Fantasy Sports Regulation: An Inclusive Way Forward

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Seth Young DFS regulation editorial

Brew yourself a cup of coffee and put your feet up, this one is a long time coming. This is an open letter to all business interests within the fantasy sports industry, the Fantasy Sports Trade Association, and to lawmakers across the country that are trying to figure out how to best regulate the fantasy sports sector.

You read the news. You know the future of a pastime that permeates the fabric of everyday life for millions of Americans is being hotly debated in jurisdictions across the country. A tangled web of ambiguous laws in different states has mired the fantasy sports industry in all kinds of legal turmoil.

Naturally, this has spurred a movement for clarity in those laws. The popularity and broad base appeal of fantasy sports puts lawmakers in an interesting position; on one hand, they can clearly see that this is an activity that the general public is interested in participating in. On the other hand, the “fantasy sports industry” has made plenty of mistakes, and it is generally recognized that oversight is important.

Thing is, this is not new, and it’s more complicated than passing bare-bones law.

The regulatory effort for fantasy sports, so far

Putting aside the question of whether or not fantasy sports should be classified as illegal gambling or as skill gaming, top legal experts are still opining on whether or not regulating fantasy sports on a state level would raise concerns that intersect with federal law, or even raise constitutional concerns in the states where legislation is being promulgated.

What we can be sure of, though, is that barring a complete shutdown of the businesses serving the sector, a framework to regulate this real money gaming activity is necessary.

For me, this has reached a boiling point. We are coming to a crossroads that will determine how the business of fantasy sports evolves in the USA.

What happens next will affect the business that I am a stakeholder in, and will affect the businesses of every other group that is similarly situated. The well-capitalized market leaders have realized this, and they – alongside the Fantasy Sports Trade Association — have deployed lobbyists around the country in an attempt to introduce and influence policy that they claim will serve the best interests of the entire industry.

Because of the way the market has evolved, I am forced to raise an eyebrow at the timing – and rushed timelines — for this push, and for the motives behind what is being introduced. Market leaders and the FSTA have suggested they are interested in seeing more inclusive, thoughtful legislation, but so far, actions speak louder than words.

There’s more than one way to skin a cat

I have no qualms in being a vocal opponent of what is being put forward. I know that I am no longer a minority voice. I am, however, going to take it a step further and introduce an alternative, inclusive, thoughtful solution that can potentially act as the framework for the sector’s long-term viability.

What has become abundantly clear to me is that the policy that has been introduced for contemplation by lawmakers across the country is not well thought out, doesn’t actually provide a basis for regulation or real consumer protection, and poses an immediate threat to the viability and growth of most of the businesses serving customers in the sector.

It is an undisputed fact that FanDuel and DraftKings control the vast majority of the daily fantasy sports market, and it may be said they have the strongest interest in how the market develops due to their massive financial investments.

It is, however, also an undisputed fact that they are not the only businesses serving the sector, and not the only businesses interested in how the industry evolves. Perhaps, though, lawmakers are not aware that there are many companies with many differences in their modus operandi.

Everyone’s best interests in mind?

The rest of the industry that does not directly employ lobbyists has been relying on the Fantasy Sports Trade Association to represent its interests, and to this point, they have been abysmal representatives. On one hand, the FSTA champions the passage of a bill in Virginia that carves out legal clarity for fantasy sports. On the other hand – after it was passed – they express concern with the steep initial licensing fees that exclude most operators from the market.

Their apparent lack of concern for small businesses may be due to the fact that the financing required for these lobbying efforts is only coming from a handful of sources well situated to provide it. I received e-mail from an industry lobbyist a few weeks ago that sums up the situation.

Paraphrasing, this lobbyist mentioned that they were trying to balance what works for big and small operators, using the licensing fees as an example. Licensing fees in states are slated to be set aside and used to cover costs of people overseeing the industry, performing background checks, and issuing regulations. The states expect operators to bear those costs. This is fair, operators should bear these costs.

The lobbyist admitted that while the better capitalized operators can afford these large licensing fees on a state-by-state basis, they recognize smaller operators cannot. In the same breath, I was told that legislators view smaller operators as part of the problem with the industry.

Inclusive or exclusive?

