Blockchain Prediction Markets: A Criminal Enterprise?
When they went after the prediction market Intrade, in 2012, the U.S. Commodity
Futures Trading Commission (CFTC) threw down the gauntlet to anybody else that fancied following in the footsteps of Intrade's founder, the late John Delaney.
David Meister, the Director of the CFTC’s Division of Enforcement, stated at the time:
It is against the law to solicit U.S. persons to buy and sell commodity options, even if they are called prediction’ contracts, unless they are listed for trading and traded on a CFTC-registered exchange or unless legally exempt. The requirement for on-exchange trading is important for a number of reasons, including that it enables the CFTC to police market activity and protect market integrity. Today’s action should make it clear that we will intervene in the prediction’ markets wherever they may be based, when their U.S. activities violate the Commodity Exchange Act or the CFTC’s regulations.
Anybody familiar with the U.S. government's war against online gambling knew that Intrade had had it coming. The term prediction market had played well with the academics and fanboys, indulged on Hayek and Surowiecki, who had hoped that Intrade would deliver the Holy Grail - a global prediction market feeding of a global liquidity pool. But hope alone was never going to make Intrade immune from prosecution, and soon after the CFTC came knocking, Intrade closed its doors.
Fast forward to 2017 and into the arena comes Augur and Gnosis, who are by their own accounts decentralized prediction market platforms (for decentralization read; no company or central authority is in control of what is being published, such that once something is published it cannot be shut down). Utilising blockchain technology, these entities share the stated aim of challenging dated jurisdictional regulation.
In its whitepaper, Gnosis, despite much revolutionary rhetoric, suggests that it will actually conform with all applicable laws, regulations and standards;
Though we feel decentralization holds great promise, we
must, and intend to, operate our business in accordance with the laws of relevant jurisdictions. As
such, Gnosis may not be immediately available in certain jurisdictions. The Gnosis team and our
advisors are aggressively pursuing strategies to bring the benefits of Gnosis and the information
sharing economy to the globe as quickly as possible. First steps may include obtaining financial or
gaming licenses as required by law.
This would indeed seem like a sensible decision, when one considers that Gnosis is headquartered in Gibraltar, and that in its recent proposal for a Blockchain regulatory framework, the Gibraltar Financial Services Commission stated:
A DLT firm must have systems in place to prevent, detect and disclose financial crime risks such as anti-money laundering and countering terrorist financing
(AML/CFT). DLT firms must adequately apply anti-money laundering and counter terrorist financing preventive measures which are commensurate with their risks, and report suspicious transactions. DLT firms need to be aware of the vulnerabilities of its products and services to financial crime risks and ensure that they implement measures to mitigate the risks. DLT firms will need to comply with the Proceeds of Crime Act and any guidance issued by the GFSC.
Gambling companies that are based in Gibraltar will of course also be subject to the European Union Fourth Anti-Money Laundering Directive,
which will cover the enire gambling sector and which stipulates that gambling companies must ensure that basic information on the payer of transfers of funds is immediately available to law enforcement and/or prosecutorial authorities to assist them in detecting, investigating, prosecuting terrorists or other criminals and tracing the assets of terrorists.
The case law of the Court of Justice of the European Union(CJEU) in relation to online gambling makes it clear that there is not, and nor is there likely to be, in the foreseeable future, a single betting market in Europe, harmonized around technical,legal,and taxation issues. For which read that companies that operate in the betting space are not free to operate across the 28-nation bloc without complying with local laws.
On 12 July 2012, the CJEU pronounced judgment in the case C-176/11 HIT and HIT LARIX. The Court noted, with reference to its previous judgements in Carmen Media and Bwin Liga, that it was established in case-law that restrictions on gaming activities may be justified by overriding reasons in the public interest, such as consumer protection and the prevention of both fraud and incitement to squander money on gambling;
the Court has repeatedly held that legislation on games of chance is one of the areas in which there are significant moral, religious and cultural differences between the Member States. In the absence of harmonisation in the field, it is for each Member State to determine in those areas, in accordance with its own scale of values, what is required to protect the interests in question.
Suffice, to say, the regulatory burden is high for those companies that wish to operate in European betting space. A point that was recently highlighted by Betfair's chief technology officer Tony McAlister;
I have to make changes in the systems where customers information and money is kept to allow for unique things like the national ID cards in Spain, which I dont have to account for in Italy, for example. There have been numerous situations where the IT team has needed to support regulatory changes, such as Italian regulators wanting to see bets taking place in real time so they can approve them, which meant establishing communications between Betfair and the authorities in Italy. Authorities in Denmark want information on bets to be placed in a safe location in case the government needs to access it, and authorities in Spain are going down the same route.
