688. When Is a Bet Not a Bet?

The Rise of Prediction Markets

0:00Welcome to the show.

0:30Gambling, in which case it would typically fall under state regulation. And when is it a trade on an event contract, which is regulated by the federal government? These are really great questions, and I really enjoy talking about these questions. That is Tarek Mansour, who co-founded and is CEO of Kalshi, the biggest prediction market in the U.S. As for these thorny questions about prediction markets? I like to think of them as risks rather than downsides. Like AI comes with a bunch of risks, and we know that there's risk of online addiction, a lot of people kind of having mental health issues because of AI, and there's job displacement.

1:04New technologies come with a series of risks. I come with the view that thinking critically about these risks and embracing regulation ahead of time up front actually is an enabler of growth. That, at least, is the path that Kalshi has taken, collaborating with federal regulators to create a new kind of financial platform. And Mansour's ambitions go well beyond betting on sports and politics and culture. He sees Kalshi as a new kind of financial exchange. Today on Freakonomics Radio, we ask Mansour and other proponents of prediction markets to talk us through the risks.

1:40On some topics, I might not recommend making a market. We also hear from a regulator. To some extent, even the stock market itself is a prediction market. And we consider whether this whole enterprise may at some point be shut down. I would not like to see prediction markets banned in the United States. Part two in our series, The Price of Prediction, starts now.

2:10This is Freakonomics Radio, the podcast that explores the hidden side of everything, with your host, Stephen Dubner.

The Promise of Kalshi

2:31Tarek Mansour is the 30-year-old CEO of Kalshi, and on paper, he's already a billionaire. When he talks about the power of prediction markets, he can make it seem as if they've got magical properties. For instance... Kalshi is really the most accurate way to predict the future, which is pretty cool. And... Allocation of capital. That's incredibly important. And even this... It will also depolarize the conversation across the board. Mansour also argues that prediction markets can be a more nutritious alternative to social media.

3:05People on prediction markets, they're reading about politics, and they're reading about the economy, and they're getting engaged, and they're getting smarter, and they have these nuanced, smart takes, taking them away from whatever they're being fed on these social media platforms that is driving them to extremes more and more over time.

3:23So, how well do these claims hold up? That depends on who you speak with.

Wolves and Sheep in Markets

3:29Let's start with another advocate of prediction markets. The George Mason University economist Robin Hanson has been exploring and promoting this type of market for decades. On accuracy, they just consistently win. It's pretty clear that when you have a market on a topic and you compare it to another mechanism at the same time on the same topic, the markets are just as accurate or much more accurate. But Hanson has by now heard all the arguments against prediction markets, like the claim that they are a slightly classier version of gambling.

4:02His point is that if you want to call prediction markets gambling, then you need to think about whether our stock markets are also gambling. Ordinary financial markets really give people pretty much as many gambling opportunities as they might like. I guess you're just going to say, oh, but the sports betting you're allowing here is maybe more fun for them. So, it's the added fun that's actually what you're objecting to, unless the losing of the money. But you might say, I don't want people to have so much fun because they lose money when they have fun. And I might go, okay, fine, you're going to be a killjoy.

4:32Then I might say, look, there's other purposes of markets, which is aggregating information, but we can distinguish roughly which markets add more information versus less. So, a market on some small sporting contest really isn't very likely to add information about very many practical decisions out there. So, I might just want to say, if you're going to cut back on people having fun because you think they're wasting too much money having fun, I'd say, well, just allow the markets on questions that matter.

5:04What comes to the top of your mind? What kind of topics? Well, there's world events. There's foreign policy. There's national policy. There's politics. There's business. There's tech. Look on Calci and Polymarket. You will see the headers of categories, and many of those headers are not as much fun for most people. So, I'm okay with people having fun, especially since I think we just allow people to spend a lot of money having fun in a lot of other ways in our society. Even risky fun. Like, we allow people to take risky careers to be actors or musicians or even journalists.

5:35A lot of those wannabes fail, and we let them take those risks. We let people go skydiving and drive race cars and all kinds of things. Indeed. And they kind of know they're risky when you talk to them, but they still seem to do it. It sounds like you're saying there is an ethical or moral taint to some betting activities. Is that the case? There are definitely people who find them as a distasteful kind of fun. I think the idea that there's greed or money involved is part of their distaste. I mean, somebody who wants to be an actor is in some sense greedy for success, but people don't think of that as greed so much for the money, I guess.

6:12I find there's a distinction, though, between betting on yourself or taking a risk yourself. I want to go skydiving. I want to become an actor, etc., versus betting on the activities of other people, because I'm not actually doing anything. I think it's Scott Galloway who once said that especially the success trajectory of a young American male is directly proportionate to the amount of time they spend sweating versus the time they spend watching other people sweat. Well, again, people who succeed often then become financial market traders and enter the finance industry, so it is a way to try to see if you would be well-suited for that.

