DraftKings
If you've spent any part of the last few months within earshot of a television, it's likely you've seen a DraftKings or FanDuel commercial parading a series of mid-20s and 30s men bragging about all the money they've won playing daily fantasy sports (DFS).
Buzz around the sites has escalated dramatically since the NFL season started in September, but the hype hit a speed bump earlier this month when The New York Times reported that a DraftKings employee accidentally leaked proprietary lineup usage data from his company and allegedly used it to garner an advantage that helped him win $350,000 on the competitor website FanDuel.
Many reports have described the incident as "insider trading." but that's not quite right. Insider trading requires the trading of stocks, bonds, or other securities of a company by individuals with nonpublic access to information about that same company, but this incident did not involve stocks and was used to gain a profit via a separate firm. In addition, reports have tended to downplay the fact that the DraftKings employee is reported to have received the information only after his FanDuel roster had been locked, which means that he would not have even been able to use this leaked information to affect his entry.
Yet that hasn't kept the story provoking a strong response from public officials. In the last two weeks alone, daily fantasy companies have already been hit with a request for a U.S. congressional hearing, nearly a dozen class-action lawsuits in five states demanding $5 billion in compensation, a probe by the New York attorney general, a review from the Massachusetts attorney general, an investigation by the U.S. attorney's office in Tampa, an investigation by the FBI and U.S. Justice Department, and dozens of states proposing laws to regulate or license DFS operators. By the time this article is published the list is almost certain to be even longer.
Sports attorney Daniel Wallach, one of the cohort of go-to sports law experts, in an appearance on C-SPAN last week declared that DFS "will be regulated," predicting it would be in place by this time next year. Wallach, who offered few solid regulatory answers other than evoking buzzwords of "transparency," "oversight," and "accountability," said, "We're going to see regulation, and the transparency that you're looking for, the safeguards, the accountability, that apparatus will ultimately be in place, and operators will be accountable through uniform regulation, there's going to be licensing, there's going to be monitoring. This industry will thrive and survive, but it can't do so in a completely self-regulated environment."
However, it's unlikely regulation, as opposed to market-driven forces, would work as advocates claim or bring meaningful real reform. Instead, it would serve mainly as a narrow benefit to state officials and gambling industry competitors. It seems a future DraftKings commercial should read, "I entered a contest on DraftKings and won $350,000 plus a multi-billion dollar regulatory bureaucracy."
An activity enjoyed by millions of fantasy players is now in serious turmoil. So, in a country where sports gambling is widely prohibited, how did we get to this point?
The first major American gambling legislation came with the signing of the Federal Wire Act in 1961, which prohibited the transmission of wagers on sporting events, ushered in after a series of high-profile mob-related fixings of college basketball games the previous decade. This law remained relatively unedited for 30 years until the major American professional sports leagues and NCAA pushed through Congress the Professional and Amateur Sports Protection Act (PASPA) in 1992, which confined legal sports betting to Nevada as well as three other states.
In 2006, with rising concerns about Internet gambling, Congress passed the Unlawful Internet Gambling Enforcement Act (UIGEA), which was intended to prohibit banks from processing payments to and from gambling websites.
It hasn't worked. As a recent New York Times report notes, "By almost any measure, the law has been a spectacular failure." Most experts estimate that legal Las Vegas sportsbooks represent less than 1 percent of all gambling activity in the U.S. Clearly, UIGEA is stopping almost no one.
UIGEA outlawed most forms of online gambling—but with one important carve-out.
To understand the carve-out, you have to understand the four types of bets you can make regarding sports. You can wager on a single event (the Cowboys will beat the Packers), or a collection of multiple events (both the Vikings and Bears will win). You can also bet on team (the Cowboys will win) or individual player performances (quarterback Tony Romo will pass for over 350 yards).
It's basically a two-by-two grid, and UIGEA exempted one section: Wagering on multiple events and that those events are individual player performances.
Fantasy football, a game played by aggregating individual player performances, is specifically cited in UIGEA as a legal safe harbor. The reason this type of game, and not others, is considered legal (with the exception of five states) is due to its arbitrary classification as a "game of skill," while the other forms are deemed by law to be "games of chance," and thus considered gambling.
In reality, all of these games involve some component of both skill and luck, and there's never been any clear legal definition as to what exactly designates a game as being "of skill" (less than 50 percent of its results are due to random chance?) versus "of luck" other than ambiguous, subjective rulings by regulators. To make matters more confusing, this designation varies by state.
Traditional season-long fantasy sports, which had been around for decades, had revolved around a collection of users drafting "teams" of individual players in a particular sport and using their stats over the course of the season to compete against other users in their league. The format very much mirrored actual sports in that users could add and drop players and make trades with other users, and this format is still widely popular today, with over 50 million players.
