The Other CFTC Consultation That Could Have A Big Impact On Prediction Markets Like Kalshi

The Commodity Futures Trading Commission’s (CFTC’s) wide-ranging request for comment on proposed rules for event contracts is likely to be a hugely consequential event for prediction markets.

But there is another CFTC request for comment that could generate a significant impact on the industry, or some participants at least, such as Kalshi.

The request asks about “Direct Clearing of Derivatives by Retail Investors by Designated Clearing Organizations (DCOs).” The consultation closed on Feb. 2, but any steps that may follow have not been announced yet.

A DCO handles the movement of money and associated paperwork behind every trade on a designated contract market (DCM). It holds collateral, processes payments, and manages what happens if a participant defaults. Some, such as Kalshi Klear, are owned by the same company as the DCM, while others like Plus500 are third parties. But either way, direct clearing means traders do not go through an FCM. 

In simple terms, the CFTC wants to know whether an exchange should be able to court customers directly, or if it should make sure that all traders go through some form of intermediary. That intermediary would typically be a futures commission merchant, the status held by Robinhood (which offers access to Kalshi contracts) or FanDuel’s prediction market arm (offering access to CME contracts).

If it doesn’t require intermediation, the CFTC could create a new regulatory status for a “retail DCO,” with its own rules designed to fill in gaps that might exist under the current framework.

Traditional futures very different to most prediction markets

Most traditional commodity futures markets don’t look like Kalshi. An individual retail trader can’t pull up CME.com to purchase corn futures. Instead, trading is done through an FCM. CFTC rules have mostly been written with the assumption that there will be an intermediary in the mix.

In the world of prediction markets, it’s different. Kalshi and Polymarket U.S. both offer direct clearing. Crypto.com has an FCM license but small print of its prediction market website suggests it offers direct clearing too. 

“Retail DCOs have become more numerous, and more active, in recent years in large part due to the growing interest in, and availability of, prediction and other event-type markets,” the consultation says.

That arguably leaves a gap in the regulation for customers who trade directly on an exchange.

While the consultation was one of the last acts from outgoing CFTC Acting Chair Caroline Pham, her replacement Michael Selig seems to be open to the idea of changing the rules too.

“I think about this with two objectives in mind,” Selig said at the FIA Global Cleared Markets Conference earlier this month. “First, how do we protect customers? We must consider which customer protections are missing when there is no FCM present in the chain and how we can maintain the protection inherent in the intermediated model.”

NFA wants change, Kalshi likes status quo

The National Futures Association (NFA), which all FCMs and introducing brokers (IBs) must join, naturally wants to see change. Its General Counsel Tim Elliott wrote a response to the consultation.

“FCMs, unlike Retail DCOs, are required to abide by specific CFTC rules that provide key protections relating to accepting, segregating and investing customer funds, which are designed to ensure the safety of those funds,” Elliott’s response said.

“In addition, CFTC and NFA rules require FCMs to supervise their activities, implement AML-CIP programs, maintain adequate capital, and prohibit the mishandling of customer funds. 

“Further, the U.S. Bankruptcy Code and DCOs offer key protections to FCM customers in the event of a DCO’s default but these protections become unclear in the event of a Retail DCO’s default, particularly as to who receives priority—the DCO’s direct retail participants or its FCM members’ customers—if the Retail DCO offers a ‘hybrid’ model [offering trades on its own platform and via an FCM].”

Kalshi’s response took the opposite stance. Its Chief Regulatory Officer and General Counsel Richard Heaslip wrote that the topic was a matter of “fair and open choice.”

“This evolution of the markets underscores the importance of promoting customer choice. Some customers prefer to access markets in a traditional manner, using FCMs who extend them overnight credit through daily margining processes,” he wrote. “But others prefer to access exchanges directly, either by fully collateralizing their positions or by relying on the exchange to liquidate them before incurring significant mark-to-market losses. Consistent with the CEA’s mandates for responsible innovation and fair competition, the Commission should not require Retail DCOs to establish an affiliated FCM, and retail participants should not be forced to trade through an FCM.”

If an FCM or other intermediary was required, it is very unlikely that Kalshi would simply stop offering contracts on its own website. Instead, it would almost certainly apply for FCM status itself.

“Integrated” structures — where the company owns an exchange, a clearinghouse and an FCM — already exist. Crypto.com already has all three. 

So for most aspects of trading, an intermediation requirement would not make a big difference for users, because the exchange would respond by setting up an integrated FCM. The direct-clearing RFC is not mainly about whether the Kalshi front end would disappear.

Some extra paperwork would move behind the scenes, adding some cost for the exchange, but the customer experience would not be dramatically different, as long as Kalshi’s operations remain the same.

Margin makes a big difference

The difference could matter more if Kalshi, as reported, plans on offering contracts on margin. Currently, direct trading on the exchange is unlikely to pose any big risks because contracts are fully collateralized. In other words, you have to deposit the full amount that you want to bet before making a trade (with an exception for trades where it is mathematically impossible to lose more than you deposit, for example cashing out of a position).

“You don’t have credit concerns, the money has to be there before trading can happen,” David Aron, special counsel at Lowenstein Sandler LLP, told InGame.

But that may change with margin. Trading on margin is a big part of why intermediaries exist in the first place. If an individual customer defaults, an FCM can absorb and manage that loss before it hits the clearinghouse or other customers by using their own capital. Problems would only arise if a whole FCM defaults, which is by nature much less likely as they would not be as dramatically exposed to specific outcomes.

