The Future of Prediction Markets in a Fragmented U.S. Regulatory Landscape

The U.S. prediction market sector is at a crossroads, caught between explosive growth and a rapidly evolving regulatory landscape. As platforms like Kalshi and Polymarket expand their offerings, they face a dual challenge: navigating a federal regulatory environment that has retreated from aggressive enforcement while contending with a patchwork of state-level laws that increasingly treat prediction markets as gambling. This fragmentation creates both risks and opportunities for investors, demanding a nuanced understanding of legal precedents, enforcement trends, and market dynamics.

Federal Retreat and State-Level Enforcement: A New Normal

The Securities and Exchange Commission (SEC) has shifted its focus in 2025, prioritizing investor protection and core market integrity over expansive rulemaking. Chairman Paul Atkins has emphasized a return to "core principles," including due process and clarity, while withdrawing 14 rule proposals from the prior administration, including those on ESG disclosures and best execution standards. This retreat has left a regulatory vacuum, which state attorneys general have eagerly filled. For instance, New York has pursued lawsuits against cryptocurrency ATM operators for unregistered activities, while Iowa and Pennsylvania have cracked down on digital asset scams according to state regulators. This trend underscores a broader pattern: states are increasingly asserting authority over financial innovation, particularly in sectors like prediction markets where federal oversight remains ambiguous.

Kalshi's Legal Battles: A Case Study in Regulatory Uncertainty

Kalshi, a CFTC-regulated prediction market platform, has become a lightning rod for legal disputes. In late 2025, a federal judge in Nevada ruled that Kalshi's sports betting contracts-such as pre-built parlays and player prop bets-constitute traditional gambling under state law, forcing the company to halt operations in the state. This decision marked a reversal from an earlier April injunction that had allowed Kalshi to operate under federal preemption according to a sports handling report. The ruling highlights a critical question: Are prediction markets governed by federal commodity laws or state gaming regulations?

The legal divide is stark. In New Jersey and Nevada, federal courts initially sided with Kalshi, citing the Commodity Exchange Act as preempting state laws. However, Maryland's court denied a preliminary injunction, arguing that Congress did not clearly intend to preempt state gambling laws under the CEA according to a legal analysis. These conflicting rulings have created a "circuit split," raising the likelihood of a Supreme Court intervention to resolve the issue. For investors, this uncertainty translates to operational risks: Kalshi's ability to expand into new markets hinges on unpredictable judicial outcomes.

Industry Growth: Valuations, Partnerships, and Market Expansion

Despite regulatory headwinds, the prediction market industry has seen remarkable growth. Kalshi and Polymarket have attracted substantial investment, reaching valuations of $5 billion and $8 billion, respectively. Partnerships with major financial platforms like Robinhood and Webull have further accelerated adoption, enabling retail investors to trade event contracts on political and sports outcomes according to a KPMG report.

Financial data also underscores the sector's momentum. Nasdaq reported a 15% year-over-year revenue increase in Q3 2025, driven by financial technology and index products, with its financial crime management and regulatory tech divisions growing by 13% organically according to Nasdaq's Q3 earnings. Meanwhile, AI-driven innovations in the IT sector have amplified demand for prediction markets, as companies leverage these tools to hedge risks and forecast trends according to BlackRock's Q3 outlook.

Regulatory Risks: Fragmentation, Taxation, and Consumer Protection

The fragmented regulatory environment poses significant challenges. State regulators have issued cease-and-desist letters to prediction market operators, while tribal authorities in California and Wisconsin have raised concerns about the impact on gaming rights according to a legal analysis. Massachusetts has even filed a lawsuit against Kalshi, alleging violations of state gambling laws. These actions reflect a broader push by states to assert control over what they view as unlicensed gambling activities.

Taxation is another unresolved issue. The IRS has yet to issue clear guidance on how to classify prediction market gains, leaving investors exposed to potential retroactive tax liabilities. Consumer protection concerns further complicate the landscape. While Kalshi operates under CFTC oversight, smaller platforms may lack the infrastructure to prevent fraud or market manipulation, creating reputational and legal risks.

The Path Forward: Balancing Innovation and Regulation

The future of prediction markets will likely depend on how courts and regulators reconcile federal and state authority. If the Supreme Court rules in favor of federal preemption, platforms like Kalshi could expand nationwide with minimal state interference. Conversely, a decision affirming state jurisdiction would force operators to navigate a labyrinth of licensing requirements, stifling innovation and scalability.

For investors, the key is to balance the sector's high-growth potential with its regulatory risks. While prediction markets offer novel tools for risk management and speculative trading, their long-term viability hinges on achieving legal clarity. Until then, the industry remains a high-reward, high-volatility asset class-ideal for those with the patience to weather regulatory turbulence.