The US Commodity Futures Trading Commission has initiated a review of three RSBIX NFL binary options sports event contracts proposed to be listed by Eris Exchange, LLC and opened a 30-day public comment period that ends on January 28, 2021.
In general, event contracts are “financial agreements linked to eventualities or measures that neither derive from, nor correlate with, market prices or broad economic or commercial measures.”[1] Event contracts are typically structured as all-or-nothing binary options that pay out a fixed amount when an outcome (an “event”) either occurs or does not occur. Currently, futures exchanges regulated by the US Commodity Futures Trading Commission (CFTC or Commission) list event contracts on the prices of foreign exchange rates, stock indices, gold and oil prices, and heating degree or cooling degree days. For example, in a weather event contract, the event that triggers a payout could be whether average temperature in a specified location over a specified period of time exceeded a specified average temperature.
Eris Exchange, LLC (ErisX) has proposed three sports event contracts: (1) a moneyline contract—based on the outright winner of a National Football League (NFL) game; (2) a point spread contract—based on the winner of an NFL game after adjusting the score by a predetermined number of points; and (3) an over-under contract—based on the total number of points scored by both teams in an NFL game. Importantly, under ErisX’s proposal, the exchange would limit the market participants that are qualified to trade these contracts to “eligible contract participants” (generally, high-net-worth entities or regulated businesses) that are (i) licensed sportsbooks, (ii) sports vendors, (iii) stadium owners, or (iv) designated market makers. Retail market participants, or speculators, would not be eligible to trade in these contracts.
Sports event contracts have never been listed on a CFTC-regulated futures market due to regulatory hurdles that apply to event contracts that involve gaming, adopted as part of the Dodd-Frank Act. The Commodity Exchange Act (CEA or Act) gives the CFTC authority to determine whether certain contracts are contrary to the public interest and, therefore, may not be listed or made available for trading or clearing on or through a registered entity (e.g., a futures exchange or derivatives clearing organization). The CFTC has this authority with respect to contracts that involve “activity that is unlawful under any Federal or State law; terrorism; assassination; war; gaming; or other similar activity determined by the Commission, by rule or regulation, to be contrary to the public interest.”[2]
CFTC Regulation 40.11 prohibits a futures exchange from listing:
An agreement, contract, transaction, or swap based upon an excluded commodity, as defined in Section 1a(19)(iv) of the Act, that involves, relates to, or references terrorism, assassination, war, gaming, or an activity that is unlawful under any State or Federal law; or
An agreement, contract, transaction, or swap based upon an excluded commodity, as defined in Section 1a(19)(iv) of the Act, which involves, relates to, or references an activity that is similar to an activity enumerated immediately above, and that the Commission determines, by rule or regulation, to be contrary to the public interest.[3]
The regulation provides the CFTC with a 90-day review period to make a determination to issue an order approving or disapproving any such contract. Previously the CFTC has exercised this authority by refusing to list political event contracts.[4]
In 2018, the US Supreme Court invalidated the Professional and Amateur Sports Protection Act, enabling states to legalize sports betting.[5] In the nearly three years since the decision was rendered, 25 states[6] plus the District of Columbia have legalized sport betting. Additionally, 21 states[7] have unsuccessfully proposed legislation to legalize sports betting. Federal law prohibits sports betting from crossing state lines.[8]
More generally, under federal law and most state laws,[9] gaming or gambling involves three elements: (1) payment of some form of consideration; (2) a result determined by chance; and (3) a prize or award. In general, each of these elements must be present for an activity to constitute illegal gambling. If at least one of these elements is removed, the offering generally will not meet the definition of “gambling” under current law. laws. Similarly, under one federal statute, a “bet or wager” is defined as “the staking or risking by any person of something of value upon the outcome of a contest of others.”[10]
The Commission has the “power to determine that a contract is a gaming contract if the predominant use of the contract is speculative as opposed to a hedging or economic use.”[11] Here, the apparent purpose of the sports event contracts is to allow sportsbooks, vendors, and stadium owners to hedge or manage risk that is inherent in their legal business. As limited by ErisX, the sports event contracts do not appear to be intended to be used to speculate, nor used solely for gambling under any state or federal law.
When the CFTC announced the review of the ErisX sports event contracts,[12] the CFTC issued six questions for comment. Below we address each question in turn.
Do any of these contracts involve, relate to, or reference gaming as described in Commission regulation 40.11(a)(1)?
To address the Commission’s first question, it is possible that the sports event contracts do not involve, relate to, or reference gaming as set forth in CFTC Regulation 40.11(a)(1). The purpose of the event contracts is to allow sportsbooks, vendors, and stadium owners—not individuals—to hedge risk. In connection with the sports event contracts, there is an argument that market participants use their business judgment and calculations, not speculation, to assess risk prior to trading a contract. The market participant uses the contract to hedge its economic exposure to a sporting event, which may be viewed as fundamentally different from an individual using the event contract to place a wager on the outcome, which is prohibited. While the outcome of the sporting event may be speculative, the economic exposure arising out of the result of the sporting event may not be.