Now, hold on a minute. This doesn’t seem very inclusive to me. For one, the industry has an optics problem because of the shortcomings of its market leaders and the choices they have made. Not every business in fantasy sports operated with the same ethos, and because of a difference in risk tolerance – or even a difference in business model entirely – they risk being shut out in certain states because of rushed law.

While these laws are being introduced under the guise of a “step forward” for the industry, I see them as something else.

Having legal clarity is great, but if we’re getting it at the expense of being unable to do business because of the uneconomically high financial barriers to entry, it’s not great. It’s the opposite of great.

I see these laws as stopgap measures that attorneys, on behalf of their clients, can point to as an example of “good policy” in other states where they are trying to mitigate the impact of operating in “high risk” environments. I understand why this is happening and don’t see anything wrong with businesses doing what they can to protect their interests, but to say these efforts represent the interests of all in the industry is, simply put, a fallacy.

In reality, it’s awful, exclusionary, toothless policy that should not be used as the model anywhere in any state. I wouldn’t call Virginia and Indiana forward thinking at all, I would call them short sighted. In this instance this could be attributed to a lack of education of its lawmakers, something that needs to be fixed.

The right kinds of barriers to entry

Secondly and perhaps to a lesser extent, there is an optics concern of the “small operator” due to a handful of fly-by-night businesses that have commingled player funds with operating funds, leaving players high and dry. This is not the norm. Both of these extremes represent the entry of groups into a market that they may not have had a fundamental understanding of to begin with, and now we are forced to deal with the issues of the present caused by the actions of the few.

I understand the reasoning behind putting barriers to entry in place for the fantasy sports market. In fact, I have been an unwavering vocal proponent of it. However, these barriers should be technical and logistical barriers, not financial barriers.

The introduction of a certain set of high standards for a gaming platform costs time and money in its own right; any operator that can satisfy the strong set of standards that I am promulgating in the latter half of this article should be able to do business in any state that permits fantasy sports activity under its law.

Is something better than nothing?

This same lobbyist went on to say, and I paraphrase, that the industry has a choice. We can either let “perfect” laws get in the way of “good” laws, or pass laws that go further than anything the industry proposed prior to November of 2015.

This lobbyist is right about one thing. We do have a choice. We should have a choice. The rest of it is wrong. The laws that are being passed are not “good” laws, and “something” is not always better than “nothing” when nothing helpful is accomplished.

I suppose you can call them good in the context of calling them good examples of awful policy. The one “inclusive” bill put forward for DFS in New Jersey is currently being opposed by lobbyists for political reasons. Policy-wise, it seems fair for most industry stakeholders. But it can’t be supported by the “industry” – a term I’m using loosely – because the state did not carve out fantasy sports as “skill gaming.” Political, not practical.

Further, everybody seems to forget that the rush to pass a law – the UIGEA was tied to a must-pass port security bill at the 11th hour – is why we’re here in the first place. Why on earth should we rush to pass more thoughtless law that breeds more issues?

Here we are, front and center, for better or for worse — an industry that has the attention of lawmakers across the country. A little more thought can go a long way in encouraging an environment for growth, competition, and innovation. It requires each group to set aside its competing interests and come together to ensure viability for all, which should be a common goal everyone can support, so long as words echo intentions.

The proposed fantasy sports regulatory framework

In the USA, we’re dealing with 50 states that all have different laws. We are faced with the potential of watching the fantasy sports industry fracture across state lines, which is not conducive to running a gaming platform that requires player liquidity in order to function optimally.

The framework, in broad strokes

The current approach to regulation sees the “industry” approaching legislators with a problem, but not providing a fleshed out solution. In an effort to solve this problem, streamline a regulatory approach for operators and government — and to introduce a solution that is inclusive of all industry stakeholders — I am proposing the following framework that can function as a “turnkey regulatory package” that, theoretically, can have the symmetry across state lines we will likely lack on the current trajectory.

This solution is aimed at putting the necessary barriers to entry in place to prevent “bad actors” in the market, aimed at deleveraging state resources in order to lower or remove initial licensing fees, creating a real enforcement mechanism and deterrent for non-compliance in the market, and introducing a set of standards to assuage public policy concerns associated with the operation real money gaming. It requires the participation of various stakeholders in the industry, which I hope can be accomplished in interest of forward progress.

Operators of season-long fantasy platforms do not have the same business model as DFS-only operators, but as they are still dealing with customer funds, they should be subject to the same technical and operational standards as others.

