Let It Ride

Sure, gambling seems like a perfect business model for the Web. But is it legal?

InformationWeek Staff, Contributor

July 3, 2002

16 Min Read

Odds are, the Windy City offers something for everyone--diverse architecture, a beautiful lakefront, dozens of museums, and world-class restaurants. But 27-year-old Scott Mauer hedged his bets with a different Chicago-area attraction: the bevy of gambling outlets on riverboats, at racetracks, and even the state lottery. So when a job transfer led him and his family to casino-free Tennessee two years ago, the recreational gambler was concerned that he'd lose out on one of his favorite hobbies.

What he found instead was a jackpot--gambling over the Web. OK, so he doesn't hear the cheers of winners, the ringing of slot machines, or the crescendo of a track announcer. Complimentary drinks and showgirls are out of the picture, too. He's exchanged all that for convenience, ready access to information, and even a sense of security. "Online is 10 times easier than on-site," says Mauer, who frequents http://www.wsex.com, a sports-betting site run by World Sports Exchange Ltd., based and licensed in Antigua and Barbuda. "Compared to gambling with a bookie, you know you're going to get paid from sites that have been around. They'll put the money right in your account. You can do it in the comfort of your own home, and you have all the information you need on your computer."

Apparently, many others are buying into that appeal. The 200 companies that run about 2,000 online-gambling sites took in $2.5 billion in revenue last year, according to InformaMedia Group, which tracks electronic gambling. InformaMedia predicts that figure, still only 1% of conventional gambling revenue, will reach $14.5 billion by 2006. "Online gambling is one of the hottest sectors on the Internet," says Charles Buckwalter, an ad-tracking analyst formerly with Jupiter Media Metrix.

The online-gambling industry got its start in 1998, driven by client-server technology, targeted marketing, the Web's global reach, and the human appetite for rolling the dice anytime, anywhere. It's a perfect business model for the Web. But as the market grows, online gambling is plagued by questions--not the least of which is whether it's even legal in the United States--and by problems such as banks' and credit-card companies' refusal to accept transactions from gambling sites. Yet online-gambling operators and vendors of the technologies that power the sites continue to develop new games and venues, marketing programs, and payment options for their customers.

Gambling sites draw about 4.5 million people. These virtual casinos offer everything from blackjack to slot machines to sports betting to bingo. Typically, customers visit the sites, register, and deposit money via credit cards, checks, or person-to-person payment services such as PayPal and NETeller. Then they play their games of choice. When they win and want to cash out, they get their money in whatever form they choose.

For now, casino-style games and sports betting account for about 80% of online gambling's revenue, says Jean Noelting, president and CEO of CryptoLogic Inc., an online-gambling software and services provider. "We expect growth in the future from lottery, bingo, and poker," Noelting says. U.S. players represent about two-thirds of the revenue in online gambling. But the industry is looking to expand geographically, to maintain growth and to minimize the risk from legal hassles in the United States. "Europe and Asia are very underdeveloped," Noelting says.

The technology used in online gambling is basic client-server architecture. Because startup costs are relatively low--a cheap server and some unsophisticated interactive software on the client side, which can be licensed from many sources--online-gambling sites pop up, and disappear, with regularity. Also, because of its rapid growth, online gambling seems to have replaced adult-oriented content as the platform of choice for the would-be Web entrepreneur. For those bent on breaking into the business, Yorktown Ventures Inc. in New York operates http://www.startcasino.com, a site that explains how to open an online casino.

Several vendors offer sophisticated Web-based gaming software, including Boss Media, Interactive Systems Worldwide, and MicroGaming. Andrew Pascal, president and CEO of WagerWorks Inc., spent 10 years developing software for video slot machines and says, "We amassed a lot of intellectual property that we felt was appropriate for online." Pascal's primary thrust has been in creating client software that's easily downloadable and doesn't take up much space on a user's PC. But there's also an emotional element. "We're trying to replicate some of the experience you get when you go into a casino," Pascal says. WagerWorks is working with the MGM Mirage to develop its online-gambling strategy and architecture, which he expects will be launched later this year.

Several companies, such as CryptoLogic, offer hosting services that provide everything needed to run an online-gambling site. Noelting says customers buy Unix servers that his company operates and maintains, then they license software for three purposes: gaming; E-commerce; and customer care, to integrate E-mail marketing, telephone support, and loyalty programs. CryptoLogic takes what Noelting terms "a small up-front fee," customers sign licenses that typically last five years, and the company does the software customizing and support. "We manage the service and guarantee performance," he says.

Virtually all the servers that run gambling sites are located outside the United States. CryptoLogic has server hubs in Argentina, the Caribbean, and the Isle of Man. That's because, according to federal and state laws, most online gambling is illegal in the United States.

Each of the four forms of legal gambling--horse racing, sports betting, casinos, and lotteries--has its own set of regulations. Horse-racing statutes are the most liberal. Federal law states that it's legal to take interstate horse-race wagers if it's legal in the sending and receiving states, says Anthony Cabot, a partner with Lionel Sawer, a Las Vegas law firm. Dozens of companies take wagers over the Internet and phone from several states.

