US Gambling goes online?

Thoughts below are my personal opinions as a VC looking to invest in internet startups, and do not reflect any views on Betfair or its strategies, intent, or prospects in regard to the US gambling market.

All forms of online gambling, with the exception of horseracing, have been effectively treated as illegal in the US for the last decade or so. (Before that, they were essentially ignored).

DoJ Rolls the Dice

DoJ Rolls the Dice

The reasons for this effective illegality were somewhat murky.  After all, gambling is traditionally a state issue, where we leave states to decide what kind of regulation their citizens want.  Utah can ban it, Nevada can permit it, and everybody’s happy.  In 1961, however, Congress passed the Wire Act, in an attempt to control the spread of the mob, who at the time controlled the illegal betting industry.  The Wire act states:

Whoever being engaged in the business of betting or wagering knowingly uses a wire communication facility for the transmission in interstate or foreign commerce of bets or wagers or information assisting in the placing of bets or wagers on any sporting event or contest, or for the transmission of a wire communication which entitles the recipient to receive money or credit as a result of bets or wagers, or for information assisting in the placing of bets or wagers, shall be fined under this title or imprisoned not more than two years, or both.

Now, a layman (read: reasonable person) reading this text would think that the act was forbidding sports bets across state lines.  One might quibble as to whether an act written in 1961 should apply to the internet (is the internet “wire communication?”). The DoJ has maintained, however, that the act applies not just to interstate sports bets, but in fact to all sorts of gambling, and if even if conducted intra-state.  Is poker a sporting event or contest?  Is blackjack?  Lottery?

However, the ominous threat of federal prison has meant that few have been willing to take the risk, and those who have, have generally been intimidated into settlement, or convicted of some other related offense.  Online gambling in the US has remained, largely, an activity conducted in the dark.

Now, it looks like someone has taken a flashlight to it.  Two states asked the DoJ to rule as to whether intrastate lottery ticket sales online would run afoul of the act, and the DoJ have seemingly reversed their stance and indicated a much narrower interpretation of the Wire Act, to where it really just applies to sports betting.  According to the lawyers who have commented on it, it’s a pretty clear opening for states to offer intra-state poker, casino, and lottery, and possible agree to pool liquidity in those businesses between their states should they agree.

While I think this is great news, many key questions remain:

  • Which states will look to legalize,which games will they legalize, and on what timeframe?
  • Who will they grant licenses to, and by what process?
  • Will taxes be structured intelligently?

When I started Flutter (now Betfair), I failed to fully appreciate the headwind that regulatory oversight places on creating a valuable new business.  Being subject to the slow and sometimes arbitrary restrictions of the government is diametrically opposed to the ideas of iteration, experimentation, and innovation.  As an investor, I’d be reluctant to invest in a regulated business — I’d still do it, but the idea would have to be amazing.  Especially amazing, not just the ordinary amazing that serves as my bar to get over.  Luckily for us, the Betfair business was amazing and worked, but if you look at the legal gambling jurisdictions, the combined market cap of all the new businesses created over the last decade is not very impressive.

Taxation is one are where this regulatory burden rears its head.  The clear impetus behind state interest in legalizing gambling is to further pursue the foundations of liberty and an individual’s right to freedom except where absolutely not in the public interest.  Oh, sorry, that was a typo — I meant to say tax it to generate revenue.  Inconsistent approaches to taxation have been a challenge for online gaming businesses in Europe.  If the tax rate is set extraordinarily high, you can’t build a rational business, and consumers will sneak back to the illegal (untaxed) alternatives.

Entrepreneurs with stars in their eyes at this opportunity are likely to face a sobering reality check when the states actually go to legalize gambling.  The actual mechanics will be voted on by a state legislature.  In many cases, these bodies are made up of part-time employees.  Even if full-time, they have no experience with online gambling, and many probably still have their secretaries print out their emails for them.  Call me cynical, but there is a real risk that the details of the legislation will be drafted by those with the most money to spend to protect their vested interest in the states, and in few cases will that be the entrepreneurs!

The existing state lottery companies, existing casino providers, native american tribes: all these parties generate a ton of tax revenue for the states already, have longstanding relationships with the decision-makers in the state congresses, and are frequently some of the largest supporters of the cost of getting re-elected.  When new opportunity is doled out by the government, be it US private military contracts in Iraq, or the dissolution of asset ownership in the former USSR, it tends to be pretty easy to predict who will get the spoils.

As an entrepreneur, or investor, you want to get started in chasing this opportunity, but it’s hard to invest your time or money, just to find out that they don’t decide to license your game, or they do but only to the existing vested interests, or they do but there’s a 20% tax on wagers that effectively cripples your market.

All cynicism aside, I’m excited for the opportunities this new change will create, by allowing entrepreneurs into the mix. Maybe not in every state, maybe not in every game, but US entrepreneurs will find the opportunity.

One of my great disappointments with online gaming, where it is legal, is how un-innovative it is.  Sure, Betfair turned betting upside down with an exchange-style market, and led the market to support in-running (mid-game) betting.  But everything else — poker, blackjack, roulette – looks just like it does in the casino.  It’s idiotic actually:  roulette is a game, based around a wheel with 37-38 slots — that wheel exists as an invention to randomly choose a number, and the 37-38 slots exist because that was the practical size for a wheel and a ball.  So now, with all the power of computers and innovation since, we have… a pixel perfect rendition of a spinning wheel, whose number was pre-chosen by a random number generator, designed to look like a 100 year old number generator?  Why does the wheel not have 1,000 numbers?  You could choose Red for a 2:1 bet, or you could chose 1-333 for a 3:1 bet, or you could choose the number 434 to for a 1000:1 bet?

Then imagine the games on Facebook, on Zynga, on your iPhone.  Social, team.  If your office pools to buy 50 lottery tickets each week, imagine doing something more social with a team chance of winning?  In the short-run, there’s no doubt the classic games will dominate: customer acquisition and trust are easier, because people know what they are getting into. And the early entrants will just be picking the low hanging fruit of customers already pre-disposed to play, waiting for the opportunity.  Europe has largely been stuck there, for various reasons from a less innovative culture of product development, to regulatory issues and small individual markets.  Hopefully the US, with the best product development and internet talent in the world, can do even better!

Full Text of DoJ interpretation

Image courtesy Alan Cleaver via Flickr CC.

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Written by Josh Hannah
Josh Hannah joined Matrix Partners after a career as a serial entrepreneur (Betfair, eHow, wikiHow.) Read more about Josh.

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