Starting around 2008, however, a new form of fantasy sports started to crop up: Daily fantasy. In this format, there are no season-long commitments, and there's no requirement to find a group of other users to form a league. Instead, users have a salary cap of fake money they can spend on players to fill out a lineup they enter into pools as small as two entries or as large as thousands competing against totally anonymous strangers. The results play out over a short-term window (usually only one night or week).
In January of 2009, FanDuel launched and quickly garnered funding, and a small crop of other DFS sites, including DraftKings, popped up soon after. Thanks to a massive influx of venture capital money on the order of hundreds of millions of dollars, FanDuel and DraftKings grew rapidly. By the end of 2014, the two companies had signed official partnerships with the NBA, NHL, and MLB, cementing their status as establishment players in the sports industry. Fantasy sports is now a $1.5 billion industry, with DraftKings and Fanduel each racking up over $300 million in funding. The two DFS sites spent over $100 million in advertising in September and control an estimated 95 percent of the DFS market.
All of this growth occurred with little regulatory framework or government oversight, but with political and bureaucratic vultures now swarming, regulation seems inevitable. It's not hard to see the motivations likely in some part driving lawyers, regulators, and politicians who would all benefit from more opportunities to litigate, additional jobs for regulators, and greater control over the economy.
Regulatory compliance officers are a growth industry. Exclusive of lawyers, the average compliance officer makes a median salary of $66,000, according to the Bureau of Labor Statistics, with 10 percent growth in employment totals during the middle of the Great Recession for a total of roughly 250,000 workers.
Additionally, states are likely leery of losing revenue from their government-backed gambling monopolies: state lotteries. In a recent Boston Globe editorial, one argument cited for regulation is that unregulated DFS "may drain revenue from the coffers of the Lottery." Governments seem to disapprove of gambling—unless they are the pit bosses.
It's crony capitalism all the way down. Along with the incentives for governments, there are three levels of private sector economic rent seekers in the gambling and daily fantasy marketplace, starting from largest to smallest in order of political influence and capital: 1. Physical casinos which would love nothing more than to see online DFS classified as gambling and prohibited; 2. DraftKings and FanDuel, which would likely welcome some regulation of the DFS industry to hamper competition; and 3. Smaller and not-yet-created DFS operators.
With regard to the highest rungs of the rent-seeking ladder, it's not surprising that two of the strongest political voices coming out against unregulated DFS were Sen. Bob Menendez and Rep. Frank Pallone, both of New Jersey, a state home to casinos that have been economically ravaged in some part due to the migration of gambling to the web. "I have serious concerns about whether these online fantasy sports leagues can police themselves," Menendez said at a press conference last week. "I think Congress needs to look into this and see whether by exempting fantasy sports from the Unlawful Internet Gambling Enforcement Act, we've created a regulatory vacuum that leaves consumers out in the cold,"
And last Friday, the Nevada Gaming Control Board, in a move widely seen as pure protectionism for its tax revenue-generating casino industry, declared DFS to be "gambling" and filed a cease and desist order declaring that no DFS sites could operate in the state without registering for gaming licenses, a self-limitation it's unclear DFS sites are even capable of executing.
While regulatory costs imposed on online DFS operators would undoubtedly help the casino industry, such costs would also likely protect the effective DraftKings and FanDuel duopoly in raising costs and barriers to entry for their competition.
An April 2015 paper from Ben Gitis and Sam Batkins at the American Action Forum found that after a 10 percent increase in regulatory burdens, there was 4 to 5.8 percent decline in the number firms of fewer than 50 employees. However, with the same regulatory costs imposed on the largest business sizes (500 or more employees) there was growth of 1.7 to 3.4 percent.
Given that regulatory burdens are generally fixed costs, this makes sense. A state gaming license fee would be a rounding error in DraftKings or FanDuel's budget, but such an expense for a new DFS startup could nix new, better businesses before they even have a chance to get off the ground. The largest cost of regulation is likely to be legal. DraftKings recently hired former Massachusetts attorney general Martha Coakley to be an adviser—likely to defend against charges from her successor in the AG position, who said this week, "There is little question that this industry will need to be regulated."
It's an unfortunate, familiar pattern we've seen in many other industries. What could result from fantasy sports regulation is what Clemson economist Bruce Yandle refers to as the "bootleggers and Baptists" concept, drawing upon that idea that prohibition support can find unlikely bedfellows in those who oppose legalization of a certain activity on moral grounds and those who do so for personal business incentives to hamper their competition.
There's already one existing thorny regulation from UIGEA potentially keeping firms out of the DFS market: the requirement that prize pools be named in advance, despite the fact that it's difficult for sites to predict the number of entrants who will participate in a contest.