“The FCM supplies money to the clearinghouse,” Aron says. “It’s an extra layer of money to protect the whole system. In general there’s more money around so the clearinghouse has its money.”

In Polymarket’s response to the consultation, Justin Hertzberg — the CEO of Polymarket’s U.S. clearinghouse — noted the significance of margin. There have been no reports that Polymarket U.S. is planning to offer trading on margin.

“Leveraged trading presents a number of risks that are not present in a fully collateralized trading and clearing model,” he wrote.

Heaslip’s letter on Kalshi’s behalf says that risks from offering margin directly on the exchange can be overstated because “retail traders are different.” If retail traders face a margin call – when the value of open positions falls low enough that they can no longer serve as sufficient collateral for the margined trades – Heaslip says that they typically just want to liquidate their positions.

Professional and institutional traders, on the other hand, typically want to hold onto their positions, and will pay more to their broker to enable themselves to do so.

He said that this, combined with other features of retail traders, means that the potential risks that could occur by allowing customers to trade on margin without an intermediary do not apply.

“Direct retail traders are unlikely to pose significant risk to FCMs and their customers because the sizes of retail traders’ portfolios tend to be smaller than institutional traders; in addition, Retail DCOs can take measures (such as auto-liquidation practices) to reduce the likelihood of tapping mutualized default resources that could spread losses to FCMs,” he wrote.

He went on to say that a structure of “waterfalls” could ensure that one large trader defaulting does not mean that other traders suffer unexpected losses.

Differences on sign-up

There are differences between the rules on sign-up too.

When customers sign up for an account, there is a difference between doing so directly with an exchange and with an FCM. People who have signed up for a Robinhood account may remember certain questions about their risk tolerance, which are required for FCMs. The same is not true for direct access.

Know-your-customer and anti-money laundering rules also mostly exist at the FCM level – there are not the same kind of specific rules about know-your-customer and anti-money laundering checks when onboarding a customer for exchanges or clearinghouses.

All registered exchanges that allow direct clearing, such as Kalshi, perform these checks regardless. Despite the lack of a specific rule, it’s hard to believe the CFTC would not find a way to take action against an exchange that bypasses all money laundering checks. 

Kalshi’s response to the consultation points to DCO core principles and the CFTC’s rule 38.15 as giving it authority to enforce AML rules. Those rules have less specifics about duties, but outline principles of preventing suspicious transactions. 

Marketing rule differences

The biggest difference, however, is likely before a customer can sign up. All FCMs and introducing brokers (IBs) are members of the NFA. And the NFA has its own marketing rules.

CFTC rules, meanwhile, assume that exchanges are not going to engage in huge mass-marketing pushes, so there are few rules in place covering that situation.

Selig alluded to that gap last month when he appeared on Bloomberg’s Odd Lots podcast. Asked about a TikTok ad for Kalshi which read, “POV: I was about to be unable to pay my rent, but I got two years of rent through Kalshi’s predictions,” Selig – widely seen as supportive of the prediction market industry – seemed to acknowledge that there was a problem with the rules.

“Well, that’s one point that I think is worth double clicking on, in the sense that there are standards for futures commission merchants, for the brokers within our markets,” he said. “Essentially the way that the Act and the regulations developed, where you have intermediation between the customer and the clearinghouse and the exchange typically in our markets.

“Now other markets cut out the FCM, cut out the broker, and so you have direct to the clearinghouse, direct to the exchange. And that model doesn’t have all the same rules and regulations, and so something that we’re thinking about is how do we make sure that we have consistent standards across both. Now I think this question of what sort of marketing and advertising either should be able to engage in as one that we’re certainly having to think about.”

As Selig alludes to, CFTC rules for DCM marketing are pretty limited, mostly covering ads that are actually misleading. But there are not the same kind of rules for DCMs to prevent marketing in a way that could be considered irresponsible, largely because the rules are written for a world where the only people advertising to everyday traders would be FCMs or IBs.

And for those entities, the marketing rules are much more strict. All FCMs and IBs have to be members of the NFA, which has a much stricter marketing code. Members cannot publish an ad that “employs or is part of a high-pressure approach; or makes any statement that commodity interest trading is appropriate for all persons.” Ads cannot “mention the possibility of profit unless accompanied by an equally prominent discussion of the risk of loss,” which would seemingly prevent the “pay my rent” ad from being published as-is.

Ads that “refer to or describe the extent of any profit obtained in the past or that can be achieved in the future,” as well as ads with specific trading recommendations, must also be pre-approved before going live, which could have a big effect on Kalshi’s influencer-heavy strategy.

Better Markets makes comparison to FTX collapse

Perhaps the strongest comments in the consultation came from financial reform advocacy group Better Markets’ Director of Securities Policy Benjamin Schiffrin, a regular critic of prediction markets.

It attempted to draw a line between direct clearing and the failed crypto firm FTX, which applied in 2022 to offer leveraged trades on Bitcoin without an FCM.

“The CFTC must recognize that direct clearing was championed by FTX and Sam Bankman-Fried before the firm collapsed and Bankman-Fried went to prison,” he wrote. “In our comment letter on FTX’s direct clearing proposal, we said that our foremost concern was that the proposal ‘will facilitate and greatly increase retail trader speculation in the extraordinarily risky cryptocurrency futures markets, and that it will be based more on enticing, if not predatory, digital engagement practices and slick marketing than informed financial decision making.’

“Prediction markets already use gamified platforms that blur the line between investing and gambling and pose tremendous risk for investors. Direct clearing without sufficient regulatory safeguards will only exacerbate the risks prediction markets pose.”