Do any of these contracts involve, relate to, or reference “an activity that is unlawful under any State or Federal law” as described in Commission regulation 40.11(a)(1)?
Likewise, to answer the Commission’s second question, there is an argument that the sports event contracts do not involve, relate to, or reference an activity that is unlawful under any state or federal law. State and federal law prohibit bets and wagers made by a person, and most require three elements: payment, a result based on chance, and a prize or award. An argument could be made that neither a result based on chance nor a prize or award is present here.
First, the event contracts are only available to sportsbooks, vendors, and stadium owners; individual investors are unable to trade the event contracts. Second, the decision to trade the event contracts may be considered a risk-based calculation based on skill, not chance. For example, a sportsbook operator analyzes the number of bets received to determine whether their books are balanced. If the book is not balanced and the sportsbook cannot or does not want to carry the risk of paying out the underlying bets, the event contracts provide a mechanism for the sportsbook operator to trade the underlying bets to another sportsbook operator who is then responsible for paying the bets. There is a similar argument that the ultimate payout results not from chance, but from the underlying event occurring—the athletic competition, sports team performance, etc. Lastly, the event contracts could be considered a calculated business purchase or sale of risk, not a prize or award.
ErisX has proposed to restrict participation in the futures contracts. If such contracts are determined to involve, relate to, or reference gaming or an activity that is unlawful under any State or Federal law, are ErisX’s proposed participation restrictions relevant to the Commission’s determination of whether one or more of the contracts serve an economic purpose and thus may impact the Commission’s determination on whether such contracts are contrary to the public interest? If so, how should such restrictions impact the Commission’s determination of whether one or more of the contracts serve an economic interest and thus may impact the Commission’s determination on whether such contracts are contrary to the public interest?
The Commission also asks whether any of the contracts serve an economic purpose and whether market participant restrictions have an impact on the Commission’s determination. The restrictions on market participants may be one of the distinguishing factors between classifying the contracts as “gambling” contracts or true risk management contracts. An event contract that is based on the outright winner of a football game may not be gambling when a stadium owner whose pecuniary interests likely are affected by the outcome of the game, but the contract probably would be considered gambling if a person without risk management needs was permitted to trade it. ErisX describes the risk management benefits of the point spread and over-under contracts as being beneficial to sportsbook operators who establish the odds of an outcome plus or minus points from a team’s total points scored at the conclusion of a game or who themselves offer over-under odds. The proposed contracts may provide hedging tools for sportsbook operators, a half dozen of whom have submitted comment letters in support of the ErisX contracts as of the date of this article.
In determining whether any of these contracts falls under the prohibition pursuant to Commission regulation 40.11(a)(1) as an activity that is unlawful under any State or Federal law, to what extent should the Commission be influenced by whether all states’ laws permit gaming (including sports gaming), and/or by the prohibition of interstate betting under Federal law?
In Question 4, the Commission asks whether the uniformity of state laws regarding gaming should influence the CFTC’s determination and whether the prohibition of interstate betting under federal law should have any impact on the determination. Because state law regarding sports betting and gambling is evolving, there is an argument that the Commission’s decision should not be influenced by state law. While it is true only 26 states and jurisdictions permit sports betting, another 21 states have recently considered the issue. In the mere 32 months since the Murphy decision, almost every state has considered legalizing sports betting. To use unsettled law to decide on the legality of the event contracts could create an unnecessary barrier to a product with the potential to hedge risk for numerous market participants.
A possibly more proper question for the Commission to consider would be, If sports betting were legal in all of 50 states, would the contracts violate state law? As the above analysis suggests, it is possible that the event contracts would not violate state law if sports betting were legal in all 50 states. Similarly, an argument exists that the prohibition of interstate betting under federal law should have no impact on the Commission’s determination. Because the contracts are limited to sportsbooks, vendors, and stadium owners, there likely is no risk of interstate betting occurring. Under the contracts, it does not appear that an individual investor or bettor is able to use the contracts to effectuate a bet in a different state, and the trading of the contracts occurs only after the bets have been placed.
Could the trading of these contracts that involve sports gaming create incentives to influence the outcome of a sporting event or other outcomes related to sporting events? What mechanisms would be available to the Commission or to the [designated contract market] to surveil for, and guard against, manipulation of these contracts through manipulation of sporting events or other outcomes related to sporting events?
The Commission also asks whether the contracts may incentivize a person to influence the outcome of a game and how the CFTC itself will surveil for manipulation. The potential to manipulate a market is always present; perhaps the better question is whether the exchange has in place adequate controls to discourage any market participant from influencing the outcome of a game or the points scored during a game. ErisX notes that it is a self-regulatory organization and, as such, has the capability to surveil the trading activity in these contracts. However, the CFTC will need access to information about the underlying markets and the stadium owners and sportsbook operators. It is unclear whether the CFTC would need to enter into a memorandum of understanding or information sharing agreement with the NFL to perform these duties.
