MIT Series Ep 6: Kalshi CEO on Building the First CFTC-Regulated Event Exchange | MIT 18.642

Hey, everyone.

Well, yeah. Well, first of all, thanks for having me, Peter. You know, I'm really, really excited to be back in the class. I know Luana did last year. I know I did — I think I did the year before that. And maybe I'll talk a little bit about background, you know, sort of leading something. So, the way I want to think about doing this is just: I'll talk a little bit about the story of Kalshi and how we decided to do it, what is the long-term vision, what we're trying to achieve, and then we'll do a little bit of Q&A. And then maybe basically see how it goes from there.

It should be on, but let me check. It's on for me, so it's on on Zoom. So, let me check. Let me double check. One sec.

Great, great. Sorry about that. I think I'm on a little bit of an unstable Wi-Fi. So, yeah. I mean, maybe I'll talk a little bit about my background. I really like going back to this class because a lot of the interest in financial markets and math, I think, stems from the class. So, I was born in California, I grew up in Lebanon. I think one of the things that I basically enjoyed doing in middle school and high school is I actually really loved math. I really, really liked math. And I think that felt like MIT was the right place to go for someone who basically really loves math. And so, got into MIT, and the thing I realized is one of the best applications of math is finance. So, started working in a number of — whether it was sell-side or buy-side. So, banks like Goldman Sachs, I worked at Citadel, I worked at small prop shops or active small prop shops. And then the thing I realized is — I'd say I realized two things. I mean, one, I like trading. I really enjoy trading, but I realized I prefer sort of building more. I like the notion of building new products and building something new that is sort of tangible. And two, when I was at Goldman, I mean, I think a lot of the things that we sort of seen is that, you know, financial instruments do get developed over time. They take a long period of time, but there is a lot of opportunities basically to develop new things, and there's always needs for a lot of new things. One example in 2016 is that a lot of people were actually trying to get a hedge or an exposure to Brexit, and there weren't really the right instruments for that. People would use traditional financial instruments like stocks and options and others to get that sort of binary exposure that people were looking for. And it was just not perfect. It was a proxy, it was indirect, and it was super expensive because it was what we call over-the-counter or OTC traded. And so what we thought, you know, it was kind of really early at the time, it's like: 'Well, what if we have a financial market?' So, we have a financial market for equities, one that prices credit like bonds and so on, one that prices commodities, and we have financial markets for currencies. What if we had a financial market that prices basically any question about the future, any event that is on the horizon that is meaningful economically or socially or culturally? And I think the thing that became very apparent is, one, if such a market were to exist, it has the potential to be the biggest financial market of all, mostly because it's just broader than anything else that came before it. And two, there were a lot of regulatory issues with that type of market. So, basically historically the US has made these illegal or unregulated. They haven't let anyone do it. And, you know, at the time we were very naive. We thought, well, that sounds like a problem we can solve, and we just got into it. So, we decided to start the company. I didn't go back to Citadel, and so we just decided to start Kalshi. And the premise is really like: what if we build sort of the first large-scale prediction market, and we want to do it as a financial exchange, a regulated financial exchange, so that this can become an asset class that's traded one day by large hedge funds and institutions and brokers and so on and so forth. And, you know, when we first started it, it was tough. So, I think that any company is really tough to start, but I think this was particularly tough because it was kind of a funny story: we called pretty much every single securities/derivatives lawyer in the country and asked them like, 'Hey, we're trying to do this, can you help us?' And the answer was basically — the range was like either being laughed out of the room all the way to sort of like, 'Hey, this is just not going to work.' Like, the CFTC and the regulators just never wanted to do anything like this. And the reason we kind of kept going is because none of the answers were actually satisfying. Like, there wasn't a clear answer. Like, 'Okay, why?' They're like, 'Well, because it could be manipulated.' I'm like, 'Okay, but that's solvable, same way we solved the stock market.' And then the other one is like, 'Well, it could be gambling.' I was like, 'Well, why is it gambling and something like grain futures is not?' I mean, some people are speculating on grain futures and sure, some people are hedging on grain futures, but it's the same thing for Brexit. Like, a lot of people are exposed to Brexit. And we kept going. We basically got the company regulated. It took 3 years — so, it took 2 and a half to 3 years to basically get it regulated, and we basically launched the first legal exchange or legal prediction market in the US after that. It took us a very long time. It was a very long journey, but we got the exchange, we got the clearinghouse — well, we got the exchange at the time. And we got up and running. And, you know, I think Peter has seen all this sort of journey of the company. We started running, and then we grew a lot, and then we had a bunch of sort of — I would say — issues and infighting between us and the federal government, the CFTC, especially this kind of prior administration which was kind of really tough in financial services and financial innovation. And the big thing that happened is they didn't let us do the election market, which we always believed is going to be one of the biggest markets of all, basically. It was a — you know, we took a very long time to make that decision. It was a very tough one, but we ended up suing the federal government. So, we were really one of those sort of first, you know, I would say, examples of a regulated company suing its own regulator. It's a very tough and painful decision to make at the time. Obviously, it was the right one now, looking back in retrospect. And we won earlier this fall. And so, that win was actually the first time in 100 years that you can actually trade legally on the election in the US. And that opens up a lot of opportunities beyond the election, because what the lawsuit was about is, you know, it's really expanding the universe of things that are considered financial instruments now. And so, where Kalshi is at now, you know, we've grown a lot over the last few years, but definitely the last month. We've done over a billion of volume in the last month alone. And, you know, now kind of as we think about our future expansion plans, we're getting into a number of different categories — you know, financial services, like just basically financial markets, sports. We want to basically have a market for every single piece of news that's out there in the world. And we want to — over time what we're doing is like we're integrating some of the large brokerages where we're going to have, you know, people can come to Kalshi.com to trade the asset, but also if you trade the asset from your own brokerage account — actually your 401k and your stocks — you'll be able to do that on Schwab, Robinhood, Fidelity, and so on. I'll talk a little bit about sort of, you know, kind of finishing the narrative arc, and then I'll talk some of the sort of personal stuff going from being a student to starting a company and so on. But one of the things that, you know, what was interesting throughout the journey is a lot of what it basically ends up taking is just perseverance around — but perseverance towards the goal that you're trying to achieve. We — you know, I mentioned in the beginning that we were naive when we first started, and in retrospect I think that was actually one of the best things — I would say one of the best tools that we had, actually being naive. Because a lot of the people that — like, if we knew how hard it would be, we probably just wouldn't have done it. And there's something to be said about, you know, when you climb a mountain, people tell you just look at the next step, one step at a time. Don't look at the summit, just because when you look at the summit you get tired. And I think there's a lot to be said — I think this applies to pretty much anything meaningful in life, I think. Just doing anything meaningful basically requires a lot of perseverance. The company has raised more than $100 million from a few investors: Sequoia, KKR, Schwab itself, YC, and a bunch of others, Silicon Valley. And I think that's about it. I think I covered most things. Peter, I was thinking we could do a little bit of Q&A, and then we can sort of orient the conversation to some of the places that the students want to hear about.