6:50Think about a bar bet, basically, a classic bar bet, right? People hanging out at the bar, some controversial topic comes up, somebody makes a drunken claim, and somebody else says, no way, want to bet. Okay? Now, that's not just a waste of time. That's a matter of who's right about this, and that's an assertion of your own confidence and knowledge and commitment to what you know. That's not just about other things besides yourself. That is about you and the other person and who actually knows better.

7:23Robin Hanson, we should remember, is an economist, and most economists believe that these differences in information are what makes any kind of speculative market work by putting a price on that difference. Here's how he explains it. Our standard simple model of financial markets is that they have two kinds of traders. One kind of trader knows something, and they are trading to profit from their information. The other kind of trader is they're trading for any other reason, and it doesn't really matter what it is.

7:57They are a worker who has to deposit so much for retirement, every paycheck, or they're a retiree who needs to withdraw money every paycheck. Either way, they have to make trades, but they don't have information. These are the two kinds of traders in the standard simple model of financial markets. So we call those noise traders. If they are noise traders, what are the first ones? Is you calling them signal traders? I'll call them wolves, and I'll call the other one sheep, to give you a vivid picture here. Okay, perfect.

8:27The wolves have information and want to trade on it, and the sheep don't. Now, the wolves want to trade against sheep, not wolves. If two wolves trade against each other, then they've got information that cancels, and they are not going to profit from that. But if a wolf trades against a sheep, then the wolf on average knows something, the sheep doesn't, and then they will profit on average from their trade. So wherever the sheep accumulate in the world of markets, the wolves go there. Well, that's why Google stock has more accurate prices than some penny stock, because there's a lot more sheep there, so there's a lot more wolves there.

9:02Presidential election markets are more accurate than senatorial election markets, because there's more sheep there, so there's more wolves attracted. There's one last thing to finish the analysis here, is just to say, manipulators are people trying to affect the price without actually having information they are sheep. For the purpose of this model, they don't actually know something, so a wolf is happy to trade against a manipulator. In fact, the more manipulators are expected in the market, the more wolves show up to counter them, and the more accurate the prices get.

9:32Let's say I am an ambitious sheep. I want to do some research, or I want to gain some deeper understanding of the way this market works. How do I tell the difference between a wolf and a manipulator? The whole thing is that when you trade in the market, it's really hard to tell, and usually you just can't tell. So you have to go on the averages. Wolves on average expect some of their trades will be against wolves, but they want to go where there's more sheep, so the odds are better. As a sheep, you would rather trade against other sheep than against a wolf, but hey, you can't help the fact that there are sometimes wolves in the markets, and you have to accept that.

10:08Robin Hansen's wolves versus sheep metaphor will be familiar to every gambler, and especially to every odds maker at every casino ever. But Hansen makes the case that every market has wolves and sheep and maybe even manipulators.

Exchanges Versus Casinos

10:23So how about Kalshi? Tarek Mansour likes to say that prediction markets can help democratize our financial markets by letting outsiders in. So you might think, well, aren't outsiders inevitably sheep, and won't they inevitably lose to the people who are setting the odds? Not necessarily. I asked Mansour to explain the difference between the Kalshi model and the casino model. It's very different. One of them, there's a house that offers lines, and you're betting against the house, and the house is betting against you.

10:55And that's the gambling business model. The house sets odds, and then the house makes money from the users. The losses of the customers are equal to the wins of the house and vice versa. Over time, what the house does is it figures out who are the big losers and makes sure that they come back. And then it figures out who are the winners and makes sure they don't come back. It is very different from a financial market, which some people will lose, some people will win. That is a fair and open marketplace where the platform itself is a neutral arbiter of what's happening there. So you're describing not only the gambling industry historically, but you're also describing, as far as I understand, at least, the current online sports gambling industry as well, correct?

11:30Yeah. You don't want the smart sharps. You don't want the people that are truth-seeking, because those people are taking away from your bottom line. Prediction markets, you want those guys. These are the people that will do a lot of volume. They're making the markets accurate. They're the ones that are doing the research. They're the crux of what we do. So how well do the smart sharps do on prediction markets? The Wall Street Journal recently reported that on Polymarket, Calci's nearest rival, two-thirds of the profits are made by 0.1% of the traders.

12:03What about Calci? Here is Nicole Kagan, who is Calci's head of research and market structure. The ratio is like 1 to 2.9. What's that mean? One person will make money off a trade and 2.9 will not. Empirically, that puts us ahead of basically every other kind of financial derivative transaction. It puts us well ahead of the traditional metric of comparison, which is a sports book. It would be unreasonable to expect every participant in an effectively zero-sum market to be profitable all the time. That would be a really strange thing to assume, and it's not true of any market that has ever existed.

