The End of Daily Fantasy Sports in America?

By Ryan Niksa

To say that discussing the legality of daily fantasy sports (DFS) affects me on a deeply personal level would be hyperbolic, but it is a topic that I certainly can relate to. While I do not play daily fantasy sports, an accelerated version of traditionally season-long fantasy sports that is instead conducted over a week or single day of competition, I have participated in fantasy sports since my freshman year of high school and have not stopped since. I recently won my fantasy football league, am currently locked in a tight playoff race in fantasy basketball, and in a few months I will be looking to draft Mike Trout, Giancarlo Stanton, or Bryce Harper in fantasy baseball. My hobby, however, has become the focal point of a legal firestorm encompassing media conglomerates, professional sports organizations, state attorneys general and federal law, sparking a debate on what actually constitutes illegal gambling in the United States.

Understanding the workings of daily fantasy is relatively simple given its close resemblance to traditional fantasy sports. In DFS, a participant selects players with fixed prices attached to them and builds a team that qualifies under the “salary cap” set by the contest. Like traditional fantasy, the selected players, and collectively, the fantasy team, score points based on the performance of those players. Whoever picks the best team and consequently gains the most points wins the cash prize amount for that specific contest. There are also consolation prizes for second, third place, etc. Companies like DraftKings and FanDuel acquire revenue from the entry fees that contestants must pay to assemble a team; these can range depending on the sponsored competitions from twenty-five cents to thousands of dollars. The operators take a predetermined fee percentage which usually hovers around ten percent, while allocating out the remainder of the entry fee to fund cash prizes.

Daily fantasy sports have been argued by some to be a more aggressive version of traditional fantasy sports. Their rapid rise to prominence certainly supports that viewpoint, resembling more of an explosion in growth than a steady ascendance. The two companies that together own 95% of the North American DFS market today, New York-based FanDuel and Boston-based DraftKings, were founded in 2009 and 2012 respectively, shortly after the inception of daily fantasy sports in 2007.  Through the absence of state or federal regulations, FanDuel and Draftkings gained mainstream popularity, not only with fans and fantasy aficionados, but media organizations, venture capitalists, and professional sports organizations. The rival startups took control of the market share over this last NFL offseason when DraftKings and FanDuel raised $426 million and $363 million in their respective investment rounds- both companies are now both valued at over $1 billion.  The DFS industry today possesses 57 million players (and growing) in North America alone, and is valued conservatively at $2.6 billion. Some of the media conglomerates and professional sports associations that currently have equity stakes in FanDuel or Draftkings: the National Basketball Association, Major League Baseball, National Hockey League, Time Warner Cable, 21st Century Fox, Comcast, and Major League Soccer. On top of those investment partnerships, ESPN is currently locked in a three year, $250 million advertising deal with DraftKings, and out of 32 NFL teams, 28 currently have sponsorship deals with FanDuel or DraftKings. [1]

The multibillion dollar industry that is now DFS emerged from a loophole in the Unlawful Internet Gambling Enforcement Act of 2006 (UIGEA), a piece of legislation sponsored by former House Banking Committee member and Iowa Congressman Jim Leach in 2005. The law seemed long overdue for the federal government, representing the first major legislation against suspected illegal betting practices since the Federal Wire Act of 1961. With the hopes of outlawing illegal gambling online, the UIGEA “modifies existing prohibitions against interstate gambling to prohibit the use of a communication facility to transmit: (1) bets or wagers; (2) information assisting in the placing of bets or wagers…” and “prohibits any individual from accepting, in connection with the placing of bets or wagers to or from the United States: (1) credit, or the proceeds of credit; (2) electronic funds transfers; (3) checks, drafts, or similar instruments, etc.” [2] To conclude, the UIGEA is ambiguous on identifying illegal internet gambling, besides explicitly mentioning online sports betting in later sections, and leaves states to interpret what constitutes illegal gambling with their own gaming laws.

The UIGEA was enacted to directly place the burden on financial institutions to develop policies and procedures restricting transactions and funding related to illegal online gambling. The 2006 law would force online poker to close shop in North America, but it also exempted multiple gaming activities from federal regulation, including horse racing, state lotteries, and fantasy sports. The law deemed these were games of skill instead of chance, actually benefitted states and businesses, and served more as entertainment products than gambling activities that needed regulation. Daily fantasy sports, as games of skill and exempted from both the UIGEA and Federal Wire Act, were illegal in only five states before this year’s NFL season began. Considering the uncertain legal future of DFS now, however, it can be said that its aggressive ascendance in popularity and exorbitant growth in capital over the summer of 2015 led to greater suspicion. Meeting the new capital demands pressured FanDuel and Draftkings to recruit new customers with aggressive marketing campaigns totaling $33 million during the first two weeks of the season. [3] In response, many state  officials and federal agencies wondered how the industry grew so rapidly and could remain unregulated for so long.