One possible mechanism that would allow the CFTC to surveil for manipulation is for the CFTC to partner with existing gaming commissions or gaming boards that regulate and enforce gaming laws in states where sports betting is legal. One of the roles of these organizations is to facilitate the rigorous and expensive licensing process that sportsbooks are required to undergo prior to operating in the state. To trade sports event contracts, these organizations could require sportsbooks to create a surveillance system as part of the licensing process, mandate in-depth recordkeeping, and implement annual certification of any requirements the CFTC deems necessary.
What factors should the Commission consider in determining whether these contracts are “contrary to the public interest”?
Finally, the CFTC should consider factors such as risk management uses of the contracts, eligibility criteria of market participants that are permitted to trade the contracts, and whether the exchange has established adequate surveillance measures and tools to mitigate market manipulation. The legislative history regarding Section 745 of the Dodd-Frank Act indicates that hedging an economic interest, as opposed to speculation, would be consistent with the public interest. The restriction on market participants that are permitted to trade the proposed contracts demonstrates that the “predominant use of the contract” is hedging, allowing only persons with a risk management need to hedge their economic interests using the contracts.
Comments must be submitted by January 28, 2021. The CFTC has at least 90 days to issue an order approving or disapproving ErisX’s proposed contracts (until March 23, 2021, or longer if the CFTC asks ErisX to extend this time period).
As noted above, these are contracts of first impression for the CFTC in the context of sports events and there may be significant regulatory inertia, especially during a transition in government administration and Commission leadership that may prove challenging. It remains to be seen whether ErisX’s restrictions on market participants will be sufficient to convince the Commission that these contracts fulfill a legitimate economic purpose and do not implicate public policy concerns regarding impermissible gaming activity on a CFTC-regulated exchange.
The Commission’s determination of the ErisX contracts will establish important precedent on sports event contracts, providing regulatory clarity to exchanges and market participants in the sports and gaming industries.
If you have any questions or would like more information on the issues discussed in this LawFlash, or need assistance in submitting comments to the CFTC, please contact any of the following Morgan Lewis lawyers:
Boston
John J. Concannon III
Chicago
Michael M. Philipp
Philadelphia
Timothy W. Levin
Orange County
Jeffrey S. Moorad
[1] Concept Release on the Appropriate Regulatory Treatment of Event Contracts, 73 Fed. Reg. 25,669 (May 7, 2008).
[2] Section 745(b) of the Dodd-Frank Act; Section 5c(c)(5)(C) of the CEA.
[3] 17 C.F.R. § 40.11(a).
[4] Order Prohibiting the Listing or Trading of Political Event Contracts (Apr. 2, 2012).
[5] See Murphy v. National Collegiate Athletic Ass’n, No. 16-476, 584 U.S. __ (May 14, 2018).
[6] These states are Arkansas, Colorado, Delaware, Illinois, Indiana, Iowa, Louisiana, Maryland, Michigan, Mississippi, Montana, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Oregon, Pennsylvania, Rhode Island, South Dakota, Tennessee, Virginia, Washington, and West Virginia.
[7] These states are Alabama, Alaska, Arizona, California, Connecticut, Florida, Georgia, Hawaii, Kansas, Kentucky, Maine, Massachusetts, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, South Carolina, Texas, Vermont, and Wyoming.
[8] 18 U.S.C. § 1084.
[9] See, e.g., Ky. Rev. Stat. Ann. § 528.010 (West) (“‘Gambling’ means staking or risking something of value upon the outcome of a contest, game, gaming scheme, or gaming device which is based upon an element of chance, in accord with an agreement or understanding that someone will receive something of value in the event of a certain outcome. A contest or game in which eligibility to participate is determined by chance and the ultimate winner is determined by skill shall not be considered to be gambling.”); Haw. Rev. Stat. Ann. § 712-1220 (West) (“A person engages in gambling if he stakes or risks something of value upon the outcome of a contest of chance or a future contingent event not under his control or influence, upon an agreement or understanding that he or someone else will receive something of value in the event of a certain outcome. Gambling does not include bona fide business transactions valid under the law of contracts, including but not limited to contracts for the purchase or sale at a future date of securities or commodities, and agreements to compensate for loss caused by the happening of chance, including but not limited to contracts of indemnity or guaranty and life, health, or accident insurance.”); Mich. Comp. Laws Ann. § 750.301 (West) (“Any person or his or her agent or employee who, directly or indirectly, takes, receives, or accepts from any person any money or valuable thing with the agreement, understanding or allegation that any money or valuable thing will be paid or delivered to any person where the payment or delivery is alleged to be or will be contingent upon the result of any race, contest, or game or upon the happening of any event not known by the parties to be certain, is guilty of a misdemeanor punishable by imprisonment for not more than 1 year or a fine of not more than $1,000.00.”); Tex. Penal Code Ann. § 47.01 (West) (“‘Bet’ means an agreement to win or lose something of value solely or partially by chance.”).
[10] 31 U.S.C. §§ 5361.
[11] 156 Cong. Rec. S5902-01, 156 Cong. Rec. S5902-01, S5906-07 (July 15, 2010).
[12] CFTC Announces Review of RSBIX NFL Futures Contracts Proposed by Eris Exchange, LLC (Dec. 23, 2020).