Lecture 20: Building the First Federally (CFTC) Regulated Exchange Dedicated to Trading on Events

Introduction to Tarek Mansour and Kalshi

Background of Tarek Mansour

• Peter Kempthorne introduces Tarek Mansour, a guest lecturer who graduated from MIT about six years ago.

• Tarek has experience working at major financial institutions like Goldman Sachs, Citadel, and Bridgewater before co-founding Kalshi.

Overview of Kalshi

• Tarek outlines his intention to discuss the story behind Kalshi, its long-term vision, and engage in a Q&A session afterward.

Tarek's Journey and Insights on Finance

Early Interests and Education

• Tarek shares his background growing up in California and Lebanon, emphasizing his passion for math which led him to MIT.

Transition from Trading to Building

• He expresses enjoyment in trading but reveals a stronger preference for building new products within finance.

The Concept Behind Kalshi

Identifying Market Gaps

• Tarek discusses the lack of appropriate financial instruments for events like Brexit in 2016, highlighting the need for better solutions.

Vision for Prediction Markets

• He proposes creating a market that prices any significant future event economically or socially, suggesting it could become the largest financial market.

Challenges Faced While Starting Kalshi

Regulatory Hurdles

• The team faced skepticism from legal experts regarding the feasibility of their prediction market concept due to regulatory concerns.

Persistence Despite Doubts

• Despite being dismissed by many lawyers as unworkable, they continued pursuing their vision because existing answers were unsatisfactory.

Legal Prediction Markets and Their Evolution

Launching the First Legal Exchange

• The speaker discusses the long journey to establish the first legal prediction market in the US, highlighting the challenges faced during this process.

• After launching, significant growth occurred, but there were conflicts with federal regulators, particularly the CFTC under a previous administration that was tough on financial innovation.

Legal Challenges and Outcomes

• The inability to list an election market led to a pivotal decision to sue the federal government, marking a rare instance of a regulated company taking action against its regulator.

• Reflecting on this decision, it was deemed painful yet ultimately correct; winning the lawsuit allowed for legal trading on elections in the US for the first time in 100 years.

Expansion and Future Plans

• Following recent successes, including over a billion in volume traded within a month, plans are underway to expand into various financial services and markets related to global news events.

• Integration with major brokerages is planned so users can trade directly through platforms like Schwab and Robinhood alongside Kalshi's own site.

Perseverance Through Challenges

• The speaker emphasizes perseverance as crucial for achieving meaningful goals. Naivety at the start of their journey helped them tackle challenges without being deterred by potential difficulties.

• A metaphor about climbing mountains illustrates that focusing on immediate steps rather than distant goals can prevent discouragement during challenging times.

Funding and Investor Support

• The company has successfully raised over $100 million from notable investors such as Sequoia Capital and KKR, indicating strong support from Silicon Valley.

Understanding Differences Between Prediction Markets and Betting Markets

Key Distinctions Explained

• A student questions how prediction markets differ from betting markets since both involve wagering on events.

• The speaker clarifies that unlike betting markets which operate through bookies setting prices, prediction markets allow direct trading between participants without intermediaries.

Regulatory Perspectives

• He explains that institutions would not hedge risks like Brexit through betting markets due to unfavorable pricing set by bookies; instead, they prefer exchanges where prices reflect independent valuations.

Convergence of Markets

• While acknowledging similarities between both types of markets, he notes that regulatory frameworks differentiate them based on whether they deal with natural or artificial risks.

Understanding Financial Markets and Risk Management

The Nature of Risk in Financial Markets

• Tarek Mansour discusses the inherent risks present in financial markets, emphasizing that these risks are not created for entertainment but exist naturally and can be transferred among participants.

• He highlights that trading occurs through an order book, similar to stock markets, allowing individuals to manage their exposure to risk either by speculating or hedging.

Arbitrage Opportunities

• Mansour notes that Kalshi is the only legal exchange for this type of trading in the U.S., leading to arbitrage opportunities primarily between Kalshi and traditional financial assets rather than betting markets.