In late September, allegations of insider trading and fraud rocked the DFS industry. Ethan Haskell, a content manager at DraftKings, inadvertently released data pertaining to fantasy football lineups labeled “proprietary information” that could not be viewed by the public. Both DraftKings and FanDuel were forced to answer for their corporate integrity, however, when it was revealed that Haskell participated in and finished second out of 229,885 entrants on a FanDuel competition later that day, winning $350,000. [4] While an internal review vindicated Haskell of what many sports and gambling lawyers called “insider trading,” Haskell and other employees from FanDuel and DraftKings confirmed that they participated in contests at each others’ websites numerous times before. News organizations, most notably The New York Times, became more interested in how far DFS was pushing its legal exemptions, and soon the Federal Bureau of Investigation (FBI) launched an inquiry examining if DraftKings and FanDuel encouraged and accepted deposits and bets from states where the contests were prohibited (a violation of the UIGEA and interstate gambling laws), and whether their employees may have used inside information not available to the public to win lucrative cash payouts. [5] Amidst the FBI’s investigation, Nevada, in mid-October, brought DFS under closer scrutiny after ruling that it constituted illegal gambling under state law, reasoning that it involved “wagering on the collective performance of individuals participating in sporting events,” and forcing DFS companies to receive a license to operate in the state or cease operations in the state immediately. A month later, New York Attorney General Eric Schneiderman declared DFS to be considered illegal sports betting in the state, citing the New York penal law’s set definition of gambling where "a person engages in gambling when he stakes or risks something of value upon the outcome of a contest of chance or a future contingent event not under his control or influence.” By early November, Schneiderman filed dual cease and desist orders against FanDuel and DraftKings, asking for an injunction to stop them from operating in New York. Since Nevada and New York decided that DFS should be categorized as illegal gambling under state law, other states have followed suit: Illinois, Vermont, Texas, Mississippi, and most recently, Hawaii have all declared that DFS should be considered illegal gambling when taken to court, while California, Pennsylvania, Florida, and Massachusetts have renewed debate on enacting new laws to regulate the DFS industry. [6]

The influx of litigation has sent the DFS market reeling, leaving its two leading companies particularly damaged. DraftKings and FanDuel have already decided to leave certain states in fears of being heavily regulated or outlawed entirely, and have been forced to lay off employees, lower prize pool amounts, and drop sponsorship deals. A decline in new users and sponsors and subsequent spending on expensive legal representation are not DFS’s worst problems, as DraftKings and FanDuel both risk losing large percentages of their current user base with states like Texas, New York, and Illinois recently considering DFS to be illegal gambling. According to sports research firm Eilers and Krejcik, with Texas, Illinois, and New York accounting for more than 5 percent, 6.7 percent, and 12.8 percent of the two companies’ customer bases respectively, both companies stand to lose a combined $50-60 million annually. [7] A possibly crippling blow came last Friday, when the payment processing company that handles a significant number of transactions for FanDuel and DraftKings, Vantiv Entertainment Solutions, notified the operators that it would “suspend all processing for payment transactions” related to daily fantasy sports in the United States and its territories by the end of February, citing the recent legal siege placed against the DFS industry as its reason. [8] Viewing the legal battle against DFS, two questions now instantly come to mind: should DFS be classified as illegal gambling under federal and state law, and perhaps more important, is banning DFS the best solution, or should there be a path towards regulation instead?