As far as tax benefit for each state goes, what I’m seeing is a fundamental misunderstanding of expected revenues for state coffers from the regulation and licensure of the sector, with no consideration given to differing business models.

The states will benefit most from promulgating a set of standards that encourages the growth of the entire sector, positioning them to tax a larger, mature industry in the future once the DFS business model is stabilized, and once the other business models in the sector are more fully understood.

Tangentially, if the states are truly interested in a way to capitalize on the popularity of fantasy sports for economic benefit, I would suggest focusing on using its state controlled entity – the lottery — or authorizing its casinos to participate with fantasy sports games that are centered in chance, not skill, to create more scalable gaming revenues, which can be taxed. Call me, I have games for you. They’re brilliant, you’ll love them, and that’s where you’ll collect revenues that really make an impact on your budget.

Notwithstanding, here’s a proposed framework for better policy.

Trust the technical auditors: Technical requirements

Fantasy operators will submit, at their own cost, to third-party platform verification with a testing house that is recognized by international and domestic regulatory regimes. Examples of these groups include but are not limited to, GLI, BMM, NMM.

Platform verification would include testing for:

Note that the effort to build or integrate these features takes considerable time and effort in order to pass platform testing, and full third-party platform testing requires a relatively expensive incremental cost in its own right. These requirements alone are likely to be a sufficient financial barrier to entry for most operators considering licensure within any jurisdiction, and passing these requirements with platform testing show a willingness to operate correctly in the real money gaming market with high technical standards.

Testing for role-based administration with database storage auditing should effectively solve the issue of traceability for “insider access to information.” In layman’s terms, this is like the Internet version of keycard access for employees within a casino.

Database storage auditing can show a clear trail of who accesses what information in back-office systems, acting both as a deterrent for the access of insider information for untoward purposes, and acting as a system to identify those that may breach regulations surrounding access and dissemination of this information. Good role-based administration in a back-office system can also prevent the access of certain information for users not authorized to view certain reports or system features, much like the design for managed access in brick and mortar establishments.

The third-party platform verification would ensure the game, as designed, complies with UIGEA standards, has the necessary responsible gaming features required by the state, that all users have the same abilities to use the platform, and that the platform is sufficiently secure to prevent the unauthorized access of user information, accounts, and other privileged content. Bi-annual audits should be sufficient to ensure the platform’s continued technical integrity, and the process can be streamlined with the operator’s submission of change logs to the auditor.

Upon the successful completion of the third-party verification, the auditing group would issue a letter of recommendation on behalf of its client, allowing the state regulatory body comfort that a credible third party with deep roots in the gaming sector believes the system passes muster sufficient for a B2C gaming operation, without the state regulators lifting a finger. These standards can easily be the same for all states, allowing for a translatable model.

Trust the financial institutions: Due diligence by financial service providers

In order to deleverage state resources while still performing the high level of due diligence necessary to obtain licensure, financial institutions that are already licensed and regulated by the state will perform the necessary due diligence on its prospective clients in order to process payments in and out of the gaming platform.

Historically, groups banking the sector required operators to submit to a high level of transparency in order to gain approval to process transactions. As financial institutions stand to have great, scalable economic benefit from processing these transactions on an ongoing basis – perhaps more than any state would see in initial licensing fees and ongoing tax benefit – and as their normal course of business already calls for most of the processes I am proposing, I would contend that states approving operators for licensure should liaise with groups in this highly regulated sector – banking – to assess the viability of each group applying for licensure.

After performing its due diligence, the financial institution can recommend or not recommend a group for licensure, acting as one of the two integral “gatekeepers” of this process.

Financial institutions view the bandwidth required to perform this high measure of due diligence as their “acquisition cost” for a new customer; they stand to generate revenue that eclipses the cost of the due diligence process, and they must perform this due diligence in order to protect their own business. Financial institutions interested in capturing this market segment must register with the state, and the regulatory body currently governing their activity will approve their participation in this streamlined process.

These financial institutions will assess whether the fantasy operator has the correct procedures in place to effectively segregate player funds from operating capital, and ensure in the event of a wind-down in business that player funds can be returned to players and not other creditors.

