Prediction Markets as the Disruptors of Traditional Gambling and Derivatives: Institutionalization and Regulatory Arbitrage Opportunities

The rise of prediction markets has redefined the boundaries between traditional financial instruments and speculative gambling, creating a hybrid ecosystem that is both a product of and a challenge to existing regulatory frameworks. From 2023 to 2025, these markets have surged in popularity, with monthly trading volumes escalating from under $100 million to over $13 billion- a 100-fold increase. This exponential growth, coupled with institutional adoption and regulatory experimentation, positions prediction markets as a disruptive force in both gambling and derivatives sectors.

The Institutionalization of Prediction Markets

Prediction markets are no longer niche tools for niche events; they have become embedded in mainstream financial infrastructure. Platforms like Kalshi and Polymarket are now integrated into major exchanges, crypto wallets, and financial media outlets. For instance, Coinbase and Robinhood have incorporated prediction markets into their platforms, while Phantom wallet and CNBC partner with Kalshi to deliver real-time probability data. This institutionalization is driven by the unique utility of prediction markets in hedging against policy and regulatory uncertainties, particularly in political and economic contexts according to analysis.

Institutional interest has followed suit. According to a report by Acuiti, nearly half of global proprietary trading firms are evaluating prediction markets for trading, with 10% already active and 35% considering participation. In the U.S., three-quarters of firms are either trading or exploring these markets. The appeal lies in their ability to isolate and price uncertainty around specific events, supplementing traditional derivatives and risk management tools. This shift reflects a broader recognition of prediction markets as a legitimate asset class, capable of generating alpha through probabilistic analysis.

Regulatory Arbitrage and Legal Tensions

The regulatory landscape for prediction markets is fragmented, creating opportunities for arbitrage between federal and state jurisdictions. The Commodity Futures Trading Commission (CFTC) has classified certain event-based contracts as derivatives under the Commodity Exchange Act, enabling platforms like Kalshi to operate under federal oversight. This classification distinguishes prediction markets from state-regulated gambling, which often includes safeguards like age restrictions and responsible gaming measures according to industry analysis.

However, state regulators and tribal authorities have pushed back, arguing that sports-related prediction markets function as unlicensed gambling. For example, Nevada, New Jersey, and New York have issued cease-and-desist orders against platforms like Polymarket and Kalshi, citing violations of state gambling laws. Tribal groups have further complicated the issue by asserting jurisdiction under the Indian Gaming Regulatory Act. This legal tension highlights a critical arbitrage opportunity: prediction markets can leverage federal exemptions while evading state-level consumer protections, creating a gray area where operators test the limits of regulatory oversight.

The Coalition for Prediction Markets, a lobbying group backed by industry players, has advocated for federal clarity to preempt state intervention. Meanwhile, New York's proposed ORACLE Act seeks to impose a comprehensive regulatory framework, while Pennsylvania has taken a more cautious approach with exploratory hearings. These divergent strategies underscore the regulatory uncertainty that both challenges and empowers prediction markets.

Implications for Traditional Gambling and Derivatives

The blurring of lines between trading and gambling has forced traditional sectors to adapt. Sportsbook operators like DraftKings and FanDuel are exploring entry into prediction markets, either by acquiring CFTC-regulated exchanges or forming partnerships with existing platforms. This strategic shift reflects the desire to capitalize on the growing demand for event-based trading while mitigating regulatory risks.

Financial institutions, too, are reevaluating their roles. Brokerage firms are assessing the feasibility of allowing clients to trade event contracts, though concerns about misuse of material non-public information (MNPI) and surveillance requirements persist. The tax treatment of these contracts remains contentious, with debates over whether they qualify as wagers subject to federal excise taxes.

Critics argue that the lack of state-level safeguards in prediction markets exposes users-particularly younger participants-to risks akin to gambling. Yet proponents, including Robinhood's CEO, frame these markets as tools for price discovery and information aggregation, emphasizing their societal value. This duality-speculative potential versus informational utility-fuels the ongoing debate over their classification.

Future Outlook: Legal Challenges and Market Evolution

The future of prediction markets may hinge on legal challenges reaching the U.S. Supreme Court, where the distinction between gambling and investing will be scrutinized. A definitive ruling could either legitimize these markets as derivatives or reclassify them under gambling laws, reshaping their regulatory and operational frameworks.

In the interim, the institutionalization of prediction markets and their exploitation of regulatory arbitrage will continue to disrupt traditional sectors. As trading volumes soar and institutional participation grows, the financial ecosystem must grapple with the implications of a market that thrives on uncertainty itself.