to us.