These financial institutions will perform a monthly audit in order to classify the risk profile of the business it is serving, receiving information on current operating capital, expected capital burn, and expected revenues. These financial institutions may also potentially act as the final signatory on bank accounts holding player funds, effectively ensuring that funds cannot be used for purposes outside the normal course of paying customers and reconciling accounts, receiving an alert if there is activity outside of the normal course of business.

The financial institutions or payment gateways will also deploy technologies for suspicious activity reporting, anti-money laundering features, or verify that its partner has sufficient requirements in place to satisfy its own regulatory requirements with respect to these issues.

Technical integration is required for payment gateways, and similar technical processes can be introduced to streamline required reporting to these financial institutions, allowing them a measure of transparency into the operation of the fantasy sports platform that could be useful in their own ongoing business processes on an automated basis.

From there, these financial institutions can submit reports on ongoing business to the state regulators, if required. Otherwise, this can be an effective, hands-off approach if all is running smoothly after initial approval, with nothing suspicious in monthly audits. The ongoing auditing by the financial institution, coupled with signatory control on player accounts, can ensure – without a shadow of a doubt – that player funds remain safe at all times.

Financial institutions are also the only group that can provide a real enforcement and deterrent mechanism; they are the lifeblood of these gaming businesses. An inability to process customer transactions in will ruin an operator’s game economy. Because of the threat of “shutting off the tap” for non-compliance, this is a legitimate deterrent to promote best practices in the sector, and more effective than fines for non-compliance.

Groups may look at fines as the cost of doing business. If, for example, a $1,000 fine will net you $10,000 in business, it can be a good business decision to break the rules. However, if non-compliance can severely impact your business in such a way that it is no longer economical to break the rules, there is little incentive to do so.

Should there be adequate reporting and auditing in place, consumers using fantasy products can rest assured that they would not be operational if they were not able to sustain the B2C business. In the event a business would need to wind-down, they can also rest assured that the financial institution has a measure of control to ensure that they are made whole, and that their balances are safe at all times.

If these financial institutions are satisfied that sufficient processes are in place to protect their own interests based on a set of regulatory guidelines for business logistics that they help define, they should recommend their client for licensure to the state. In this case, the state will have a measure of comfort that one of its highly regulated, credible businesses is giving its stamp of approval.

This can occur with limited government interference, providing a second turnkey approach to the licensing process. These standards can easily be the same for all states. The initial vetting process, like the technical audit, only needs to be done once.

Limited access for who can play

Fantasy operators should limit employee play on its own platform to testing purposes, or to private games only. Employees shall be barred from playing on other sites if they have access to the role-based administrative system, which will supply each employer with an audit trail for who accesses what information.

Restrictions should be placed on professional athletes playing contests in their respective leagues, and this can be accomplished by the leagues furnishing a master list of athlete information to the operators in order to build in filters in the compliance systems.

Background checks

Fantasy operators should, at their own cost, submit its key executives and employees to background checks. Individuals that have been convicted of financial crimes or crimes of moral turpitude shall not be permitted to obtain licensure to operate a fantasy platform.

These background checks can be submitted as part of due diligence with financial institutions, or directly to the state regulatory body as part of it’s “turnkey checklist” for licensure.

Conclusion: A framework that works

This framework should provide a rational basis for discussion about how states can eliminate or vastly decrease its initial licensing fees for fantasy sports operators to include all interests in the market, offer real regulatory enforcement without taxing state resources, and support the growth of an industry that has not matured with a solution that can be applied on a scalable basis.

Operators that wish to obtain licensure are presented with a number of important barriers to entry that must be satisfied in order to be approved for operation within each state. Financial institutions would be given the clarity they seek in order to process transactions within these states, with comfort that they would only be working with groups that satisfy standards of technical due diligence verified via a third party technical audit, and their standards of financial and operational due diligence in order to protect their own interests as regulated businesses.

Governmental interests can be assured that platforms are adhering to high technical standards, and the proper logistical standards of operating a real money gaming business. States would benefit economically from the managed growth of a popular product, income taxes from players, corporate taxes from financial institutions, and perhaps a fair flat tax rate on its operators, while being afforded the savings of taking a hands-off approach with a different, streamlined, mutually beneficial regulatory process.

What this proposal does not consider are rules governing the advertising of these products to the general public, which is also an important part of protecting the constituents of each jurisdiction.

This is to say, there can be choices. This can be one of them.