• He mentions hedge funds engaging in arbitrage during events like elections, where they exploit price differences between election markets and other assets such as cryptocurrencies or S&P indices.

Career Insights from Trading Experience

• A student asks how Mansour's trading background influenced his work at Kalshi. Mansour responds that firsthand market experience is crucial for understanding customer needs and product adoption.

• He warns against becoming too conditioned by industry norms, which can hinder innovation; maintaining a degree of naivete can be beneficial.

Company Culture Influenced by Trading Background

• Mansour reflects on his time at Citadel, describing its performance-driven culture characterized by meritocracy and minimal management layers.

• He explains how this culture allows young employees significant responsibility based on their performance, contrasting it with more politically driven environments found in tech industries.

Margin Requirements and Cash Collateralization

• In response to a question about margin requirements, Mansour explains that Kalshi operates on a fully cash-collateralized model where participants must provide full upfront payment for their positions.

• He elaborates on marking positions to market daily in real-time and hints at introducing leverage next year while explaining traditional margin practices used by hedge funds.

Introduction to Leverage and Regulation

Understanding Upfront Losses and Future Leverage

• The initial investment is limited to what is put up upfront, ensuring that losses cannot exceed this amount.

• There are plans to introduce leverage gradually, with a focus on regulatory compliance to prevent crises similar to 2008.

Regulatory Requirements for Margin Introduction

• Anticipation of introducing margin trading by the end of next year, contingent on regulatory developments.

• Some products already allow for collateral return based on strong correlations between two products, indicating a move towards more flexible trading options.

Impact of Elections on Trading Volume

Changes in Company Projections Post-Election

• The election period significantly increased trading volume; however, current volumes have surpassed those leading up to the election.

• Customer retention appears strong as new accounts continue engaging with various products beyond just political predictions.

Diverse Market Opportunities

• Increased activity noted in crypto markets and economic products alongside political predictions about government structure and cabinet appointments. Weather-related markets also show high engagement levels.

• While post-election volumes may not match peak days, they remain elevated compared to pre-election levels, marking a successful marketing moment for the company.

Client Demographics and Market Trends

Breakdown of Institutional vs Retail Clients

• Current client volume consists of approximately 30% institutional clients and 70% retail clients, with expectations of moving towards a 50/50 split over time.

• Institutions tend to conduct higher volume trades but at lower charges compared to retail clients who trade less but can be charged more per transaction.

Shifts in Financial Market Dynamics

• Acknowledgment that average individuals now hold significant influence over market valuations (e.g., NVIDIA), reflecting broader participation in financial markets due to increased wealth and engagement from retail investors.

• Companies like Coinbase thrive despite lower overall volumes than traditional exchanges due to their ability to charge higher fees per trade, suggesting a shift in business models favoring retail engagement over institutional dominance.

Future Directions: Prediction Markets and Sports Betting

Exploring New Market Avenues

• Plans are underway to expand into sports betting while maintaining both prediction-based bets and traditional money line bets for customer retention and engagement purposes.

• Regulatory challenges exist but are expected to ease under the upcoming administration which shows favorable attitudes toward financial innovation including prediction markets specifically.

Company Profitability and Revenue Model

Overview of Company Profitability

• Jake Xia inquires about the company's profitability, highlighting the commission-based revenue model that attracts investors.

• Tarek Mansour states that while the company can be profitable, it currently prioritizes growth over immediate profitability, which is a common strategy at this stage.

Challenges and Strategies in Exchange Operations

• Tarek emphasizes the difficulty of establishing an exchange but notes their potential for high profitability once operational with sufficient liquidity.

• The current strategy focuses on aggressive expansion and reinvestment into marketing rather than short-term profits; revenue comes from trading fees similar to traditional exchanges.

Revenue Sources and Market Making

• The company generates income through transaction fees (e.g., $1-$2 per $100 traded) and market-making activities, competing with established firms like Citadel.