Debating on whether DFS is a game of chance or a game of skill is difficult because a game could feasibly have chance, skill, or both and still be considered a gambling or non-gambling activity - state laws are left to determine if the activity is considered illegal gambling. There are facts to support both sides of the argument - supporting the twelve state attorney generals who have now deemed DFS to be illegal gambling, a player is technically paying to participate in the game and betting on the performances of players and the outcome of an athletic event that is beyond the player’s control, which legally constitutes sports betting. Skeptics of the skill argument have also pointed to the short-term aspect of DFS that has now dominated fantasy sports, which further diminishes the influence of skill with more immediacy and variance in results and less opportunities to display a competitive advantage. They also cite how online poker and DFS are intertwined now more than ever: operators of online gambling sites have begun investing in fantasy sports, and some of DraftKings’ senior managers come from online gambling companies or are former professional poker players. Even certain poker terms, including “sharks” (expert players), “minnows” or “small fish” (inept players who lose small), and “whales” or “big fish” (bad players who lose big), have infiltrated fantasy sports, especially the DFS industry. While there is merit to all of these points supporting DFS’s categorization with online poker as illegal gambling, as a person who plays fantasy sports, I can also contest that DFS is more skill-based than most realize. While skeptics point to how DFS’s sharks do not gain a competitive advantage through skill and practice but through barraging the same contest with hundreds or even thousands of entries, increasing their winning probability and their return on investment (ROI), there is a noticeable correlation between participant’s proficiency in economics or mathematics and their success in DFS. The elite cadre of DFS players have developed complex statistical models and designed software programs that automatically analyze thousands of players at once, which you will not find in poker or the lottery. Michael Mauboussin concluded that a key method to discern if an activity could be determined predominantly by skill over chance and vise-versa is finding if one could lose the said game completely on purpose. While every card in poker or blackjack could lead to the winning hand and every number in the lottery could lead to the winning ticket, with both activities so dominated by chance, there are certain athletes in professional sports who are statistically proven to perform better and worse than others - not all players can plausibly contribute to the winning DFS roster, and for me, users could intentionally “tank” their fantasy sports lineups. [9]

The infiltration of these aforementioned “whales” and “sharks” in daily fantasy sports, for me, is the more serious problem, and relates to the second question regarding the regulation of DFS. The transfer of unchecked power to sharks in online poker contributed to its demise in 2011, and we now see the same problem in the DFS industry today. The infiltration of whales and sharks into the DFS industry again relates back to the market’s aggressive ascendancy and the intense pressure for FanDuel and DraftKings to meet their new investment valuations. For both companies, creating contests with million dollar prizes is the optimal way to recruit new players and new entries, which results in the two companies competing with each other for customers, through aggressive marketing campaigns and progressively increasing the cash prize amounts of their contests. As we know, DFS companies like FanDuel take a “rake” or percentage of the entry fee, and use the rest of the fee for the cash prize, so the only way for these DFS companies to increase the cash winnings, with such high acquisition costs, is to obtain a steady flow of new entries every day. The two companies soon discovered, however, that instead of trying to recruit new players, they could allow the players they already have to enter as many as thousands of entries for the same contest. Sharks were thus born in the DFS market and the need for supply to meet demand, as FanDuel and DraftKings found high-rollers to be the answer to their worries: if they could persuade their high rollers to enter several hundred or even several thousand entries apiece, then the demand for new users decreases dramatically in funding these multi-million dollar contests. The underlying issue: this leverages an unstable amount of power towards the high rollers, whose success has now afforded more entries to further sway the odds in their favor at the hands of minnows and whales.

Power now rests on a powerful oligarchy of players who control a competitive advantage in the most lucrative DFS contests. With no regulations, these sharks are also free to practice “bumhunting,” a poker term describing high rollers targeting novice players and exploiting them for their money. While poker deters such behavior, DFS companies do not, as the inexperienced players instantly aspire to play the million dollar challenges, unaware that the sharks have a competitive advantage. The competitive imbalance that heavily favors the sharks inevitably creates a massive disparity in cash winnings and losses between sharks, minnows, and whales. According to data obtained by the New York Attorney General’s office, between 2013 and 2014, 89.3 percent of players had a negative return on investment in DraftKings. A recent McKinsey study showed that in the first half of the 2015 Major League Baseball (MLB) season, 91 percent of the prize money was won by just 1.3 percent of the players. [10] Delving into the disparity related to the 2015 MLB first-half season statistics, the top 11 players paid on average $2 million in entry fees and profited $135,000 each, accounting for 17 percent of all entry fees. The rest of the top 1.3 percent of players paid on average $9,100 in entry fees and profited $2,400 each, for an extremely impressive 27% ROI, accounting for 23 percent of all entry fees and 77 percent of all profits. The top 1.3 percent of player’s winnings magnify how important the fish are to the DFS economy and how much the whales and minnows actually lose. The meager 5% of players who comprised the whales lost $1,100 on entry fees of $3,600 on average (-31% ROI), while the minnows, who comprised 80% of the bettors, lost $25 on average entry fees of $49. The big fish sustain the DFS economy, as each loses on average between $3000 and $4000 per year and usually represents 60-75% of the losses. The losses provided by the fish are divided between the winners and providers, so the fish help provide the remaining profit for DFS companies with high rollers providing the majority of entries but winning with such great returns on investment, allowing DFS companies to continue creating million dollar contests for high rollers and more unaware big fish to squander their money. [11]