12:34I asked Tarek the same thing, but I'd like to hear you lay out the difference between the Calci business model and, let's say, a casino sports book. We are a peer-to-peer exchange. We are a CFTC-regulated derivatives exchange. The implication there, and in terms of action that we take, is that we don't set pricing. We don't set lines like a sports book does. I want to kind of draw a distinction between this and gambling. That's Mansoor again. There is speculation on Calci. There is speculation in all financial markets. When you look at the percentage of hedging versus speculation in any derivatives markets,

13:06like grain futures or commodity futures or stock options, it tends to be very tilted towards speculation. The reason you want speculation is you want liquidity. Liquidity begets liquidity. You know, it's like the more efficient the market gets, the tighter the spreads, the more consumer surplus there is, the more trading there is. Mansoor explained in last week's episode that Calci makes its money by operating as a neutral platform, for which it takes a fee. Here's Kagan again. They're actually parametrically set. So lower fees at the tails, higher fees in the middle. We simply launch a market, and then the market prices the value of those things.

13:40We don't intervene further from the perspective of the exchange to set any kind of pricing for any event that we have live on our platform. We might provide incentives to get people to trade on certain questions because we might think that they're interesting or that they need liquidity. We might reward people for participating in markets by rebating fees or removing fees from markets. But as a general rule, we'd never set pricing on any of the markets that we have on our platform.

14:05In any market, making an offer versus taking someone else's offer comes with a risk that economists call adverse selection. Imagine you are trading on the 2024 presidential election, and right before Joe Biden's terrible debate performance, you make an offer to buy Biden to win at 50 cents, and nobody takes it. Then the debate happens, Biden tanks, and suddenly someone is happy to sell you Biden to win at 50 cents because the market is now pricing it at 30 cents.

14:37Your offer got filled precisely because it had gone stale. To encourage people to make offers and to juice up liquidity, Kalshi generally charges makers far less than takers, often nothing at all. But the taker fees especially add up. Kalshi says they are generating well north of $350 million in fees per month. So even though they don't function like the house in a casino by setting prices, Kalshi does design the incentives that determine how those prices emerge.

15:09It also chooses which betting contracts to create in the first place. The Wall Street Journal just reported on a high volume of nearly identical trades on Kalshi in what is called a perpetual futures market for the cryptocurrency Ether. These trades could be evidence of what's called wash trading, which is illegal in a regulated futures market. Kalshi denies this. It says what we're seeing is normal trading activity that comes with building up liquidity in a new product. Tariq Mansour says that while Kalshi does incentivize liquidity, he also feels an obligation to design the guardrails.

15:45In terms of creating checks and balances and tools for people to use so that they risk manage appropriately and they don't exhibit excessive behaviors. Look, I believe in personal responsibility. It's not my job to block or ban or I don't even have authority on the law to do that. But to give them a lot of warning signs and stop marketing to them and stop pushing them in a bad direction. Just give them all the signs and keep repeating, hey, you're losing this amount of money. You're showing patterns of unhealthy behaviors. Maybe you should take a beat. Maybe you should stop. And we're adding tools like close circle accounts where people can track each other so that there's pure accountability and a variety of different tools in that direction.

16:19The key piece, in my opinion, and I think a large part to where like the unhealthy behaviors happen is the discriminatory marketing that happens in the traditional model, like in traditional gambling sites, which is like the winner, we stop marketing. But the losers, we keep giving them promos to come back. It's something we have the opportunity to solve at the federal level, which is like, let's just put rules of the road that don't enable marketing differently to different types of users so that you cannot like market differently to people that are most prone to these types of unhealthy behaviors. I also think marketing should reduce across the board. I think we should be able to watch a game without a million ads.

16:52Good luck with that. Yeah, that's moving in the opposite direction. I'm in favor of that. But I guess who doesn't like these types of regulations at the federal level? Tell me. Well, it's not a very difficult guess, right?

17:05Coming up after the break, where do DraftKings and FanDuel stand in the prediction market debate? I'm Stephen Dubner. This is Freakonomics Radio. We will be right back.

State Regulations and Federal Jurisdiction

17:29In January of 2025, Calci began offering bets on sporting events, and the demand has been extraordinary. At one point, nearly 90 percent of their trading volume came from sports. Now they report it's somewhere around 80 percent, but it fluctuates with big events. Even though Calci operates within the rule structure of the CFTC, the federal agency that regulates futures and other derivatives markets, the sports betting has caught the attention of state gambling regulators.

18:00Some states have ordered Calci to stop, and the disputes are landing in federal courts. New York state has sued Calci, seeking at least $36 billion. I went back to Tarek Mansour with some questions about this. So I saw that Minnesota Governor Tim Walz signed the first outright state ban on prediction markets, not just sports contracts, but the whole category with felony liability and so on. And then within a day, the CFTC sued Minnesota to block it. So we've now got a federal government that goes to court to defend essentially your business against the state.

18:36I think that's an unfair way to put it. They're defending their jurisdiction. I mean, what else would you do, right? Like, this is the whole point of federal versus state. Why does the CFTC exist in the first place? They set up a federal agency who operates under the Commodities Exchange Act, who is what we call a preemptive statute. It preempts state law. Because they figure out that there's a number of things that act like financial markets because they have open markets where people are trading at each other, and there's price discovery. That does have speculation. The speculation looks like gambling. The very reason this debate exists is because there are similarities, but things that are trading on a financial exchange are going to be preempted.

