A BETTER LEGAL DEFINITION OF GAMBLING: WITH APPLICATIONS TO SYNTHETIC FINANCIAL INSTRUMENTS AND CRYPTOCURRENCY.

• Author: Bunting, W.C.

1. INTRODUCTION

   In many cases, gambling is relatively easy to identify. Purchasing a lottery ticket, betting on a particular team to win the Super Bowl, and playing blackjack at a local casino, all these activities undoubtedly constitute gambling. You just know it when you see it. But sometimes you do not. In some cases, gambling is not so easy to identify. Over time, questions have arisen as to whether certain transactions, often of critical importance in the moment, constitute gambling. Roughly a decade ago, for instance, there was considerable debate around whether trading in synthetic collateral debt obligations (CDOs) constituted gambling no different than placing a bet on the Yankees or, instead, served a socially useful purpose in the management of risk. (1) More recently, there has been a similar debate about the intrinsic value of cryptocurrency and whether cryptocurrency is merely a vehicle designed to enable gambling, allowing buyers and sellers to participate in what is, in effect, a lottery based upon a randomly drawn market price. (2) Today, similar confusion exists over whether governments should regulate the use of loot boxes in video games as facilitating digital gambling systems aimed primarily at children. (3) Daily fantasy sports also raise analogous questions regarding the distinction between entertainment and gambling. (4)

   This confusion over what constitutes gambling matters because vastly different outcomes can obtain depending upon whether a transaction is classified as gambling or not. If trading in synthetic CDOs, for example, had been clearly classified, at the outset, as a form of gambling, then financial regulators may have implemented much more stringent regulatory safeguards than existed at the time, which might have prevented--or at the very least mitigated the impact of--the 2008 financial crisis. Likewise, social commentators would surely have been less willing to ascribe such revolutionary potential to cryptocurrency if trading in this asset class was viewed as merely a novel form of gambling. Presumably, parents would be much less willing to allow their children to play video games if a significant part of the appeal for children was the opportunity to engage in unregulated gambling. In general, if the law classifies a transaction as gambling, then the government tends to regulate the transaction much differently than other risk transactions, typically giving the transaction heightened regulatory scrutiny to address certain problems commonly linked to gambling, such as addiction. (5)

   Given the significance of a transaction being categorized as gambling, the continuing confusion over what constitutes gambling is surprising. This Article suggests that this confusion stems, in large part, from the fact that gambling is not presently well-defined under state or federal law. Current legal definitions are overinclusive and do not permit easy categorization of novel risk transactions. In response, this Article, as its main contribution. provides a much more formal and precise definition of gambling than presently exists in the legal literature. Specifically, this Article extends the analytic framework set forth by Professor Lynch in an article that has been somewhat overlooked in the literature given its originality and depth of analysis. (6) The key insight in this article is that "[a party] who enters into a derivatives contract is either motivated to hedge [or transfer] a pre-existing risk [of economic profit or loss] or is not." (7) That is, derivative counterparties can be divided into two mutually exclusive categories: (1) hedgers, defined as those motivated to hedge an existing risk of economic profit or loss, and (2) speculators, defined, in the negative, as those who are not motivated to hedge such risks. (8) In the corresponding taxonomy of derivative contracts based upon counterparty motivation, three categories of contracts thus exist: (1) hedger-hedger, (2) hedger-speculator, and (3) speculator-speculator. (9) Similarly focusing on the motivations of contract parties with respect to an existing risk of economic profit or loss, this Article expands the scope of this novel framework beyond derivative contracts to provide a formal definition of gambling that highlights the central importance of risk creation solely through contract.

   The Article proceeds as follows: Part II considers how the law has sought to define gambling. Unless modified by statute, the law has defined gambling as any activity that includes the following three elements: (1) consideration, (2) chance, and (3) prize. (10) Traditionally, jurisdictions have divided regulated forms of gambling into three categories: (1) lotteries, (2) wagering, and (3) gaming. (11) Part II provides a brief survey of each category.