If you think so, there's a lot of similarities. I mean, and I would say there's a lot of similarities between betting markets and just any traditional financial markets. There are a lot of people that like — I expect betting or gambling on a lot of — we have a lot of markets including crypto and stocks and really anything. But I think like it's a bit more of a structural difference. Like, first of all, this is an exchange. People are trading against each other. There's no bookie. There's no concept of bookie. And actually any institution that wants to hedge against that would never do it on a betting market, just because, you know, the prices are set by the bookie. They would do it probably with an investment bank, which is what they're doing right now. But the prices are kind of bad at the investment bank. It's like over-the-counter. You know, you negotiate bilaterally with the investment bank instead of just basically doing it on an exchange, right? Like, there's other people that are independently pricing the event, so that you can basically know what the right price is to basically make the transaction at. I think like there are a lot of similarities, and frankly like we don't really discern them quite much. I think like over time the two are converging and they're going to end up being one and the same. The fundamental difference I'd say, like from a regulatory or legal perspective, but also like sort of why is it a financial instrument, is like: are you trading on natural risks or are you trading on artificial risks? Right? So like when you go to a casino and you roll a dice, that's like a risk that you're creating for the purpose of entertainment. Whereas, you know, Brexit — that's not a risk that you're creating for the purpose of entertainment. That's a risk that exists that some people have and they're exposed to, and they may want to basically transfer it to someone else. And so that's sort of the delineation of why this is a financial market and why, you know, having it on a financial market is appropriate. But yeah, I mean, I think the two main differences: like, it is an exchange. Like, we have an order book. People are trading in the same way as a stock market, the same way they trade in a stock market. And then two, it's risk that exists, and so people can basically do what they want with that risk — whether they want to get exposed to it more by speculating, or they want to get exposed to it less by hedging. It's a great question.