19:07They're going to be federally regulated. Now, if states are going to start taking on from that jurisdiction, that's a real problem because that same thing that happened in Minnesota could happen on the NASDAQ. It could happen on futures. It could happen on anything, really. If I trade on an option and I'm putting some money on exchange of more money from something I don't control, I mean, that fits the definition of gambling in like 30 state statutes. If making it felony to trade on the NASDAQ or operate the NASDAQ, it's a real problem because you're now having a patchwork of state-by-state regulation that has shown itself not to work effectively, whether it's on market integrity or customer protection.

19:39But it also prevents having a global liquidity pool on an actively traded financial market. I mean, obviously, you know, an agency whose sole existence is to preempt state law will defend its jurisdiction and vice versa. I've seen that in 2010, when Congress wrote the law that governs your business, Dodd-Frank, they thought about something like Kalshi. And there's a record from the congressional record between Dianne Feinstein and Blanche Lincoln. And Lincoln was anti-prediction 100 percent and now is a lobbyist for Kalshi. What does that represent? Was she anti? I don't know. Anyone who knows Blanche Lincoln would tell you the same thing.

20:10I mean, one of the highest integrity, kindest people, like literally on the planet. At the time, she said the commission should be able to stop contracts that exist predominantly to enable gambling through supposed events contracts. So you could say predominantly, I mean, there's a lot in that sentence, right? And what is the definition of gambling in there? And this is the whole point. It says, like, we're giving the commission the authority based on prevailing circumstances to make that decision.

20:34This phrasing is currently being argued over in courts across the country. And Kalshi, as part of its lobbying efforts, has brought on not only former critics like Blanche Lincoln, but allies like Donald Trump Jr. The venture firm where Don Jr. is a partner has also provided financial support to Polymarket, and he sits on their advisory board. And the Trump administration's CFTC has so far been good to Kalshi. Along with Minnesota, the CFTC has sued several other states and filed on Kalshi's behalf in Ohio.

21:07Here is CFTC Chair Michael Selig from earlier this year announcing the agency's first court intervention on behalf of prediction markets. Over the past year, American prediction markets have been hit with an onslaught of state-led litigation. Today, the CFTC is taking an important step to ensure that these markets have a place here in America and have the integrity and resilience and vibrancy that our derivatives markets deserve.

21:37So that's the position of the current administration's CFTC.

The Legal Status of Swaps

21:41We thought it might be worth speaking with a former CFTC chairman. My name is Gary Gensler. Gensler chaired the Securities and Exchange Commission under Biden and the CFTC under Obama. And now Gensler finds himself on the opposite side of the agency that he used to run. He recently submitted an amicus brief in the federal appeal over Ohio's attempt to regulate Kalshi's sports event contracts. At issue is whether they fall under the CFTC's exclusive federal jurisdiction, which would preempt state gambling law.

22:14I asked Gensler what it's like to be challenging the agency that he used to run. I like to think that filing that friend of the court brief, which was the first time I've ever done it in my life, was actually pro the Commodity Futures Trading Commission because it was to accurately say what we were trying to do in 2009 and 2010 when the Commodity Exchange Act was amended. In front of the court right now is this question.

22:47Is a bet on whether somebody makes a three-point shot in a particular basketball game, is that what has come to be known as a swap under the Commodity Futures Trading Commission? And your answer then was no. No, no. Let me put it in the easiest terms and so forth. Swaps are a form of derivative. They're about hedging risk. It was initially about farmers trying to hedge their price risk of their crop.

23:23Actually invented in Japan in the 1730s for rice farmers. And then the U.S. picked it up in the 1850s for corn and wheat farmers. A hat tip to the Japanese there. And it was, all right, I have to plant my crop, but I don't know the price at harvest time, and I don't know how much I'm going to actually harvest. Fast forward more recently. Let's see if we can hedge other risks for oil and gas and interest rate risk and credit risk and even hurricane risk.

23:56I worked on some of this in the Clinton administration in 1999 and 2000. There was a law that was passed at the end of the Clinton administration that said that these new forms of derivative swaps would not be regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission. It was done in the thought of creating some legal certainty and that these contracts were really amongst and between sophisticated institutions and banks.

24:27Now, looking back, that was not a good thing for the American public. And part of the financial crisis in 2008 were these credit default swaps and interest rate swaps. The financial crisis happens in 2008. Congress comes together and says, we need to reverse something we did in 2000. Congress passed the reform bill called Dodd-Frank. In that, it granted the CFTC and the SEC authority over the swaps market. And in that, there was a definition of swap that'd be a little technical that had six prongs to it.

25:03And one of them had this long list of things called like interest rate swaps and credit default swaps. But there was another piece of it that talked about event contracts associated with economic, financial, or commercial risks. Nowhere, not once did I ever hear somebody say, Kerry, we've got to cover sports betting. Simply put, nobody in 2010, in my presence or my understanding, was talking about moving sports betting authority from the states to the federal government and preempting the states.

