Prior to the 2024 presidential election, various prediction markets like Polymarket, PredictIt, and ForecastEx were leaning towards a victory for Donald Trump, despite election models and poll aggregators showing a close race.
As it turned out, the prediction markets were accurate in their forecast.
The outcome of the previous election could mark a significant shift for these platforms, some of which have been operating in a legal gray area. A Trump administration might lead to a more lenient regulatory environment moving forward.
What are prediction markets?
Prediction markets are online platforms where individuals can wager on future events.
These events can range from elections to financial markets, like whether the S&P 500 index will surpass a specific level by year-end, or even pop culture events, such as predicting the winner of the Academy Award for best picture. The events must involve binary, “yes or no” or “one or the other” questions that will be resolved by a specific date.
Prediction markets operate using event contracts, a type of financial instrument with a nominal value, often $1. Traders can purchase “yes” or “no” positions on these contracts for a fraction of that value. When the event occurs, the contract pays out to the correct prediction.
For example, consider an event contract on whether the S&P 500 will close above 7,000 points by the end of 2025. If a trader buys “yes” positions on 1,000 contracts for 25 cents each and the index does close above that level, the trader would earn $1 per contract, resulting in a return of $1,000 on an initial investment of $250. However, if the prediction is incorrect, the trader loses the $250 investment.
There are three prominent prediction markets currently in operation in the U.S.: Kalshi, PredictIt, and ForecastEx, with the latter being a subsidiary of Interactive Brokers.
Fees, minimums, and structures vary between platforms. Some platforms charge as little as $0.01 per contract, while others take a percentage of profits. The variety of contracts offered also varies significantly across platforms.
Are prediction markets legal?
The legality of prediction markets is complex, but regulators appear to be gradually more accepting of them.
Historically, regulators have taken a tough stance against unlicensed online betting platforms, particularly those allowing election betting. In 2022, the Commodity Futures Trading Commission (CFTC) banned Polymarket from accepting bets in the U.S.
However, there has been a shift in recent years. While the CFTC tried to impose similar bans on PredictIt and Kalshi, PredictIt successfully defended its case in July 2023.
The ongoing case against Kalshi by the CFTC saw an October 2024 injunction allowing it to continue operating while the legal process unfolded, signaling a positive outlook for prediction markets, including those related to elections. Following this ruling, Interactive Brokers introduced ForecastEx contracts to its trading platform, and Robinhood launched an election betting market using ForecastEx contracts.
Trump’s advocacy for relaxed business regulations, including in the financial sector, suggests a potential for a more lenient regulatory approach towards prediction markets under the incoming administration and Congress.
On November 14, 2024, the Judiciary Committee of the Republican-majority House of Representatives issued an open letter urging the CFTC to halt its legal actions against Kalshi, hinting at a lack of interest from the incoming administration in pursuing the case further.
How are prediction market winnings taxed?
Prediction markets represent a novel financial technology, and their tax treatment may evolve in the future. Currently, many prediction markets like PredictIt and Kalshi issue annual 1099-MISC forms to users listing their net profits as ordinary income.
This implies that prediction market winnings are likely subject to ordinary income tax rates. Even if a more specific tax status is assigned in the future, prediction market winnings will probably be subject to short-term capital gains tax rates, equivalent to ordinary income rates, as they involve trading assets typically held for less than a year.
The risks of participating in prediction markets
The CFTC’s argument against Kalshi suggests that prediction markets may be considered a form of gambling. While this argument may not prevail in court, investors should weigh it when deciding on involvement in prediction markets.
Event contracts in prediction markets are high-risk, all-or-nothing bets based on uncertain future events. This makes them riskier than many other investment options and generally unsuitable for long-term wealth building, similar to sports betting.
Gambling tendencies can be addictive, and prediction markets could serve as a new avenue for such behavior.
If you suspect that you might be struggling with a gambling issue, the National Council on Problem Gambling provides a phone helpline at 1-800-GAMBLER to offer support and assistance.
However, if you are financially stable and have some extra funds you would like to use in prediction markets, it is important to follow some sensible guidelines:
– Only gamble with money that you can afford to lose.
– Limit your betting to special occasions and avoid making it a regular habit.
– Set a budget for your gambling activities and stick to it.
– View your bets as entertainment expenses rather than investments.
By adhering to these guidelines, you can enjoy prediction markets responsibly while avoiding the pitfalls of excessive gambling.