Sports betting is the most conservative. The only state with legalized sports wagering is Nevada. Several Web sites, mostly startups with servers located in Central America and the Caribbean, take sports bets because they're outside of the United States' jurisdiction. They use foreign banks to transfer money, making it difficult for U.S. authorities to trace who's placing bets. Technically, it's illegal under U.S. law for the offshore sites to take bets from U.S. residents living anywhere except in Nevada, but they do. So far, federal law-enforcement agencies haven't pursued individual U.S. residents who bet on offshore sports sites. A few states, including New York and Minnesota, have threatened to do so, Cabot says.

Casinos and lotteries fall into a gray area. The statute most cited as governing lotteries and electronic casinos is the 1961 Federal Interstate Wireline Act. In essence, this law says that any bookie who uses wire communication between states or between a state and a foreign country to take bets on any sporting event or contest is guilty of a felony. The confusion relates to the words "sporting event or contest." The Justice Department says "sporting" modifies "event," and the word "contest" covers everything else. Online gambling advocates say the word "sporting" modifies "event" and "contest," and therefore applies only to sports betting, Cabot says. What's more, some question whether the Internet is covered under "wire communication" because the law referred to phone wires when it was written.

State laws, many of which prohibit gambling beyond state-sponsored lotteries, don't appear to be in online gambling's favor. "Accepting casino-style wagering is probably illegal under most state laws," Cabot says. "But most state laws were adopted 200 years ago, so the question is, how do they apply to the Internet?"

Two things could clear up the uncertainty. The first is federal legislation to deal specifically with online gambling. The House of Representatives Subcommittee on Crime is examining legislation proposed by Rep. Bob Goodlatte, R-Va., that would make all forms of Internet betting illegal in the United States.

The second is a pending ruling by the 5th U.S. Circuit Court of Appeals, stemming from a class-action case that went before the New Orleans federal court two years ago. In the suit, attorneys argued that credit-card companies damaged their clients, who were online gamblers, by allowing them to use credit cards on gambling sites. They said it was a violation of the Federal Interstate Wireline Act, but the court ruled that the law doesn't apply to online casino gambling, just to sports betting. The appellate court is expected to rule this year on whether the act applies.

In the meantime, Mauer will continue gambling online. "The legal issues concern me, but then they really don't," he says. "I'm not afraid of the IRS going after me. With the amount of money I wager, I don't worry about it." But he advocates legislation that protects the consumer. "I'd like to see some kind of legislation that prevents Joe Schmo from opening a sports book for a few weeks, then closing and ripping people off. It's happening all the time."

Even if the United States government regulates Internet gambling, many players will continue to use offshore sites to avoid having to pay taxes on their winnings, says Carter of the Internet Gaming Commission

Even if the U.S. government starts regulating Internet gambling, many players will continue to prefer offshore sites so that they can use foreign banks to avoid claiming their winnings on their tax returns, says Ron Carter, chairman of the Internet Gaming Commission, an industry-advocacy group. "People have money that they don't want the government to know they have," he says. "None of that information will ever be transmitted to the government" by offshore operators. If the government explicitly allows online gambling, it could mandate that the online casinos report who wagered more than, say, $10,000 in the past month. "That could be part of the rules to make this legal within the U.S."

Legal questions aren't the only problems that confront online gambling. Banks that issue credit cards present a huge challenge for the sites and their customers. Most recently, Citibank, which controls about 12% of U.S. credit-card business, said it would no longer accept transactions from online-gambling sites, joining a group that includes Bank of America, Chase Manhattan, Direct Merchants, Fleet, and MBNA. Credit-card issuers that do accept those transactions typically hold half or all of the money for six months to one year to make sure consumers don't dispute the charges and indeed pay their bills, Carter says. Since banks began rejecting the transactions, the online-gambling industry has lost $500 million to $1 billion in revenue, he adds. "A substantial portion of online transactions are done with credit cards," Las Vegas lawyer Cabot says. But setbacks like that are usually temporary, he says. "Once you throw out an obstacle, someone will find a way around it."

Person-to-person payment sites, such as PayPal and NETeller, are emerging as an alternative to credit cards for online-gambling transactions. They transfer money directly into and out of customers' bank or credit-card accounts. For the online-gambling operators, though, this option doesn't come cheap: PayPal, for instance, charges the casinos an average of 8.5% per transaction, Carter says. Some payment sites, by masking gambling debts, may even allow online gamblers to skirt the credit-card ban. Not PayPal, says a spokesman. The company codes gaming transactions so that credit-card issuers recognize them.

As online-gambling revenue climbs, conventional casinos must walk a fine line. They want to be involved in a growing market, yet they don't want to risk breaking laws by encouraging their U.S. customers to gamble online. MGM Mirage, Station Association, and Sun International are the land-based gaming companies with the most aggressive online-gambling strategies, says Marc Falcone, former leisure and gaming analyst with Bear Stearns, now with DeutscheBank. MGM Mirage runs its Internet operation from the Isle of Man, a British territory, to offer online gambling in Europe and other parts of the world where it's legal. "The larger companies are going to jump in, at least on an offshore-to-offshore basis," Cabot says. "It's not a question of if, but how."