25:43Harry Reid, who was then the majority leader of the U.S. Senate, happened to have been from Nevada, happened to have gotten his start in politics as chair of the Nevada Gaming Commission. If somebody would have said to Harry, that's what we're doing, he would have stopped us. And it's because we were not doing that. So do you object to the business model of Kalshi and Polymarket? Look, we already have FanDuel and DraftKings.

26:14These are national platforms that comply with individual state laws. 39 states allow sports betting. 11 do not. It's a state-regulated business, and that's not the issue. I mean, we've had betting on sports since antiquity. And most people would argue that a regulated market is better than an unregulated market, yes? Yeah. And right now, it's regulated at the state level, and it's been a traditional state enforcement and police authority for many decades.

26:45Sports betting, that is. Kalshi would argue, however, and they do argue, that the fundamental difference and the reason that they are, in their view, superior to a DraftKings or a FanDuel or to a casino in Vegas or anywhere else is that in those places, on all those platforms, you're betting against the house who set the odds. Whereas, in Kalshi, you're betting against your fellow bettors, and therefore, it's more of an open market like the stock market.

27:16What's wrong with that argument? Well, that's a product argument. That's not a legal argument. In terms of the law and where they're just completely mistaken, with all respect, is that the law that was passed in 2010 and defined swaps was neither venue-specific nor was a counterparty specific. So, you might say, oh, my counterparty is a dealer. They're the house. By the way, that's called Goldman Sachs.

27:46That's called J.P. Morgan. If you enter into an interest rate swap with J.P. Morgan, J.P. Morgan is the house. If you follow what I'm saying? Yes, I do. And so, they don't have to resell. You can call three places and get three quotes for interest rate swaps or credit default swaps. So, I think they're wrong on the legal argument on venue. And I'll say one other thing. Sports betting is swaps. This is an interesting thing.

28:18I testified in Congress 54 times during the Obama administration. I was in the room where the thing was happening. And we included a provision in those reforms that said that certain folks, big institutions, what was called eligible contract participants, could enter into swaps both on an exchange and off an exchange. And this was a big debate. And there were people like Senator Tom Harkin who chaired the Senate Ag Committee and then moved on to chair this Senate Health Committee.

28:51Tom said nobody should trade these things off exchange. And we had to convince Senator Harkin, no, the big institutions should be able to do interest rate swaps even if they were bilateral. But the compromise was that non-eligible contract participants, you might call it the retail public, but I would note you had to have $10 million of liquid assets to be an eligible contract participant. So a non-eligible contract participant, they can only trade a swap on what was called a designated contract market.

29:29I'll call it an exchange. So that all went into place in October of 2012. If sports bets are swaps, then every sports bet that was entered into since October 2012 was an illegal off-exchange swap and voidable, voidable. And that's presumably not going to happen. And it also gives you a sense of the unlikelihood that that's what really did happen. And I think it's unambiguous, this will end up debated and discussed amongst nine individuals in a small conference room in Washington, D.C., and that's called the Supreme Court.

30:08None of us will be in the room. Under current regulations, Calci's earnings are taxed like ordinary corporate income. Sportsbooks pay that too, but they also pay a tax on gross gaming revenue, around 7% in Nevada, 36% in Pennsylvania, up to 51% in New York. States impose heavy taxes on sports betting, in part to offset the social costs of gambling, and also because it's reliable money.

30:43But prediction markets like Calci don't pay those gambling taxes, which creates a nice lucrative loophole. Critics call this regulatory arbitrage. Here again is Tarek Mansour of Calci. If we're doing a regulatory arbitrage, and that took us six, seven years to get up and running, we did a bad job. A regulatory arbitrage is someone who's taking a shortcut to building a business outside of the rules. We've actually proactively seeked out for four years before launching our product to get regulated by the federal government. Getting a financial exchange and financial clearinghouse license is significantly more stringent than getting regulated by one of the 40 states that have sort of been competing for people's business.

31:21So a change in tax structure would threaten Calci's business model, but there are other, even bigger risks. That's coming up after the break. I'm Stephen Dubner. This is Freakonomics Radio.

31:45Since the vast majority of action on Calci at the moment is sports betting, and since Calci's right to offer sports betting is facing serious legal challenges, the Calci model itself is a somewhat risky proposition.

Insider Trading and Market Integrity

32:00Another risk is insider trading. In the past several months, Calci has suspended several current and former U.S. political candidates for betting on their own races. On the offshore platform of Polymarket, which trades crypto rather than dollars, an American special forces soldier made $400,000 betting on the raid that captured Venezuelan president Nicolas Maduro, a raid that he helped plan and execute. He also tried to open an account on Calci, but Calci blocked him.