Noting that having to deal with these changes could easily have consumed all of Betfairs resources and budget McAlister went on to describe how the company had to build what it calls a jurisdictional architecture, a project that broke the Betfair's IT architecture down into various country-related components...enabling independent deployments and changes, depending on what has to be presented to the customer.
In a statement that should send a shiver down the backbone of every traditional betting company and betting industry regulator, Augur is on the record as having said; Augur is different from existing prediction markets in that it cannot be shut down once it goes live at least not without shutting down ethereum (the blockchain platform) or tracking down thousands of pseudonymous people many of whom would be situated in legal territories where their part in the system is legal.
Whereas Intrade was responsible for publishing its own prediction markets, with Augur and Gnosis, the onus to create markets rests with a market creator (punter/trader), who we are told, in the case of Augur, must click on Create Prediction Market, in order to include his event in a prediction market. Liquidity in each market, so the theory goes, will be provided by a market maker and, in the case of Augur, each transaction will be settled, when holders of Augur's own Reputation token, acting as market reporters, reach a consensus as to the outcome of the event.
The legal entity behind Augur, the Forecast Foundation, is a not-for-profit corporation established, it says, with the specific purpose of building and developing; open-source, public forecasting tools. The Foundation goes out of its way to emphasise the fact that they will have no control over the Augur prediction market platform, or indeed, what is done on it. They also, as previously noted, champion the fact that Augur's exchange will be decentralised, and will have global reach; anyone, anywhere in the world can access and use Augur, potentially bringing unprecedented liquidity, volume, and a diversity of perspectives and topics unseen in prior iterations of prediction markets. Referencing the verdict of the the U.S. Sixth Circuit Court in Junger v Daly, which held that software source code is protected by the First Amendment, the Foundation has stated; The law does not prohibit the creation of open-source, decentralized prediction market software, nor the distribution of cryptocurrencytokens. The notion very much being that as the authors of open source software and, indeed, a cryptocurrency, the team at the Forecast Foundation are immune from prosecution.
Whilst asserting that any software used on the Forecast Foundation Site, is the property of Forecast Foundation or its suppliers and protected by copyright the Forecast Foundation does take great steps to distance itself from the useages to which its software may be put. Augur’s attorney is on the record as saying that; We’ve taken the steps that we need to take in order to bracket the individual's risk and the organization’s risk. Users of Augur will be asked to warrant to Forecast Foundation that they will not use Augur for any purpose that is unlawful and the Forecast Foundation reserves the right at all times to disclose any information as necessary to satisfy any applicable law, regulation, or legal process. In a post on the Reddit platform in 2016, a spokesperson for Augur Support wrote; Augur will be a global, decentralized platform, not a US-only one. It's ultimately up to users to be compliant with their own local rules and regulations, which will vary everywhere.
Expressing their broader legal credentials Augur also wrote;
We hired top law firm Pillsbury Winthrop Shaw & Pittman:
New York Law School professor Houman Shadab is an adviser
Crypto legal expert Eliazbeth Stark is an adviser
We've consulted with regulators - past and present - from the start
It has been reported that the founder of Augur, Joey Krug (who is on the record as defining a prediction market as being somewhere that you can make a financial market on any future event) and the team at Augur were planning to meet with CFTC staff go over how their system works before it is officially launched. Krug, we have been told, does not believe that he and the team at Augur have anything to worry about;
Our friends in Washington, D.C. say the CFTC will probably just dismiss Augur and say it’s not a big deal.
On the Augur Reddit page Krug had this to say in relation to the subject of Augur and regulation: If you're making markets on augur, you should be careful anyways because you'd be spending hundreds or thousands of dollars on initial liquidity --- some basic legal research into the ramifications of this isn't that big a deal. And since augur's markets are so broad, they range from markets that are perfectly legal in the US to ones that are not, but we're not going to put out a point by point case by case bulletin going over that (just as bittorrent doesn't put out a bulletin over all the files that are legal to download and all the ones that aren't, and all the files that are legal in your state but not in mine). There're 100+ countries who have people who are part of the augur user base, if we spent time researching the laws of market making (which we ourselves aren't even going to do at all) for all of them, all of the funds raised would go to that, we'd still probably be quite a few million short, and the platform wouldn't get built. We are looking into the ramifications of reporting, and are in dialogues with regulators surrounding that.
