Regulatory Risk in Prediction Markets: Navigating Scrutiny and Its Impact on Investor Returns

The regulatory landscape for prediction markets in 2025 has become a battleground of federal and state authority, with profound implications for market integrity and investor returns. As platforms like Kalshi and Polymarket navigate a patchwork of legal challenges, the sector faces a critical juncture that could redefine its role in the financial ecosystem.

The Regulatory Crossroads: CFTC Inaction and State-Level Crackdowns

The Commodity Futures Trading Commission (CFTC)'s abrupt cancellation of its planned 2025 roundtable on prediction markets has left a void in federal oversight, exacerbating legal uncertainty. Acting CFTC Chair Caroline D. Pham had previously emphasized the need for a "common-sense" regulatory framework to foster innovation, according to a HodlFM piece, but the agency's retreat from proactive engagement has allowed states to step in. Ohio, Nevada, New Jersey, and others have issued cease-and-desist orders against platforms offering sports-related event contracts, arguing these products constitute unauthorized gambling, as discussed in a Holland & Knight briefing. For instance, Ohio regulators labeled Kalshi's contracts as "sports gaming" and demanded compliance with state licensing requirements, a development reported by The Block.

This regulatory fragmentation has created a dual challenge: operational disruption and investor hesitancy. Kalshi's trading volume surged to $323 million during the NCAA men's tournament in March 2025, according to a FINRA report, yet subsequent state actions led to a 34% drop in December 2024 trading volume for Polymarket, a platform that had previously reached $2.63 billion in a single month (reported by The Block). The lack of a unified federal framework has also emboldened state regulators to act unilaterally, risking a "chaotic system" where compliance costs and legal risks vary by jurisdiction, according to a Covers analysis.

Legal Battles and Market Volatility

The legal frontlines are defined by high-stakes litigation. In New Jersey, a federal court granted Kalshi a preliminary injunction against the state's gaming regulators, affirming its argument that event contracts fall under CFTC jurisdiction (as detailed in the Holland & Knight briefing). Similarly, Kalshi secured a temporary restraining order in Nevada (see the Holland & Knight briefing). However, these victories are provisional, and the Supreme Court's eventual ruling on the classification of prediction markets-as financial instruments or gambling-could determine the sector's fate, a point highlighted in the Covers analysis.

Quantitative data underscores the volatility. Robinhood's prediction markets saw a 76.5% decline in open interest (OI) on Polymarket from November to December 2024, reflecting user caution amid regulatory ambiguity (The Block). Meanwhile, Kalshi's sports contracts attracted $500 million in March 2025 (Holland & Knight), but this figure could not offset the reputational damage from cease-and-desist orders.

Investor Returns: A Tale of Two Scenarios

For investors, the regulatory uncertainty has created a bifurcated landscape. On one hand, platforms that secure legal clarity-such as Kalshi's federal licenses-have seen robust growth. Kalshi's cumulative trading volume reached $500 million in March 2025 (Holland & Knight), while Polymarket's $9 billion in 2024 volume highlights the sector's appeal (The Block). On the other hand, regulatory crackdowns have eroded confidence. Vanguard's Capital Markets Model projects U.S. equities to return 3.3–5.3% annually over the next decade, a modest outlook that contrasts with the high-risk, high-reward nature of prediction markets.

The risk-reward calculus is further complicated by fraud concerns. Arizona regulators criticized Kalshi for lacking age verification and responsible gaming tools (The Block), raising fears of unregulated access. FINRA's 2025 report emphasized the need for robust third-party risk management and AI governance in financial markets, a challenge for prediction platforms reliant on algorithmic trading (FINRA).

The Path Forward: Innovation vs. Control

The CFTC's inaction has forced market participants to innovate within constraints. Kalshi, for example, has adopted time and price priority mechanisms from traditional finance to enhance transparency, as noted in the HodlFM piece. However, without federal clarity, these efforts may be insufficient to counter state-level enforcement. The Supreme Court's eventual decision could either legitimize prediction markets as a financial innovation or reclassify them under gambling laws, triggering a regulatory overhaul (Covers).

For investors, the key lies in balancing exposure to high-growth platforms with hedging against regulatory shocks. BlackRock's 2025 midyear outlook warns that macroeconomic volatility and policy shifts will require active risk management, a principle equally applicable to prediction markets.

Conclusion

Prediction markets in 2025 stand at a regulatory crossroads. While platforms like Kalshi and Polymarket have demonstrated resilience and innovation, the absence of a coherent federal framework has left them vulnerable to state-level crackdowns and legal uncertainty. For investors, the sector offers high potential but demands a nuanced understanding of regulatory risks. As the Supreme Court weighs in and the CFTC reassesses its role, the coming years will test whether prediction markets can evolve into a legitimate financial asset class-or collapse under the weight of fragmented oversight.