32:32The George Mason University economist Robin Hanson, a longtime proponent of prediction markets, has a more nuanced view of insider trading. Speculative markets or betting markets are an information institution, just like journalism. Journalism is supposed to go solicit contributions, summarize them into an aggregate news, and then distribute that news to the world. Journalism has, in fact, often tempted people to reveal information that they had promised to somebody else to keep as a secret.

33:03Many famous news stories are based on that, and we as a society have a trade-off there. On the one hand, we'd like to get more news, and news is valuable. On the other hand, maybe organizations keeping secrets has some value, too. That same trade-off exists in speculative markets. If one of the main values of speculative markets is their prices and price accuracy giving us information, and the institution itself is inviting people and paying them to contribute information, then, of course, it will be the most tempting to people who have the most information.

33:37And that's, according to the logic of the institution, exactly what it and we should want. On the other hand, there might be other issues in societies that we'd trade-off against having more accurate prices in the speculative markets, and I think that's the right way to see this. We shouldn't either make sure all secrets are always kept as some universal law, nor should we require all secrets to be revealed. We should allow this combat or trade-off of organizations trying to keep their secrets and news and other information institutions trying to find things out about the world.

34:11I ran Robin Hanson's argument past Gary Gensler, the former CFTC chair we heard from earlier. Robin's argument and those that make that argument, they are saying the markets will incentivize people to get information out there faster. An insider at Apple or Google will get that information out there because they will profit from it. But what I think is the cost, and a very real serious cost, is trust in the markets. Those that say, let's financialize information and let's say there's no prohibition on insider trading, they fail to take in that that will have a cost to our overall capital markets, and our overall capital markets will have less trust in them.

34:59And then everybody trying to raise money in those capital markets will probably get a slightly lower price-earnings ratio. Literally, the cost of capital will go up. Now, for individuals, it's also like a raw deal. You mean somebody else is going to have an inside scoop as to whether the president's going to bomb Venezuela tomorrow? That just, to me, undermines capital markets. And where does Koushi CEO Tarek Mansour stand on this question?

35:29Do I think insider trading should be banned? I think it should be. It's not even just philosophical. It's very pragmatic. Some of our competitors, they say, we should let it go because it makes markets more efficient, right? Like, it surfaces information faster. But you can make that same argument for a stock market. So why is insider trading banned in the stock market? Well, because it's like, if the game is intrinsically unfair, like if the thing is unfair, who would participate? Maybe give an example in the stock market, because you could imagine that if I'm like representing a pension fund and I know that the officers of the companies that I want to invest in are trading the stock of their company with insider trading.

36:12Well, that's really valuable information to me as a non-insider. So why is that not a good idea in your view? Because people on the other side of those trades over time will realize the game is rigged and they start trading. And somebody's got to lose. It's a marketplace that doesn't have fair rules of the road, right? But if you have access to unique differential information because of your virtue of employment or access to government or having insight, you will have an inherent advantage. Okay, so these are the reasons that you don't want insider trading on Kalshi. And what do you do about it?

36:43Exact same thing as what the NYSE and NASDAQ do about it. So one, you ban it. Number two is you run what you call surveillance. First, you have to KYC anyone that participate on the market. KYC is know your customer, yes? Yes, you have to do customer verification. You have to ID them, basically, who they are, where they live, all that. And same thing as like when you open a Schwab account. Every trader on Kalshi, what do you call them? Yeah, trader, user, they're KYC. PolyMarket's US platform does this too, but its offshore platform from what I understand does not. I don't know what they're doing these days, but historically, they don't KYC.

37:15You can access the offshore platform, which is the vast majority of the product, by just sending Bitcoin somewhere and you start trading. You don't have to say who you are. But I think that's a key pillar of flagging fraudsters because someone commits frauds, you don't even know who they are. How do you catch them? Number two is you run surveillance. So basically, any suspicious patterns that happen on the exchange, they get flagged by our system. Give me a for instance. Something was trading at 10% and all of a sudden there's huge buys. And then the day later, there's a big announcement that moves it to 40%. That's suspicious. What about a small scrutiny sports bet?

37:46Like there will be a double fault on the third point of the fourth game of a tennis match in Macedonia? We don't do these. We don't do micro. I think because they have some heightened risks there, but it doesn't end just there. Generally, not 100% of the time. When people commit fraud, they don't do it for 10 bucks. You're not going to commit a financial crime federally to make $10. The next step of that is it goes to investigations and that could go from fines to criminal prosecution, like the traditional stock market. Now, cash goes a step beyond that, which actually most financial markets don't.

38:18We proactively ban people from trading on things that they can have control over. There's all these lists that will tell you, hey, who's a politically exposed person and to what? There's lists that tell you all the sports, like the athletes and the coaches and people around them for like a team or a league and so on and so forth. These lists, we use them proactively so that when someone signs up and gives us their information, we block them from trading on markets that they basically might have influence over. We do it a little bit conservatively, like we overblock. And if people like tell us, actually, I don't have influence and they prove us otherwise, then we let them trade it.