It is clear that those that have developed the Augur exchange software are fully cognizant of U.S. gambling law and that it is their contention that the decentralised nature of the exchange removes them from having any liabiliy as regards infringment of said law. Moreover, they also clearly believe that their creation of a digital coin (Reputation) and its sale to users of their platform will not cause or materially contribute to any such infringing conduct. Moreover, they presumably also believe that The Wire Act, the primary U.S. federal criminal statute in relation to gambling, cannot be applied to the users of the Augur platform, because it only kicks in when an entity knowingly accepts online wagers from U.S. based citizens.
Reputation (REP)tokens, limited to 11 million, will, it is hoped, be the crypto-fuel that will keep the Augur exchange engine running. To date, 80% of these tokens have been sold to the crowd, 16% have been reserved for the founding team and early advisors, and 4% has been reserved for the Forecast Foundation, who, we are told will use their REP for new employee packages, bounties, funding development, etc. Investors in the Reputation token have provided the capital that will pay the staff of the Forecast Foundation but they will be able to share in the profits of the Augur exchange, through reporting accurately on the outcome of prediction market events. Without their reports there will be no contract settlement - no bet, no payout. Half of all settlement fees on the prediction market are allocated to Reputation holders. Thus, Reputation holders through their reporting activities, settle the contract between individual entities trading in the so-called prediction market and benefit accordingly. Outstanding settlement fees will, we are told, be slipt between market creators and market makers.
Through ownership of the Reputation digital token, people will benefit, in line with the overall performance of the Augur exchange. The better the performance of the exchange, the greater will be the appreciation of the digital token on the digital asset exchanges. The creation of markets, the provision of liquidity to those markets, and the settlement of them, through reporting, is therefore essential if investors in REP are to get a significant return on their investment. The relationship between holders of REP and market creators/makers is accordingly a symbiotic one. No market creators/makers, no exchange and REP will become worthless. No REP holders (and market reporters) and markets will not be settled and the Augar exchnage will collapse. Accordingly, it can be seen that the structure of the Augur exchange ensures that both REP holders and market creators/makers are incentivised to advertise the markets that are available on the Augur platform.
It stands to reason that those who have bought REP Tokens were investing in a common enterprise and are reasonably expecting to earn profits through that enterprise. In the event that REP tokens are deemed to be securities, such persons are likely to find themeselves liable under Section 5 of the Exchange Act which encompasses any person’ who participates in the offer or sale of an unregistered, non-exempt security.
Applying a theory of inducement of copyright infringement, the Court in the Grokster case held that anyone who distributes a device with the intent of promoting its use to infringe copyright, as shown by clear expression or other affirmative steps taken to foster infringement, is liable for third party infringement. It was held that evidence of Grokster's and Streamcast's words and deeds going beyond distribution as such shows a purpose to cause and profit from third-party acts of copyright infringement. The Supreme Court concluded that Grokster's and Streamcast's unlawful objective is unmistakable. It said that they could have used their own software to check for infringing works made available for downloading on the networks created by their software. Thus, where an entity distributes a device with the object of promoting its use to infringe copyright, and profits from said direct infringement, then they are liable for the resulting acts of infringement by third parties. Moreover, where a product is good for no use other than infringement, an intent to infringe or to induce infringement may be presumed.
The Court identified three features of such of evidence of intent:
1. Each company showed itself to be aiming to satisfy a known demand for copyright infringement.2. Neither company attempted to develop filtering tools or other mechanisms to reduce infringing uses of its software. 3. The more their software was used, the more the companies benefitted from it.
If you cannot control the types of markets that appear on your exchange platform, then, you cannot, for the purposes of the law, dictate what
sort of exchange it is that you have unleashed on the world. Intrade got away with being a so called prediction market and got prosecuted as being a one, because of the types of markets that it was knowingly putting up on its exchange. Gnosis and Augur, in that they are, by their own account, decentralised, do not have the luxury of determining or dictating what markets will appear on their exchange. Accordingly, their claim to be pure prediction markets, is at the very least tenuous, and is unlikely to offer much of a defense in the event that their exchanges are seen to be offering traditional sports betting markets.
It could be argued, that in that the Augur exchange software will be freely available to anyone, anywhere in the world that market creators/makers and the people doing the reporting on Augur could, be prosecuted for aiding or abetting criminal infringement. It could also be argued that the the founding team, early advisors and employees of Augur, who hold Reputation tokens, have a financial incentive related to the infringing activity. Accordingly, the argument would run, that the founders and employees of a decentralised blockchain exchange, that chooses to shun regulatory compliance, are guilty of facilitating wrongful conduct, of failing to take steps to prevent that conduct, and, in fact, of promoting it through the creation of a digital coin that is integral to the survival of the exchange and through the incentivisation programmes that are related to it.