• Valuable data generated by the platform is currently offered as open source, with plans to monetize it in the future as demand increases.

Incentives for Market Makers

Requirements for Market Makers

• Tarek explains that there are specific requirements for market makers regarding bid-offer spreads; for example, a $0.01 spread with at least $1 million on each side during elections.

Competitive Landscape

• He discusses how incentives are structured to attract market makers initially, allowing them to profit from trading flows against competitors.

• Unlike stock exchanges that face significant competition due to regulatory frameworks, event-related markets have less competition, positioning Kalshi favorably.

Transitioning from Employment to Entrepreneurship

Journey from Citadel to Kalshi

• A student expresses curiosity about Tarek's transition from working at major financial institutions like Citadel and Goldman Sachs to founding his own exchange.

Decision-Making Process

• Tarek shares his thought process behind leaving a lucrative job: he weighed long-term regret against immediate comfort. His desire to pursue a unique idea drove him despite familial concerns about job security.

Entrepreneurial Insights and Personal Growth

The Importance of Taking Risks

• The speaker emphasizes the necessity of taking risks in entrepreneurship, stating that not trying would lead to regret. They express a passion for creating a market that enhances understanding of future possibilities.

• A quote from Mark Andreessen highlights that while good CEOs attribute their success to strategy and execution, the best ones credit their perseverance: "we didn't give up."

• The speaker reflects on the duality of youth and experience in entrepreneurship, noting that young entrepreneurs often lack knowledge but are more willing to take bold risks.

• Resilience is identified as a crucial trait for entrepreneurs; the ability to fall and get back up is described as a superpower that distinguishes successful individuals.

Learning from Experience

• The speaker shares personal growth lessons learned from their co-founder Luana, emphasizing the value of risk-taking over merely optimizing career paths.

• They advise choosing something meaningful to work on and committing to it, suggesting that conviction can lead to positive outcomes despite challenges.

Navigating Authority and Conviction

• When asked about external validation, the speaker reveals they do not rely on authority figures for guidance, asserting that many influential people also lack certainty in their decisions.

• They stress the importance of internal conviction when pursuing entrepreneurial ventures, acknowledging the inherent risks involved but encouraging belief in one's vision.

Characteristics of Successful Partnerships

• Peter Kempthorne praises Tarek's passion and persistence as key factors attracting significant investments. He highlights the importance of having a supportive partner like Luana in achieving success together.

Final Reflections for Aspiring Entrepreneurs

• Tarek concludes with advice for students at MIT, advocating for taking classes that inspire them rather than focusing solely on traditional academic paths.

Tarek Mansour's Insights on Practical Learning and Career Paths

Emphasizing Practical Experience Over Theory

• Tarek reflects on the importance of balancing study with enjoyment, suggesting that students should explore their interests rather than obsessing over optimal career paths.

• He expresses gratitude for being at MIT and encourages students to reach out for help while keeping his email private.

Memorable Lessons from Class

• Tarek recalls how every mathematical concept learned had a direct application in finance, making the learning experience more tangible compared to other classes focused solely on pure math.

• He shares an anecdote about writing a paper involving complex regression analysis and reinforcement learning aimed at predicting the stock market.

Real-world Applications of Academic Concepts

• Although his model did not work as intended, Tarek found value in applying theoretical concepts like Markov chains during his time at Citadel, which impressed colleagues.

• He mentions Jon Tipermas, a successful portfolio manager from MIT, highlighting the caliber of individuals who apply similar academic knowledge in high-stakes environments.

The Importance of Being Well-Rounded

• Tarek emphasizes that success in finance often comes from being practical and well-rounded rather than just academically brilliant.

• He cites examples of prominent figures in finance who are not necessarily the smartest but possess broader skills and perspectives.

Closing Thoughts on Passion and Persistence

• Tarek concludes by reinforcing that passion, persistence, and energy are crucial for achieving dreams.

• Peter Kempthorne adds to this sentiment by sharing his own journey from academia to entrepreneurship, encouraging students to reflect on their paths.