38:48How much information do you have on your customers? Do you know exactly what they do? You know exactly where they live? Do you have their bank account, et cetera? There's a lot of stuff, name, address, social security. There's all these KYC providers. There's a lot of them. We use a number of them. They can give you essentially the full profile. With a high degree of certainty and do it pretty fast. And sometimes they don't. And then you have to route them into more checking and more verification, right? The tree becomes very complicated. And we've built that over years. But we know a lot about our customers as a TLDR. How important in the CalCity success story to date do you think has been your uber Boy Scout position on insider trading?

39:23Like you spent a lot of dollars and a lot of hours to be seemingly as legitimate and rule abiding as possible. I'm just curious whether you see that as a necessary driver of your success or something that kind of got you in the door. You're definitely the former. If people don't trust the market over time, they're just going to stop trading. Also, if you are a fraudster or an insider today and you want to, you know, commit insider trading, would you go to the place that's regulated, that's reporting all your trades to the government, all your trades are transparent, where you have to ID yourself?

39:56Or would you go to a place where none of these things are true? I just think offshore prediction markets are a much better venue for fraudsters, right? Like, they don't know who you are. You just send Bitcoin somewhere. You get paid out that Bitcoin.

40:13I think legislators are increasingly picking up on the fact that prediction markets are becoming a larger and larger industry. That, again, is Nicole Kagan from CalCity. I'm worried that we might be grouped together in the way that we are seen, when in fact we're two extremely distinct entities. The two distinct entities she's talking about are CalCity and Polymarket. Polymarket's U.S. operation has more stringent rules around its markets, but its offshore crypto-based platform is much looser. The first thing that I would say is we collect all that customer information and they don't collect any of it.

40:46The second thing that I would say is every market that we have live on our platform has an economic justification for existing and has a list of source agencies that we're going to look to to resolve that market. Polymarket in structure is fundamentally quite different. Their markets don't have contractual rules. They have sometimes a paragraph or a few paragraphs increasingly that identify what the rules are for the markets and what the source agencies might look like. But their resolution is done by a third-party cryptocurrency token vote. So there's also this added layer of protection that we have in terms of identifying the credible source agencies that we would want to use to resolve markets and listing markets on things that we think are reasonably important.

41:24There are certain markets that we just would not list because we think that there is no material way for us to understand what the outcome of the underlying event is. So we have a robust set of rules that are accessible on the page for every market that is listed. These are legal contracts that people are signing on to when they're trading those markets. Calci just followed all the rules and applied for legal permission and got it. That, again, is the economist Robin Hanson, who has been watching prediction markets for a long time.

41:54In the aughts, there was a place called the Hollywood Stock Exchange that had made markets on movies, and they were actually really quite accurate and informative. They were play money markets, and they decided to go through all the legal hoops to get real money markets on movies. A few months before they were going to go live, movie executives got wind of this and lobbied Congress to make it illegal. And that was only the second kind of futures markets made illegal. The previous one was Onion Futures in the 50s. So Calci took that risk, too, but they got lucky, and they are legal.

42:28There is a risk of a backlash. We have to admit that here. The prediction markets have risen very fast without much public warning or anticipation, and there's a lot of people who don't like them. And so there's an attempt at a backlash, and they may win. Polymarket was going more the crypto route where they could more defy regulations. I'm sure they claim they're following regulations, but the point is they could more defy them. And if there's a backlash, Calci will suffer more from the backlash because they are more firmly under the thumb of the regulators. Polymarket will survive a backlash more.

Competition and Future Risks

43:00And there might soon be other competition for Calci to worry about. I asked Tarek Mansour about this. I've seen that DraftKings and FanDuel, the big online sports betting firms, now not only operate their own prediction market exchanges, but that they both left the American Gaming Association, which is the trade group for the casino industry, which has opposed prediction market bets. So does that mean that DraftKings and FanDuel are coming after you, especially seeing that more than 80% of your current trades are sports trades? I hope they invest more in prediction markets, and I hope others do as well.

43:32I think competition is good. Moving activity from this unhealthy gambling model that promotes addiction to more of an open marketplace model is a good thing. There's more consumer surplus, and it's better for the consumer long term. I hope more people do it. And I think it's going to grow the marketplace. People always forget that for all of these products, whether it's crypto, prediction markets, even like, you know, general, like traditional markets, like a huge chunk of the market is still offshore. Regulated onshore players gaining territory for places where, you know, the complete wild west is a good thing.

44:03I know that among your allies, you have former Biden White House officials. You have former Obama officials. You have Donald Trump Jr. as an ally. You also have some crypto firms as allies. From the outside, at least, it's a pretty weird, big tent. What are the greatest risks to you, you think, going forward? What are you hoping most to insulate yourself against? Look, there's politics, and, you know, it's just like part of the reality of today's world. The world always, I think. Maybe prediction markets can, like, help depolarize some of that.