Yeah, I mean, well, we're the only legal one in the US, so there's kind of — I mean, in terms of — there's more arbitrage between us and traditional financial assets. So, with the election for example, people were arbitraging — like a lot of hedge funds were arbitraging the election market with other assets like crypto or like S&P and so on. And we see a lot of that.

I would say like maybe a few things. So, one, I mean, it's always good to get first-hand exposure into how things are done in a market that you're trying to disrupt. It's like good — you have to have a reasonably good understanding of how things work. And the thing I'd say is like it's interesting: like if you stay in an industry for too long, it actually gets a bit harder to disrupt it. You get too conditioned to how things are done. And maybe it gets harder for you to have any degree of naivete, which I think is not a very good thing. But I think some degree of experience is good so that you have a base understanding of what your end customer — how your end customer basically thinks about the world and how they use different products and adopt them. The second thing I think is I would say I learned a lot from the Citadel culture. Maybe less from Goldman and some of the others, but Citadel — I really enjoyed working at Citadel. I really like a lot of the aspects of the culture and the way that things are done. And I would say it was interesting because I think Citadel had sort of this ultimate version of — let's call it sort of like performance-driven culture. And what I mean by that is like it's a full meritocracy. There's very little sort of management layers. Even if you're young, they will give you a lot of ability to sort of take risks and do big things. And they're uniquely fit to do that because in trading — something that's very unique to trading is that you have a P&L. Like, it's undeniable whether you're doing well versus not. You know, if you make money, you're doing well. If you're not, you're not. Whereas in a lot of — like in tech and others — like there's a lot of politics, like, you know, the boss likes you versus not. I mean, there's just a lot of noise. And I think we try to kind of bring that to the culture of the company as much as we can. We're very flat as a company. Like, we have a lot of people, you know, they're a few years out of college. A lot of them are from MIT. You know, they're running huge chunks of the company already and with teams and so on. And just because like, you know, for us it's very similar: like if you do well, you basically grow extremely fast within a few months with the company. And if not, then not. And that comes a bit from the trading culture, I would say.

Good to see you.

Yeah. So, we are fully collateralized right now. So, what it means is like people put the money up front for their positions. And then we basically mark to market every day — actually mark to market on a real-time basis. So, we do it real time. We are going to introduce leverage next year, I think. And that's going to be pretty interesting. We're thinking about, you know, what kind of our margin model is going to be. And maybe for the class explain: so in other financial markets, what people consider kind of margin leverage is like when you buy — when hedge funds basically buy, let's say, an interest rate future or like S&P future, let's say they want to buy like a million dollars worth of S&P future. They don't put up a million dollars with the clearing house and the exchange. They put up, let's say, 100,000 dollars or 10,000 dollars, which would be 10% or 1% margin. And then as the thing moves over time, you know, the clearing house asks you to — you know, if you made a little bit of money, the clearing house pays you, and if you lost, the clearing house asks you to put up a bit more margin to cover your losses. And it goes like that over time. Kalshi is a simpler model where like we actually ask for 100% up front. We tell everyone like, 'Hey, give us all the money up front so that there's no risk in the system, and you're always sure that anything you lose is like what you put up up front. You cannot lose more than that.' Over time, we're going to start introducing leverage, which is like we don't take 100% up front. And that's what Diego was asking about. And I think it's a complicated thing because regulators are becoming very strict about how we do this, and we have to be very — we need to make sure that nothing like 2008 can happen again. And so there's a lot of requirements around how this needs to be done. And, you know, so we expect to basically just maybe margin like end of next year, potentially. And, you know, we'll see how that goes. We do have some products where, for example, if there's a lot of strong correlation between two products, we return some collateral to the participants. And we've already started doing some of that. But, you know, over time we'll do more and more. Yes, it's a great question.