Why Regulators Are Scrutinizing Prediction Markets' Trading Arms

Fast-growing prediction markets like Kalshi and Polymarket are well known for their consumer apps, where people can bet on everything from sports and elections to the weather and stock prices.

But those companies do more than operate consumer apps. Behind the scenes, several prediction markets operate their own exchanges and clearinghouses for the contracts, and some even have trading firms that make bets using the same contracts that are available to customers. Those kinds of setups have caught the attention of U.S. regulators, which have been examining potential conflicts of interest in recent years following the 2022 collapse of crypto exchange FTX and its Alameda Research trading arm.

The FTX implosion highlighted the crypto firm’s entanglements between in-house trading and its exchange. Those functions are generally kept separate in traditional financial markets—stock exchanges, for example, typically don’t own the market makers trading on them. More recently, the CFTC has included prediction markets in that scrutiny.

The Commodity Futures Trading Commission, which oversees prediction markets including Kalshi and Polymarket US, is now seeking comments on proposed rules aimed at preventing exchanges from giving affiliated trading firms an advantage over customers. They would require trading and exchange businesses to operate independently and would bar the trading firms from making speculative bets against customers.

“It’s really to address a different type of market structure that’s being used by crypto and prediction markets,” said Gabe Rosenberg, a partner at Davis Polk who advises financial institutions. “It’s about how many functions in the market can be done by one affiliated group and what protections need to be in place.”

Though the rules would apply across U.S. derivatives markets, the CFTC highlighted prediction markets as an area with recent “practical significance.” The agency said it knows of at least six exchanges that allow trading by affiliated firms, which can be a significant source of liquidity for prediction markets.

The CFTC comment period ends in early October, after which the agency could revise the proposal and move toward final rules. For now, some of the most popular prediction markets say their setups provide a level playing field for customers, and any affiliated trading firms are market makers that provide liquidity so contracts can trade easily.

In the case of Polymarket, a company spokesperson said it doesn’t have its own market maker, either for its U.S. platform or for its separate, blockchain-based platform for international users.

Kalshi, which is the biggest U.S. prediction market and is close to raising fresh cash at a $40 billion valuation, operates its own exchange and also owns Kalshi Trading, which trades on that exchange. A Kalshi spokesperson said the company supports the CFTC’s efforts.

“Kalshi Trading is unprofitable and represents a very small percentage of our volume. This is a very common and regulated practice in our industry,” the spokesperson said. Kalshi Trading doesn’t receive preferential treatment and doesn’t share personnel, office space or communication channels with Kalshi, the spokesperson said.

“Like any financial market, including the stock market, market makers are industry standard because they help bootstrap liquidity,” the Kalshi spokesperson said. Institutional market makers, including outside trading firms as well as Kalshi Trading, represent less than 5% of volume on the exchange’s most liquid contracts, the spokesperson said.

Robinhood until recently relied on outside exchanges, including Kalshi’s. Last year, it invested in Rothera, a joint venture exchange between Robinhood and trading giant Susquehanna International Group, with each holding a 45% stake. Robinhood has since been routing some customers’ orders to the new exchange, and Susquehanna makes markets on the exchange.

“In compliance with CFTC regulations, we provide a level playing field with fair, transparent and impartial access for all participants,” a Rothera spokesperson said.

The rule proposal comes at a time when prediction betting is starting to resemble serious Wall Street markets, drawing outside market makers and sophisticated traders looking to profit from shifting odds. Prices on prediction contracts can change constantly, especially around short-term outcomes such as who will win the next set of a U.S. Open match.

In its rule proposal, the CFTC noted concerns that prediction firms could give their own trading operation preferential treatment over other traders or access to nonpublic information. That could put everyday traders and other market participants at a disadvantage, the CFTC said.

Under the proposed rules, an exchange would need to disclose any affiliated trading firm and keep its office space, personnel and information systems separate from those of the exchange. Any exchange that offers an incentive program to affiliate trading firms would have to ensure that unaffiliated members can participate on equally favorable terms.

The exchanges also can’t give preferential treatment to affiliated firms under the proposal. For instance, if an independent trader puts in a buy or sell order at a given price, the exchange would have to fill their order first even if an affiliated firm placed the same order earlier. Affiliated trading firms wouldn’t be allowed to make directional bets and would need to put in both buy and sell orders for contracts rather than just taking a one-sided position.

The CFTC’s focus on the affiliated trading firms comes amid separate regulatory battles prediction markets are facing over the sports-related trading that makes up the bulk of their trading activity.

Kalshi, Polymarket and others are under scrutiny over whether their sports contracts are unregistered gambling offerings that should be subject to state-level registrations. Part of the firms’ argument that prediction markets should fall under federal rather than state regulation’ is that, unlike sportsbooks, they don’t trade against customers and are merely matching orders.

The fact that some prediction markets also have affiliated trading firms arguably undercuts that logic. Even if the firms are simply market makers providing liquidity, they’re nonetheless taking the other side of customers’ bets on each trade. That underlines the challenge for regulators as they grapple with how prediction markets fit in with existing financial and gambling rules.