44:35Like, climate change, real or not? Maybe let's ask a market. Let's stop having a different answer every four years, you know? It'd be amazing. We have a lot of people, very smart people that are working on that. We have advisors on both sides of the aisle. But my focus as CEO is, I just think about making sure they're building a great product for people. And I think that will end up being the ultimate decider of this whole thing. Because this whole fight, you read about articles about, oh, the prediction markets, people lose money. All these articles. I mean, you know who's stealing these articles? It's the casino industry. And partially Wall Street as well. Because it's a threat. Do you have proof of that?

45:05They're even doing it publicly on Twitter these days. I don't even know if it's a secret. If it's a secret, it's definitely not well-kept. The whole point here is, it's the Uber, it's the Airbnb. The taxis don't go out and say, their message is not usually, hey, we have a monopoly right now. We don't want this because this competition is going to drive our margins down. What do they say? The other guy's evil. Yeah, Uber is unsafe.

45:31Are you familiar with the concept of a pre-mortem? Yes. So, pre-mortem Kalshi for me, you've been forced to think about many potential complicating factors for a bunch of years now in order to build a business. If Kalshi were to die or go down in flames somehow sometime in the next 10 years, why would it be? And how do you protect against it? I think we didn't manage to police some of the insider trading issues. I feel pretty good about that. Number two goes back to having a healthy balance. I think of it as like a highway. You want a highway that is wide enough, well-paved, so innovation can thrive.

46:04So users can come and do research and trade and make their mistakes and learn and grow and do all these different things. But at the end of the highway, you want to have the guardrails. You want to have a barricade so that you cannot really fall off the cliff completely. Getting those guardrails wrong or if society doesn't adopt that fast enough. And I don't think this is just in the context of prediction markets. Kalshi has ambitions beyond prediction markets. What do you think Kalshi will be in five years? Do you want to replace NASDAQ or the New York Stock Exchange? I do want to build a next generation financial market, one that can capture and bring in a much broader set of people and that captures the speed and velocity at which things are moving.

46:40Kevin Hassett wrote about this a few years ago. But this idea that as society gets more and more complicated, the entropy in the system goes up, which means that the pricing of our traditional assets gets worse over time. Today, if you want to have a very good pricing of S&P or home prices or other asset prices, you have to have a very good view on AI. You have to have a very good view on geopolitical risk. You have to have a very good view on healthcare or new COVID or hantavirus outbreaks. All these are independent dimensions that end up impacting our asset prices. There is a theory, which I think is being put in practice, that you have to have infinite markets to capture all these dimensions, to price them effectively.

47:19Having prediction markets on all these different questions will enable us to have a better gauge, lower the entropy in those questions, which inevitably lowers the entropy in our broader understanding of the world. As we've heard today and last week, it is still an open question whether Kalshi and other prediction markets will succeed in the long run. It depends on whether they can be adequately policed and who will be doing the policing. It also depends on whether they can survive the public backlash.

47:51Judging from the comments we received from the first episode in this series, some of you are dead set against the very idea of prediction markets. But what if these markets do thrive? What if the backlash isn't enough to stop them? Here's Robin Hanson again. If there is not a successful backlash, clearly these markets will grow in size. They will get legal precedent. They will develop infrastructure. They will get customers familiar with them. I would say all innovation is a combination of simple, elegant ideas with lots of messy details.

48:23And the elegant ideas don't actually change the world until somebody explores the space of different details to figure out which details can work to make the ideas work. My thanks to Robin Hanson of George Mason University, to Tarek Mansour and Nicole Kagan of Kalshi, and former CFTC and SEC chair Gary Gensler. Let us know what you think about Kalshi and other prediction markets. Our email is radio at Freakonomics dot com. Meanwhile, coming up next time on the show.

48:55There's really not anything anybody can do to magically make beef prices come down. This is a demand story at the end of the day. The most important thing for your listeners to know about the skyrocketing cost of ground beef right now is it encapsulates all this brokenness. Why are beef prices so high? The answer is not as simple as you might think. That's next time on Freakonomics Radio. Also, please check out the TV talk show we're making. It's called Better in Person. You can find it on the Freakonomics YouTube channel, also on Apple Podcasts.

49:28We will be back here in a week with a new episode of Freakonomics Radio. Until then, take care of yourself. And if you can, someone else, too. Freakonomics Radio is produced by Renbud Radio. You can find our entire archive on any podcast app. It's also at Freakonomics dot com, where we publish transcripts and show notes. This episode was produced quite expertly by Tao Jacobs, who was edited by Ellen Frankman and mixed by Jake Loomis with help from Jeremy Johnston. The Freakonomics Radio Network staff also includes Dalvin Abouaji, Eleanor Osborne, Elsa Hernandez, Gabriel Roth, Ilaria Montenacourt, and Pete Madden.

50:04Our theme song is Mr. Fortune by the Hitchhikers, and our composer is Luis Guerra. As always, thanks for listening. Maybe this is a little bit embarrassing. So I went to Harvard for my undergraduate and first graduate degree. That's not that embarrassing. It's okay.

50:26The Freakonomics Radio Network. The hidden side of everything.