For MGM Mirage, at least, the "how" has to do with the software it's using from WagerWorks. Pascal says his company has spent considerable time developing technology that's "regulatory-based," that can verify where a potential customer is from and how old that potential customer is. "We focused on regulatory issues," Pascal says. "We understand them. We know how to deal with them."

Most major U.S. casinos want to leverage the Web just as the traditional click-and-mortar pioneers did. And there are ways to deal with the law. Some U.S. casinos offer play-for-free games online. Customers can earn tokens or certificates that they can redeem for prizes or use when they go to the brick-and-mortar casinos. "They'll give you two nights for free or send you a T-shirt," Carter says. "They're just building a following." Most industry observers pooh-pooh the idea that online gambling will cannibalize the land-based casinos. "We think it's going to help expand that marketplace," Falcone says. "There are cross-marketing opportunities meant to drive physical visitations to the casinos."

The biggest challenge for online gambling these days is customer acquisition and retention. That's why the more sophisticated online-gambling sites use personalization and customer-support software, in much the same way booksellers or airlines do. They create profiles of their customers, track their activities, and offer promotions to lure them back to the sites. Online casinos have an edge over their brick-and-mortar counterparts in most cases, because it's easier to track who's doing what online than it is in a physical casino. Online, each gambler must register and use a log-on each time he or she visits a site. "They do know a lot more about you online," Carter says.

One way gambling sites have expanded their potential customer base is by buying pop-up-ad space from search engines and portals, a shift in their approach to advertising on the Web that's serving them well, says analyst Buckwalter. Last year, most of the advertising for online-gambling sites was placed on niche gaming sites. This year, about half of the industry's 2.5-billion-plus ads are showing up on mainstream portals to attract new customers who may not even know online-gambling sites exist. "The wide reach and impact is serving them very well," Buckwalter says. "Online gambling's reputation has been on the underbelly of the Internet. This change in strategy has helped."

Maybe. The online-gambling industry has its problems. It grew very quickly, creating Web sites that went out of business before gamblers could recoup their money. That's given the online-gambling industry an image problem. "A lot of these sites are scams," Mauer says. "They'll open for two weeks, take your money, and then shut down." The industry is littered with scams, on both sides. The casinos don't always deliver what they promise, and some consumers have found ways around glitches in the gaming software that runs the sites so they can win money unfairly. Customer-acquisition costs have risen because companies haven't figured out who their best prospects are and how to effectively market to them, Falcone says. What's more, lawmakers are concerned that the sites offer organized-crime groups a simple way to launder money.

Place Your BetsThe online-gambling community has attempted its own damage control. For instance, Majorwager.com, an online gambling site that runs pop-up ads for casinos, provides a listing of sites that it recommends people avoid.

The Internet Gaming Commission, formed about 2-1/2 years ago, provides a portal to gaming sites and resolution of consumer complaints. The commission doesn't test the sites. Instead, it relies on consumers' reporting whether they've had bad experiences, and it keeps a database of each gaming site. It provides links only to sites that have high ratings among customers. "We write to the gaming sites and tell them of allegations," Carter says. "Most of the time, we get a very good response."

Because gamblers register with the sites, gaming software can track how successful they were during their visits. Consumers often complain that they didn't win enough money or that a site was rigged. "But the sites can come back and say, 'This person has a 98.35% win rate,'" because of the software, Carter says. (A win rate reflects how much the game has paid out to an individual but doesn't factor in how much of those winnings he or she continues to wager--and often loses.)

For the most part, Carter says, casinos don't have to cheat because the odds are in their favor. But some are undercapitalized, which gives them an incentive to delay payments. A gamer could win $2,000, and a site promises to send his money within 24 hours: "They'll stall and give you excuses. Then you get frustrated and gamble it all away."

Online casinos face their own problems with fraud. For example, some gamblers use stolen credit cards to start their accounts. When they win, many sites will credit only $500 back to their credit cards and mail the rest. Now, the casinos mandate that customers fax them copies of their driver's licenses to verify their addresses and identities.

And like any other Internet citizens, online-gambling sites have problems with hackers. Last year, hackers broke into CryptoLogic servers and "caused higher win rates in certain games," according to the company. In the end, gamblers won $1.9 million before CryptoLogic discovered the attack.

Moving forward, industry observers expect that innovation will drive online gambling into new areas. "There's a big business opportunity," Cabot says. He expects a convergence of gaming, such as video games or other online games, and gambling. When people play skill games online, they could bet on who will win. So rather than having one person play blackjack against the computer, sites will start offering multiplayer options.

No matter how the laws shape up, the technology will work its way around them. There's online-casino software that blocks out IP addresses based in the United States and Canada, so even if law-enforcement agencies wanted to prosecute online gamblers, they would have a tough time tracking them down because there's no record of the site visits. While other dot-com industries have crashed and burned, online gambling has taken off. Despite the potential for some serious setbacks, smart money says it's a good bet to keep growing.

Illustration by Michael Morgenstein
Photo by Eric Breitenbach

Never Miss a Beat: Get a snapshot of the issues affecting the IT industry straight to your inbox.

You May Also Like

More Insights