When Kalshi launched, it introduced a disruptive innovation into the derivatives market. Kalshi gave investors a way to directly hedge against unpredictable real-world events. For example, Kalshi’s weather markets saw heavy traffic during Hurricane Ida. Investors could buy Kalshi’s event contracts on local weather conditions, profit from those contracts, and lessen the financial impact of Hurricane Ida’s destruction. No other financial instrument can offer direct hedging against disasters like that. It’s a critical innovation to the investment industry.
However, that kind of innovation is difficult to pull off in a highly regulated industry like investing. With all the strict rules, creating something unique seems impossible for many would-be startups. The gambling industry faces those same steep barriers to entry. It discourages innovation and ices startups out before they’re funded. Consequently, bettors miss out on better games and products that they never had the chance to try.
Bettors feel the consequences of industry homogeny. Sportsbooks look and work the same. So, a disruptive startup could shake the market dominance that DraftKings and FanDuel take for granted. Startups that want to shake the sports betting industry can learn a lot from Kalshi’s founding strategies. And if major sportsbook brands want to stay on top, they should pay attention to Kalshi’s story, too. We spoke to Xavier Sottile, a Kalshi markets team member, about how Kalshi innovated with its regulators instead of around them.
Kalshi’s Regulatory Challenges
Kalshi faced so many regulatory obstacles that it took three years between founding the company and launching it. “This [founding] involved becoming a DCM, a designated contract market, with the CFTC, our regulator, who regulates derivatives in the United States,” said Sottile.
Becoming a DCM involves many moving parts. Some of the requirements include:
- Enforcing security measures to prevent fraud or market manipulation
- Vetting brokers that the DCM may reach agreements with
- Raise enough money to cover one year of operating costs on top of other business costs
It’s good that these rules are in place. They protect investors and ensure investors understand the risks associated with their investments. Without risk transparency, financial markets crumble. That’s one of the reasons the United States experienced the 2008 mortgage crisis. Rating agencies rated the risk of mortgage-backed securities lower than they really were. So, people who had no business buying them were accepting more risk than they knew. When the bubble burst, many were caught off guard, and the United States spiraled into the Great Recession.
So, these regulations are in place for good reasons. But they make innovation challenging. However, Kalshi had a critical asset that made it accessible to bettors and investors alike: its exchange.
How Kalshi Made Itself User-Friendly
Derivatives markets are not usually easy for amateur investors to understand. Many people don’t even know what derivatives are. But Kalshi makes its derivatives easy to understand. All the event contracts are yes or no questions with shares priced between $0.01 and $0.99. Traders who predict correctly get paid $1. Traders who choose incorrectly get nothing. The yes or no questions have clear conditions and deadlines, so anyone can pick a question and trade.
However, Kalshi’s product isn’t the only thing that’s easy to understand. The exchange itself is intuitive to professionals and rookies alike.
“I think the exchange model is a really intuitive one for people to understand compared to traditional sports gambling where there’s a line and you may not understand what it means,” said Sottile.
This is a common critique that startups inside and outside the sports betting industry have of traditional sportsbooks. Even though welcome bonuses and odds differ among sportsbooks, they all work the same way. They all use the same terminology, layout, and gambling methods.
That makes startups like Sporttrade interesting. Sporttrade is a betting exchange that’s getting its start in New Jersey. On Sporttrade, bettors can trade game lines like stocks. For example, bettors could buy a Cowboys win for $54 and hold onto it until the Cowboys win for a $100 payout. Or, bettors could sell their shares when prices increased to avoid the risk of losing everything. The exchange model is not only easy to understand, but it also allows new strategies that are unavailable at traditional sportsbooks.
Like Kalshi, Sporttrade is easy to understand and requires no education on industry terminology. It’s a lesson sportsbooks must learn to attract newer and younger bettors.
The Tug-Of-War Between Innovation And Regulation
Bringing simplicity and novelty to an old industry requires a level of creativity that’s rare even among entrepreneurs. Adding a social media component to a traditional sportsbook is new, but it requires little creativity or market analysis. Disruptive innovation demands something that makes big companies reconsider how they operate. However, existing regulations force startups to conform to business models that have already worked. So, startups face a tug-of-war between innovation and regulation.
“Kalshi ultimately had to work a lot with our regulators, the CFTC, to try and become something novel,” said Sottile. “[Kalshi is] the first of its kind exchange for event contracts where you can trade on practically anything.”
The gambling industry is short on this type of innovation. Some sportsbooks, like Wagr, have made incremental changes by adding new features to their traditional sportsbooks. But its core product is the same as its competitors, so it won’t make DraftKings wonder whether it should offer something new.
Other gambling products “innovate” around regulations. For example, virtual lottery terminals tweak their products so they don’t qualify as licensed gambling machines. Instead, they can be placed in any public place with no license needed. These products are close to unregulated and lack the basic protections that licensed sportsbooks and casinos create for bettors. Building products around legal loopholes is not innovative.
However, Kalshi took a unique approach. It worked with its regulators instead of around them.
How Kalshi Innovated Alongside Its Regulators
Adding new features and exploiting loopholes are lazy paths to innovation. Instead, Kalshi did the hard work of integrating its vision with existing regulations.
“Uber and Airbnb are great examples of that sort of innovation around the regulation [strategy],” said Sottile. “We didn’t want to take that approach. We didn’t think that it would be successful and didn’t think that it would be good for our firm to go that route. Instead, we took a regulatory first approach. We went to regulators, made a strong case for the utility of [event] contracts, and ultimately they [the CFTC] rewarded us and our patience with designated contact market status.”
It took Kalshi three years to go from its founding to its launch. During that time, it had to create a new financial instrument. It was the equivalent of being the first company to found a stock exchange for stock trading. But finding creative solutions to regulatory concerns paid off for Kalshi. Instead of compromising on its vision, Kalshi was able to bring something new to an industry with onerous regulations and high barriers to entry.
Innovating In The Face Of Impossible Odds
Gambling startups can learn to innovate by understanding how Kalshi did it. Kalshi went back and forth with its regulators to become a DCM, offer event contracts, and conform with industry regulations. New sportsbook companies must endure the same process to be original.
Starting a gambling company is difficult. The licensing fee prices reach six or seven figures, complicating fundraising efforts. Sometimes starting a gambling company is impossible. Casinos and sportsbooks face hard limits on the number of companies allowed to compete in a given market. Few founders can overcome those obstacles.
However, it can be done. Sporttrade managed to develop in Philadelphia and launch in New Jersey. It faced an uphill battle to bring a betting exchange to the market. But it managed to conform to existing regulations while offering a new platform for sports bettors. Long-term, a company like Sporttrade could be more dangerous to DraftKings and FanDuel than the other traditional sportsbooks.
But large sportsbooks can learn from Kalshi too. Industry leaders like DraftKings and FanDuel could acquire a startup like Sporttrade as it gains traction. Major sportsbook companies could also invest in new games, products, and services for bettors. This would increase R&D costs and lead to many dead-end ideas. But the time and money invested in new ideas would grace bettors with new products that would complement existing sportsbooks. It would also protect market leaders from their greatest vulnerabilities: gaps in the marketplace created by all the largest companies offering the same product.