Who Would Have Predicted It? Polymarket Settles for Operating Unregistered Swap Execution Facility
On January 3, 2022, the Commodity Futures Trading Commission (CFTC) announced an order against and settlement with Polymarket, a blockchain-enabled prediction market that allows users to “bet” on the occurrence of certain future events, for offering off-exchange event-based binary options contracts that constituted “swaps” and failure to obtain designation as a designated contract market (DCM) or registration as a swap execution facility (SEF).
Polymarket describes itself as a “decentralized information markets platform” that allows users to bet on their beliefs. Users build a portfolio based on forecasts, buying and selling “shares” based on how a future event resolves, such as whether Bitcoin will be worth more than a certain amount on a certain date or whether a particular candidate would win a political election. The CFTC determined that these shares instead are binary options contracts that constitute swaps and are thus subject to the CFTC’s jurisdiction and related regulatory obligations. Under the U.S. Commodity Exchange Act (the CEA), as amended by the derivatives regulatory reform provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, swaps generally can only be offered on a bilateral basis among eligible contract participants, or over a platform that is registered as a DCM or SEF. Specifically, the CFTC noted the use of an algorithmic “automated market maker” (AMM) to price premiums for the options based on relative demand for each position, with trading volume and liquidity automatically adjusting based on demand and other factors. Market participants were charged a 2% fee on each transaction which was used to compensate the liquidity providers, although Polymarket itself claimed to have reaped no profits.
The definition of “swap” as a category of regulated product under the CEA is very broad, and could be read to encompass most financial contracts that provide for an exchange of value on the basis of some external reference like the occurrence of an event or the price of some asset or index, even where those contracts are not commonly referred to among market participants as a swap. The principal exclusions from the definition of “swap” are products that are subject to an alternate regulatory regime, such as options on securities that are subject to the jurisdiction of the U.S. Securities and Exchange Commission (the SEC). Therefore, any offering of financial contracts whose value is linked to the occurrence of an event or the price of some asset or index runs the risk of enforcement action by the CFTC to the extent they are not already subject to an alternate regulatory regime.
The SEC has taken similar action against providers of financial contracts linked to the price of securities. In 2015, the SEC instituted an enforcement action against the Sand Hill Exchange, which was billed as a platform for investors to purchase contracts linked to the price of pre-IPO technology companies, arguing that the contracts constituted “security-based swaps” subject to the SEC’s jurisdiction and associated regulatory requirements. Accordingly, there is also a risk of enforcement by the SEC against issuers of financial contracts linked to the price of digital assets that the SEC has determined to be securities.
Because the betting contracts were deemed swaps, the CFTC found that Polymarket violated Section 5h(a)(1) of the Commodity Exchange Act and Regulation 37.3(a) thereunder which prohibit the operation of a facility that offers a trading system or platform in which more than one other market participant has the ability to execute or trade swaps with more than one other market participant unless such facility is registered as a SEF or a DCM. Under the order, Polymarket is required to cease offering access to trading in noncompliant markets and to wind down those markets unless the offering, solicitation or trading in those markets complies with CFTC regulations. Polymarket was also ordered to pay a $1.4 million civil penalty. While Polymarket did not admit or deny the findings in the order, it is required to cooperate with the CFTC on an ongoing basis and is prohibited from making statements denying the findings or conclusions of the order and from giving the impression that the order is without factual basis.
The CFTC previously has granted limited no-action relief for operators of prediction markets. For example, in CFTC Letter No. 14-130, the CFTC granted no-action relief for Victoria University of Wellington, New Zealand, to operate a submarket for binary contracts concerning political elections and economic indicators. Importantly, nobody was to receive compensation for operating the market, which was being used for educational purposes, with strict limitations on the number of contract participants, the size of the contracts, the maximum “bet,” and how the site would be advertised, including prominent disclaimers that the proposed market is unregulated, experimental, and being operated for academic purposes. Similar relief was granted to the University of Iowa in 1993 for the operation of Iowa Electronic Markets.
This could create significant regulatory burdens for a provider that seeks to launch as a commercial enterprise a platform for trading event contracts, whether linked to cryptocurrency or other events. Providers could proceed under an existing regulatory model, such as the CFTC’s futures and options regulatory regime, the CFTC’s swap regulatory regime, or, potentially for contracts relating to securities, the SEC’s securities or security-based swap regulatory regime. Each would subject the platform to conditions and criteria imposed by the relevant regulators and would require regulatory approval prior to launch. See, for example, the current CFTC review of the proposal by Eris Exchange, LLC to offer event contracts linked to sports on a CFTC-registered futures exchange, or the rejection by the CFTC in 2012 of a proposal by the North American Derivatives Exchange to list event contracts related to certain political events.
The CFTC order continues its trend of bringing enforcement actions against participants in the crypto industry. For instance, in September 2021 the CFTC filed charges against 14 cryptocurrency options exchanges, many of whom falsely claimed to be regulated by the CFTC, and settled charges with cryptocurrency exchange Kraken for allegedly offering margined retail commodity transactions in digital assets to U.S. customers who were not eligible contract participants.
Per public statements, the CFTC apparently is also looking at more conventional DeFi swaps facilities, such as Uniswap and Sushiswap. It may also be considering whether the very presence of an AMM within a DeFi protocol might be viewed as operating a swap execution facility (or an alternative trading system, if the digital assets in question are securities rather than commodities) and whether staking or lending of tokens in liquidity pools could be deemed entering into a regulated commodities option. Furthermore, this raises questions regarding other prediction-based platforms and decentralized autonomous organizations (DAOs) attempting to prove the governance theory of futarchy (a theoretical form of government where decisions are made by prediction markets to determine which policies would have the most positive effect).
The settlement may also give the CFTC an angle to bring enforcement actions against those participating in, rather than operating, certain DeFi swaps markets, due to their status as major swap participants. On the other hand, the CFTC’s order goes into significant detail about how Polymarket was not decentralized, but rather internally decided on the outcome of any bet and resolved any dispute. Per the order, “Polymarket’s market resolution conditions are defined solely by Polymarket. Any dispute or ambiguity in the market resolution—i.e., the determination of which contracts are winners and which contracts are losers—is resolved solely by Polymarket’s ‘Markets Integrity Committee’, which is staffed solely of Polymarket personnel.” This focus on centralization raises the question whether the outcome might have been different for a fully decentralized platform.
Going forward, other operators of blockchain-enabled prediction markets are likely to pay close attention to whether Polymarket is able to continue running a prediction market in the United States and if so, how it complies with the conditions of its settlement with the CFTC.