The Current State of Prediction Markets

Prediction markets burst onto the American marketplace in the fall of 2024, and their popularity has only grown since^1,2. While these markets have existed in the U.S. for decades, their use expanded rapidly last year after KalshiEX LLC (Kalshi), a federally regulated derivatives exchange and clearinghouse, began offering contracts based on the outcome of political events (e.g., “Will Trump win the White House”)³. The Commodity Futures Trading Commission (CFTC) under the Biden Administration sought to prohibit such contracts, arguing that they were akin to gaming and contrary to the public interest; however, Kalshi sued the CFTC in court and won^4,5.

Since Kalshi’s 2024 legal victory, prediction markets have expanded to offer event contracts based on crypto, climate, economics, financials, companies, and—most controversially—sports. Entrenched incumbents, including gaming associations, Tribal nations, and the States, have filed lawsuits and cease-and-desist letters to protect what was traditionally their domain^6,7,8. Other industry participants, however, have sought to capitalize on opportunities they’ve identified:

With much influx in the world of prediction markets, this article shares our insights on emerging opportunities and risks for markets participants.

Banks, IBs, B/Ds, and Asset Managers:

The traditional financial services industry has two key aspects of prediction markets to consider:

1. How to surveil employee trading, and
2. Whether to allow clients to trade on event contracts through brokerage accounts.

Control Room Surveillance – Our clients have expressed concerns regarding the use of material non-public information (MNPI) in prediction markets, which pose a substantial threat beyond the integrity of these markets and onto the firms and individuals themselves. To protect their reputation, comply with regulatory requirements, and uphold the highest standards of ethical conduct, financial service firms should consider proactive measures to identify, mitigate, and prevent such risks. Specific risks and challenges include exploitation of sensitive information as employees with access to MNPI misuse it to enter into event contracts, predicting outcomes of financial events; market distortion, including insider-driven trades impacting market integrity; and regulatory and legal consequences, if controls and safeguarding are insufficiently designed to prevent misuse of MNPI, including regulatory action, fines, and reputational damage.

Offering Event Contracts to Retail Consumers (e.g. Banking App interface) – Consumer appetites are evolving and driving growing retail demand for unconventional assets, leading some financial service firms to identify event contracts as an attractive new offering. While current media coverage is focused on more controversial events (e.g., sport and political outcomes), events in the financial industry, such as company earnings and Fed rate decisions, may give consumers further methods to enhance their portfolios. From the banks’ perspective, offering these capabilities could deepen client relationships – showing they can attempt to innovate and respond to client pain points and demand. By leveraging their trusted platforms, banks may attempt to capitalize on opportunities they identify, either by partnering with established DCM/DCO platforms or by using their own trading capabilities. For an example of partnership structure, a firm may reference Robinhood’s partnership with Kalshi to offer its customers access to prediction markets through brokerage accounts¹⁶.

Traditional Derivative Exchanges:

For established derivative exchanges and trading venues, the rise of event contracts offers both a growth opportunity and a strategic challenge. Opportunities include:

1. Offering event contracts, thus increasing product and client diversity.
2. Adapting to markets with heavier retail participation and opening new industries for partnerships.

Event contracts provide an opportunity for traditional exchanges to diversify their offerings beyond standard asset classes. These contracts can appeal to retail traders thanks to their intuitive yes/no format, potentially attracting participants who find trading traditional futures or options too complex. Additionally, there could be potential for partnerships with traditional sportsbooks, possibly allowing exchanges to integrate sports trading (betting) to reach a broader retail audience.

The incorporation of event contracts could diversify product offerings and attract new revenue streams, yet it poses challenges in defining risk parameters traditionally managed within established derivatives risk management frameworks. Event contracts, with their discrete outcomes, challenge traditional risk models that are designed for continuous market variables, making it difficult to predict price movements using standard metrics. Additionally, the lower liquidity in these markets leads to more volatile bid-ask spreads and unpredictable pricing, complicating the accurate calibration of risk measures like margin requirements. To effectively manage these risks, firms could start by developing innovative risk models that integrate advanced analytics with fresh insights and potential new regulatory guidance tailored to the unique dynamics of event contracts.