Imagine if your March Madness office pool (not that those happen since they're illegal, of course) were mandated to announce the first prize prior to knowing the number of entries. Your pool manager would be hesitant to offer too large a prize and risk losing money when only five people enter, but at the same time be fearful of naming too low a prize and have co-workers angry when they win a 30-person pool and only get $40. (One can only imagine the complaints from state governments if state lotteries were also subject to this onerous regulation themselves that they feel no qualms imposing on everyone else.) Thanks to their large reserves of venture capital funding, DraftKings and FanDuel can afford to lose money (neither is yet profitable), but that's not the case for smaller firms.
With the past two weeks of litigious rhetoric, we've already seen punishment for the little guys—and the resulting consequences for firms and players: StarsDraft, the fifth-largest DFS site (though one backed by a multi-billion dollar gaming company), announced Monday that it would discontinue service in all but four states.
What also gets dicey with gambling taxation in particular is in deciding how to divvy up taxes as well as a potential cut leagues may demand for licensing stats to sportsbooks. Betting markets tend to leave extremely slim margins for bookmakers—often just 4-5 percent. This is unavoidable; if books take too much of a cut, they'd be unable to offer remotely decent lines for bettors.
Higher costs of complying with regulation would trickle down to lower payouts, likely driving fantasy players to underground 100 percent tax- and regulation-free betting that is less safe than current iterations of daily fantasy games.
We've already seen one cautionary tale of heavy-handed regulation stifling French betting markets. Gambling proponents there initially applauded the country's passage of the 2010 Gambling Act, which legalized and regulated online gambling. However, the law mandated a high 8.5 percent tax on all sports bets, forcing sportsbooks to offer lines with extremely poor odds in order to turn a profit. This drove many bettors away from the regulated sportsbooks, and since 2010, over half the websites that first acquired licenses have since left the regulated market—a fate that could befall American DFS sites subjected to overzealous American regulators.
So far, at least, daily fantasy players don't seem particularly motivated by the scandal. According to the industry research firm SuperLobby, in the first NFL weekend post-scandal, FanDuel and DraftKings racked up 7.1 million entries to their guaranteed prize pool tournaments, worth $43.6 million in entry fees, both all-time records for the sites. It's possible that the story has actually driven more people to play, with fears of prohibition spurring some users to play while the game is still legal. What's more likely is that all the news made even more people aware of the daily fantasy sports industry, and those customers weren't concerned about the alleged unfairness of the market. (However, this past weekend, those record numbers did slightly recede.)
Some critics of daily fantasy games have argued that because the games are not a liquid market—with player prices locked and unresponsive to market demand as in traditional betting markets—it is not fully efficient and thus needs some regulation to survive. This claim is certainly plausible. A recent Sports Business Journal analysis found that over 90 percent of DFS winnings accrue to only about 1.3 percent of players, a sharks-vs-fish setup only possible due to the lack of dynamic pricing.
However, that begs the question: If this wagering system is so flawed and requiring of regulation to survive, is it worth using taxpayer money to save in the first place? With the rapid growth of all sorts of fantasy sports games in just the last five years, it seems highly likely the market will soon produce some alternative game that will account for and correct this efficiency issue.
Despite the sudden consumer protection watchfulness, there have never been any major reported issues of payouts in legal DFS sites. Instead, the only widespread customer issues have arisen from sites with the most stringent government oversight—more traditional sports betting websites based offshore that are illegal in the United States.
At this point, DFS could follow two routes: It could be like Uber, rapidly staking out a large enough market share and popularity so as to resist regulation. Or it could be like online poker, which ultimately did not have enough grassroots support to resist legal restrictions.
If the Department of Justice were to suddenly rule that DFS is no longer permissible under UIGEA, then it could instantly wipe a multi-billion-dollar taxable industry off the taxable books and effectively shepherd it underground to the black market. The DFS scandal has already drawn parallels to what is known in the poker world as "Black Friday." On April 15, 2011, Manhattan U.S. Attorney Preet Bharara (a Reason favorite) unsealed an indictment that claimed the three largest online poker websites at the time had circumvented UIGEA and tricked banks into processing illegal gambling payments. The indictment froze the accounts of 75 poker companies and their processors, effectively killing the once-thriving online poker industry and leaving an estimated $150 million in customer account dollars locked away in now-banned websites with no means to access them, something experts fear could also befall the DFS industry.
It seems the popular and widely played daily fantasy industry is more in the Uber camp, though, and has quickly and sufficiently entrenched itself enough in the culture to avoid an outright ban. However, the growing push to regulate of the industry could soon freeze today's status quo, in which two big players rule the ecosystem, in place for many years to come, with little possibility of meaningful transparency requirements.
That's not to say there's no silver lining for sensible gambling reform advocates. The regulatory classification of DFS as "gambling" and widespread awareness that American society is no worse off with its legalization may finally be the push needed to bring all other forms of now-illegal gambling out of the shadows and into the legal market. Whether that's worth the tradeoffs of a highly regulated industry is up for debate.
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