Overall, Daily Fantasy Sports is certainly a game of skill - a game of too much skill, where almost a decade of no federal and little state regulation has allowed power to be transferred to an elite group of players. Another troubling aspect of the infiltration of sharks and fishes has been the rise in what one could identify as gambling addictions, particularly for high rollers, who now consider their fluctuating winnings to be a primary source of income and playing DFS to be a full-time career. To enter hundreds or thousands of lineups a day and perform well, these high rollers need to invest in DFS as a full-time job, with the most successful players investing 10-15 hours a day keeping track of their contests and forging new rosters. I believe that like the lottery, however, the DFS industry is less ruinous to society than online poker, and could become a valuable source of state and federal tax revenue like the lottery today - I am against outlawing DFS and instead a proponent for keeping DFS legal but heavily regulating it. Massachusetts might have the necessary blueprint to effectively regulate the DFS industry because its plan discusses the creation of much needed safeguards. Massachusetts attorney general Maura Healey has discussed regulations like only accepting players who are 18 and older, limiting abusive practices by gamblers, setting deposit limits and not marketing to those who identify themselves as having gambling problems, and prohibiting DFS companies from advertising or promoting themselves at high schools and universities. [12]

To decrease the viability of sharks in the DFS industry, however, there needs to be drastic reform in setting regulations followed by everyone, from the DFS company employees to the high rollers. Some possible solutions include limiting the number of entries a high roller could enter each day, and protecting DFS novices by preventing high rollers from participating in smaller cash prizes. To prevent future allegations of DFS “insider trading,” employees must be prohibited from playing any contests, and must be stricter in enforcing against tools like computer scripts and optimization software that high rollers utilize to add last minute entries that adjust to sudden player injury news, to eliminate unfair competitive advantages. All these solutions assume that the DFS industry can weather and recover from the growing legal and legislative assault. If they can, they will need to make serious alterations that place power back to the companies, and that starts with stricter state and federal regulation, including a reworking of the UIGEA. We have witnessed the DFS industry after eight years of minuscule government regulation and the unbridled ambition and poor business practices that have resulted: if DFS is not careful, it will travel down the same path as online poker and reach the same destination: an alienated industry on North American soil with little sympathy or protection.

References:

1. Alba, Davey. “DraftKings and FanDuel Scandal Is a Cautionary Startup Tale.” Wired. Conde Nast, 09 Oct. 2015. Web. 01 Feb. 2016.

2. Federal Deposit Insurance Corporation. “Unlawful Internet Gambling Enforcement Act of 2006.” FDIC. Financial News, 2010. Web. 01 Feb. 2016.

3. Montgomery, Mike. “The FanDuel DraftKings Scandal Shows the Risk Of Building Businesses In Legal Gray Zones.” Entrepreneurial Section. Forbes Magazine, 18 Oct. 2015. Web. 01 Feb. 2016.

4. Drape, Joe and Williams, Jacqueline. “Scandal Erupts in Unregulated World of Fantasy Sports.” Sports Section. The New York Times, 05 Oct. 2015. Web. 01 Feb. 2016.

5. Drape, Joe and Williams, Jacqueline. “Fantasy Sports Said to Attract F.B.I. Scrutiny.” Sports Section. The New York Times, 14 Oct. 2015. Web. 01 Feb. 2016.

6. Grove, Chris. “DFS StateWatch: Monitoring Daily Fantasy Sports Action In State Government.” Legal Sports Report, 28 Jan. 2016. Web. 02 Feb. 2016.

7. Drape, Joe. “Payment Processor to Stop Working With Daily Fantasy Sports Clients.” Sports Section. The New York Times, 29 Jan. 2016. Web. 02 Feb. 2016.

8. Drape, Joe. “Payment Processor to Stop Working With Daily Fantasy Sports Clients.” Sports Section. The New York Times, 29 Jan. 2016. Web. 02 Feb. 2016.

9. Chemi, Eric and Wells, Nicholas. “So is daily fantasy gambling or not?” CNBC, 10 Nov. 2015. Web. 02 Feb. 2016.

10. Brustein, Joshua and Boudway, Ira. “You Aren't Good Enough to Win Money Playing Daily Fantasy Football.” Businessweek. Bloomberg Magazine, 10 Sept. 2015. Web. 02 Feb. 2016.

11. Miller, Ed and Singer, Daniel. “For daily fantasy sports operators, the curse of too much skill.” Sports Journal. Sports Business Daily, 27 July 2015. Web. 03 Feb. 2016.

12. Henning, Peter. “Daily Fantasy Sports Sites Face Challenges, and Options.” DealBook. The New York Times, 23 Nov. 2015. Web. 03 Feb. 2016.