   Part III introduces the baseline model of bilateral risk creation and extends this model to include two additional variables: (1) endogenous risk, and (2) risk mitigation. With the addition of these two variables, this broad definition of bilateral risk creation can be mapped onto the three traditional categories of regulated gambling examined in Part II. As one of its central claims, this Article contends that gambling, as currently defined under state or federal law, is overinclusive and fails to distinguish a risk transaction that transfers an existing risk of economic profit or loss, such as a securities investment or insurance contract, from a transaction that creates risk solely through the contractual exchange of bets. This Article proposes a model statutory definition of gambling that includes the concept of risk creation as a limiting principle to distinguish gambling from other bilateral risk transactions.

   The analytic framework developed in Part III highlights two main regulatory concerns in connection with bilateral risk transactions: (1) moral hazard or fraud, and (2) risk mitigation. In general, these traditional regulatory concerns do not appear to justify the heightened regulatory treatment of gambling, however. Part IV argues that the difference in regulatory treatment between gambling and other forms of risk transactions derives from the key distinguishing feature of gambling: that gambling involves risk creation, and not risk transfer. This Article contends that the principal basis for a more rigorous form of consumer protection than found in the regulation of other risk transactions, such as securities investments or insurance, is most often a paternalistic one centered on the prevention of self-harm and a recognition of the fact that risk creation or gambling is, for some, the unfortunate byproduct of a self-destructive mental disorder.

   As an illustrative application of the analytic framework. Part IV applies this novel definition to the regulation of synthetic trading positions and makes the case that the increased use of derivative contracts has allowed investors to enter synthetic trading positions that constitute gambling no different than placing a wager on the spin of a roulette wheel or the outcome of a sporting contest. Although financial regulators have recognized the counterparty risk implied by such synthetic trading positions, regulatory authorities have been reluctant to condemn such positions more generally. (12) The analysis below suggests that this is a mistake as risk creation is not only antithetical to the broader social mission of the financial sector, but makes the financial system less sound, amplifies volatility, and, ultimately, renders the economy susceptible to financial crisis and protracted recession.

   As a second application. Part IV demonstrates how the analytic framework set forth in Part III can be employed to make the purely theoretical case that trading in cryptocurrency constitutes unregulated gambling. The claim is that cryptocurrency has no independent value as an economic good. Rather, cryptocurrency is merely a vehicle designed to enable risk creation or gambling, and not to transfer the existing risks of asset ownership to other parties who can bear these risks more efficiently. Betting on expected market price allows people to participate in what is, in effect, a lottery, with market participants placing bets on whether a "randomly drawn" market price will increase or decrease in the next period.

   Part V briefly concludes.

2. GAMBLING DEFINED

   Part II examines the legal definition of gambling and surveys the three traditional categories of regulated gambling: (1) lotteries, (2) wagers, and (3) gaming.

   1. Elements of Gambling

      Unless modified by statute, the law has defined gambling as any activity that includes the following three elements: (1) consideration, (2) chance, and (3) prize. (13)

      1. Consideration

         To start, for a game to qualify as gambling, a player must provide some form of consideration in exchange for the opportunity to participate in the game. (14) If no consideration is required, then the contest in question is categorized as a sweepstakes (or a no-purchase-necessary sweepstakes), and not gambling. (15) The consideration required for the creation of a gambling contract is usually more than the nominal (or peppercorn) consideration sufficient to satisfy the consideration requirement for a legally enforceable bargain under ordinary contract law. (16) The consideration must be more than a minimum effort. (17) Often, the consideration given in exchange for the opportunity to participate in a game is money. (18) A game that requires all players to bet cash, for example, plainly satisfies the consideration requirement. (19) A game in which players can enter free of charge, on the other hand, clearly lacks consideration. (20) An activity cannot constitute gambling unless the participant is required to risk something of economic value. (21)

      2. Chance

         Gambling must also involve a game of chance: games of skill cannot constitute gambling. (22) For a game to qualify as a game of chance, the outcome must be determined by...