In that the Augur exchange will be accessed through a website, there is nothing to stop the team at Augur from ceasing access for users that are based in the United States, providing that those users are not taking steps to hide their location. Moreover, it is also the case that on the blockchain itself, geo-location technologies could be used to locate would-be online gamblers and to block transactions from individuals located in countries with which Augur is not compliant. Any entity that could, but fails to take these steps, could find itself being found guilty of facilitating the placement of online wagers by U.S. based persons. (The Wire Act does not exclude bets transacted in a peer-to-peer setting, and there is scope to argue that a cryptocurrency transaction used for the purposes of betting in a peer-to-peer setting, constitutes an electronic fund transfer. under the Unlawful Internet Gambling Enforcement Act of 2006. The Unlawful Internet Gambling Enforcement Act of 2006 defines a bet or wager as the staking or risking by any person of something of value upon the outcome of a contest of others, a sporting event, or a game subject to chance, upon an agreement or understanding that the person or another person will receive something of value in the event of a certain outcome. The notion that blockchain exchanges operate in some sort of supra-legal environement, because current laws only pertain to fiat currencies, is of course total nonsense. In the Bitcoin Savings and Trust case the court found that bitcoins are indeed money, or tokens representing money, and are thus consideration. The Travel Act may be violated whenever the internet is used to place or receive a bet in a jurisdiction where gambling is prohibited.).
Let us take the following hypothetical example; a person based in the U.S. puts up a sports betting market on the Augur platform, which is traded by another person, also based in the U.S. in violation of the Wire Act. Until the market is reported on, the bet will not be settled. The market reporter, without even knowing that the market creator is committing a crime, provides a service to him by reporting on his market, and therefore leaves himself open to a charge of aiding and abetting. Under the law of aiding and abetting indirect actors will be found guilty where it can be shown that their actions have been a substantial factor in causing the resulting tort. (Section 2(a): Aiding and Abetting. (a) Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.).
Whilst Augur states that its concept of a decentralised exchange is innovative, that innovation still nonetheless pertains to the field of betting. And, moreover, whilst the Augur exchange will be built on the Ethereum blockchain, it will still be accessed through the internet. The Reputation token links the founders,employees and advisors of Augur to the Augur platform. Market creators, market makers and reporters are financially incentivised to act in the service of the exchange by settlement fees and through the possibility that Reputation will significantly appreciate in value, the more popular that the Augur exchange becomes.
It would be wrong for anyone to conclude that tech companies have no responsibility for the services that their software unleashes.
Moreover, whilst using the ethereum blockchain to develop a decentralised exchange may make prosecution more difficult, it does not mean that it will not happen. Where a company has created a computer system architecture that encourages infringement and receives a financial benefit directly attributable to the infringing activity it is likely to be prosecuted. Moreover, anybody that provides services, in whatever form, to that company is leaving themselves open
to a charge of aiding and abetting.
I hate to be the one that spoils the party, but any blockchain prediction market exchange that explicitly sets out to circumvent laws and regulations, should, at the very least fully disclose all associated risks to its customers, as compared with simply trying to exclude its own liability. Augur should, for example, make its future customers aware of the fact that Senators Chuck Grassley, Dianne Feinstein, John Cornyn and Sheldon Whitehouse have co-sponsored bill S.1241 (Combating Money Laundering, Terrorist Financing, and Counterfeiting Act of 2017) which will add language to existing anti-money laundering provisions to include digital wallets, prepaid access devices, and other digital currency exchangers if they contain over $10,000 of cryptocurrency. This Act has the potential to blow the entire Blockchain Prediction Market Model out of the water. They should also, vis a vis their ICO and REP, highlight the importance of the judgements in SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943); the reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as investment contracts or as any interest or instrument commonly known as a security and Reves v. Ernst & Young, 494 U.S. 56, 61 (1990); Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called. And, of course, the significance of the recent judgement in Securities and Exchange Commission v. Traffic Monsoon et al, which suggested that initial coin offerings are probably regulated by Securities Law. If it is the case that they are, then it is also the case that those who have participated in Augur's unregistered offer and sale of securities are liable for violating Section 5 of the Exchange Act.
Augur's Krug of course, disagrees:
By the time our sale came about in late summer 2015, all involved parties had a fairly high degree of confidence that we had developed a token and offering that would not fall foul of regulations.
The problem with law is that it evolves. It is now 2017 and on July 25, the Securities and Exchange Commission issued an investigative report cautioning market participants that offers and sales of digital assets by virtual organizations are subject to the requirements of the federal securities laws;
The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets. In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.