688. When Is a Bet Not a Bet?

22:07I 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. I 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?

22:42They 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 financial exchange are going to be preempted. They'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.

23:15It 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, but 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.

23:47I've seen that in 2010, when Congress wrote the law that governs your business, Dodd-Frank, they thought about something like Calci, and there's a record from the congressional record between Dianne Feinstein and Blanche Lincoln, and Lincoln was anti-prediction 100%, and now is a lobbyist for Calci. What does that represent? Was she anti? I don't know. Anyone who knows Blanche Lincoln would tell you the same thing. I 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.

24:19So 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.

24:31This 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 Calci's behalf in Ohio. Here is CFTC Chair Michael Selig from earlier this year announcing the agency's first court intervention on behalf of prediction markets.

25:13Over 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. So that's the position of the current administration's CFTC. We 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.

25:56He 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. I 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.

26:40In front of the court right now is this question. Is 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. I actually invented in Japan in the 1730s for rice farmers. And then the US picked it up in the 1850s for corn and wheat farmers. Hat tip to the Japanese there.

27:34And 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. I 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 derivatives, swaps, would not be regulated by the Securities and Exchange Commission or the Quality Future Trading Commission.

28:14And it was done in the thought of creating some legal certainty and that these contracts were really amongst and between sophisticated institutions and banks. Now, 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. and 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.

29:00One 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. Harry 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.

29:54If 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. These 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.

30:43Sports betting, that is. Calci 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 CalSHE, you're betting against your fellow beddors, and therefore, it's more of an open market like the stock market. What'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.

31:35So you might say, oh, my counterparty is a dealer. They're the house. By the way, that's called Goldman Sachs. That's called J.P. Morgan. If you enter into an interest rate swap with JP Morgan, JP 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. I testified in Congress 54 times during the Obama administration. I was in the room where the thing was happening.

32:22And 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. 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 the Senate Health Committee. Tom 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.

33:16So a non-eligible contract participant, they can only trade a swap on what was called a designated contract market. I'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. 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.

34:05None of us will be in the room.

34:14under 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 seven percent 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. But prediction markets like Kalshi don't pay those gambling taxes, which creates a nice lucrative loophole. Critics call this regulatory arbitrage. Here again is Tarek Mansour of Kalshi. If we're doing a regulatory arbitrage and that took us six, seven years to get up and running, we did a bad job.

34:58Regulatory 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. So a change in tax structure would threaten Kalshi'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.

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38:04Since 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. Another 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.

38:46He also tried to open an account on Calci, but Calci blocked him. The 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. Many famous news stories are based on that.

39:26And we as a society have a trade-off there. On the one hand, we 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. And that's, according to the logic of the institution, exactly what it and we should want.

40:01On the other hand, there might be other issues in societies that we 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 tradeoff of organizations trying to keep their secrets and news and other information institutions trying to find things out about the world. I 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.

40:45An 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. And 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.

41:33You 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 Kousy CEO Tarek Mansour stand on this question? Do 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 ban in the stock market?

42:07Well, 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. well, 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.

42:44It's a marketplace that doesn't have fair rules of the road, right? 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 Calci. and what do you do about it? Exact 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.

43:16You 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 CalSheet, 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. You 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 fraud, you don't even know who they are.

43:46How 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? Like 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.

44:18Generally, not 100 % of the time. When people commit fraud, they don't do it for 10 bucks. You're not gonna 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. We 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.

44:51These 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 tell us, actually, I don't have influence and they prove us otherwise, then we let them trade it. How 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.

45:18There'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 CalShe success story to date do you think has been your Uber Boy Scout position on insider trading? Like, you spent a lot of dollars and a lot of hours to be seemingly as legitimate and rule-abiding as possible.

45:51I'm just curious whether you see that as a necessary driver of your success or something that kind of got you in the door. 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 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, or 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?

46:21Like they don't know who you are. You just send Bitcoin somewhere. You get paid out that Bitcoin.

46:32I 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 Kalshi. 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 Kalshi 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.

47:05The 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.

47:43There 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 onto when they're trading those markets.

48:02Calci just followed all the rules and applied for legal permission and got it. That, again, is the economist Robin Hanson, who's been watching prediction markets for a long time. In 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.

48:38The previous one was Onion Futures in the 50s. So, Couchy took that risk too, but they got lucky and they are legal. There 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 their following regulations, but the point is they could mortify them. And if there's a backlash, CalShe will suffer more from the backlash because they are more firmly under the thumb of the regulators.

49:16Polymarket will survive a backlash more. And there might soon be other competition for CalShe 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.

49:51I 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.

50:22I 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 it's just part of the reality of today's world. The world always, I think. Maybe prediction markets can help depolarize some of that. Climate change, real or not? Maybe let's ask a market. Let's stop having a different answer every four years.

50:59It'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? They're even doing it publicly on Twitter these days.

51:26I don't even know if it's a secret. If it's cigarette, 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.

51:50Are you familiar with the concept of a premortem? Yes. So premortem, 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.

52:23So 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 society doesn't adopt that fast enough. And I don't think this is just in the context of prediction markets. Calci has ambitions beyond prediction markets. What do you think Calci 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.

52:51One that can capture and bring in a much broader set of people and that captures the speed and velocity at which things are moving. Kevin 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.

53:25All these are independent dimensions that end up impacting our asset prices. There's 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. Having 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.

53:51As we've heard today and last week, it is still an open question whether Calci 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. Judging from the comments we received from the first episode in the 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.

54:30They 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. And 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 Calci and other prediction markets. Our email is radio at Freakonomics.com.

55:10Meanwhile, coming up next time on the show. There'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. We will be back here in a week with a new episode of Freakonomics Radio.

55:50Until 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.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, Ellaria Montenacourt, and Pete Madden. Our theme song is Mr. Fortune by the Hitchhikers, and our composer is Luis Guerra.

56:28As always, thanks for listening.

56:34Maybe 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 OK.

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