Case Study 1: Kalshi's Path to CFTC Approval

Overview

Kalshi's journey from a startup idea to the first federally regulated prediction market exchange in the United States is one of the most consequential stories in modern financial regulation. This case study traces that regulatory journey in detail, analyzes the DCM application process, examines the landmark election contracts litigation, and draws lessons for future platforms seeking regulatory approval.

Background

The Founders' Vision

Kalshi was founded in 2018 by Tarek Mansour and Luana Lopes Lara, both former MIT students. Their central thesis was that prediction markets could become a mainstream financial tool if they operated within the existing regulatory framework rather than outside it. This was a deliberate strategic choice — previous prediction markets had either operated offshore (Intrade, Polymarket) or under precarious no-action relief (PredictIt).

The founders recognized that the CFTC's event contract authority under Dodd-Frank provided a legal pathway for regulated prediction markets, but no platform had successfully navigated that pathway. The existing DCMs (CME, CBOE, Nadex) focused on traditional derivatives; none had seriously pursued event contracts as a primary product.

The Market Opportunity

Kalshi's founders identified several factors that made the timing propitious:

1. Growing demand: The 2016 election cycle had generated enormous interest in prediction markets, with PredictIt seeing record volumes despite its small position limits.
2. Regulatory maturity: The CFTC had been thinking about event contracts since Dodd-Frank's passage in 2010 and had nearly a decade of experience with the concept.
3. Technology readiness: Modern exchange technology and cloud infrastructure made it feasible for a startup to build an exchange with institutional-grade reliability.
4. Investor interest: Venture capital firms were increasingly interested in fintech and alternative trading platforms.

The DCM Application Process

Phase 1: Preparation (2018-2019)

Before submitting its DCM application, Kalshi spent over a year preparing:

Legal Foundation. Kalshi retained experienced financial regulatory counsel to guide the application process. The legal team included former CFTC officials who understood the agency's internal decision-making processes.

Technology Build. Kalshi built its exchange technology platform to meet CFTC system safeguards requirements from the outset. This included: - Matching engine with millisecond latency - Real-time risk management systems - Market surveillance capabilities - Cybersecurity infrastructure meeting NIST standards - Business continuity and disaster recovery plans

Compliance Infrastructure. Kalshi developed comprehensive compliance programs: - KYC/AML procedures meeting Bank Secrecy Act requirements - Sanctions screening against OFAC SDN and other watch lists - Transaction monitoring for suspicious activity - Customer complaint handling and dispute resolution

Capital Raising. Kalshi raised initial venture capital to fund the application process and build-out. The company ultimately raised over $100 million across multiple rounds, with investors including Sequoia Capital, Charles Schwab, and Henry Kravis.

Phase 2: Application Filing (2019-2020)

The DCM application itself is a massive document — typically hundreds of pages — demonstrating compliance with each of the DCM Core Principles established by the CFTC:

Phase 3: CFTC Review (2020)

The CFTC's Division of Market Oversight conducted a thorough review of Kalshi's application:

Staff Review. CFTC staff examined every aspect of the application, requesting supplemental information and clarification on numerous points. This iterative process took several months.

Commissioner Engagement. Individual CFTC commissioners and their staffs reviewed the application and raised questions about the novel event contract model.

Public Comment. While DCM applications do not always receive formal public comment periods, the novel nature of Kalshi's application attracted attention from industry participants, academics, and advocacy groups.

Phase 4: Approval (November 2020)

In November 2020, the CFTC approved Kalshi's application for DCM registration. The approval was notable for several reasons:

1. First event-contract-focused DCM: Kalshi was the first DCM whose primary purpose was offering event contracts rather than traditional commodity or financial futures.
2. Unanimous commission vote: The approval received support from all sitting commissioners, signaling broad agreement that event contracts fit within the CFTC's regulatory framework.
3. Conditions: The approval included standard conditions applicable to all DCMs, plus specific conditions related to event contract settlement and monitoring.

Launch and Early Operations (2021-2022)

Initial Contract Offerings

Kalshi began trading in June 2021 with a carefully curated set of event contracts:

• Economic events: Federal Reserve interest rate decisions, GDP growth, inflation readings
• Climate events: Hurricane landfalls, temperature records
• Public health events: COVID-19 case thresholds
• Regulatory events: Government policy decisions

These initial offerings were strategically chosen to be clearly within the scope of permissible event contracts — economic indicators with obvious hedging value and minimal political sensitivity.

Market Development

Kalshi faced the classic chicken-and-egg problem of a new exchange: traders want liquidity, but liquidity requires traders. The platform addressed this through:

• Market maker partnerships: Engaging professional market makers to provide continuous quotes
• Retail marketing: Targeting retail traders through social media and content marketing
• Institutional outreach: Engaging hedge funds, proprietary trading firms, and research institutions
• Media partnerships: Providing prediction market data to news organizations

The Election Contracts Controversy (2023-2024)

The Filing

In 2023, Kalshi submitted a proposed contract to the CFTC for listing binary options on the outcome of US congressional elections. This was the most politically significant event contract ever proposed by a registered DCM.

Kalshi's filing argued that: - Election contracts serve legitimate hedging purposes (political risk management) - They provide valuable price discovery (forecasting election outcomes) - They are analogous to other permissible event contracts (economic indicators, policy decisions) - The CFTC had no statutory basis to categorically exclude election contracts

The CFTC's Rejection

The CFTC rejected Kalshi's proposed election contracts, issuing an order determining that the contracts involved "gaming" and were contrary to the public interest. The agency's reasoning included:

1. Gaming classification: The CFTC argued that wagering on election outcomes is a form of gambling that falls within the statutory "gaming" exclusion.
2. Election integrity concerns: The agency expressed concern that election contracts could create incentives for vote buying or other election interference.
3. Public perception: The CFTC worried that allowing trading on elections would undermine public confidence in the democratic process.
4. Regulatory precedent: Approving election contracts could open the door to contracts on other politically sensitive events.

The Litigation

Kalshi challenged the CFTC's determination in the US District Court for the District of Columbia. The case — KalshiEx LLC v. CFTC — became one of the most closely watched financial regulatory cases in years.

Kalshi's Arguments: - The CFTC exceeded its statutory authority by treating all election contracts as categorically impermissible - Election contracts do not constitute "gaming" under any reasonable interpretation of the statute - The CFTC's public interest analysis was arbitrary and capricious - The decision was politically motivated rather than based on sound regulatory analysis

CFTC's Defense: - The agency has broad discretion under the "contrary to the public interest" catch-all provision - Election contracts share fundamental characteristics with gambling - The agency's determination deserved deference under administrative law principles - Approving election contracts would create unacceptable risks to election integrity

The Court's Decision (September 2024): The court ruled in Kalshi's favor, finding that: - Election contracts do not fall within the statutory "gaming" exclusion - The CFTC had not provided adequate justification for its categorical rejection - The informational value of prediction markets weighed in favor of permitting election contracts - The agency's concerns about election integrity were speculative and not supported by evidence

The CFTC initially sought a stay pending appeal but was denied. Kalshi began listing election contracts ahead of the 2024 presidential election.

Impact

The immediate impact of the ruling was dramatic: - Kalshi listed contracts on the 2024 presidential election and key congressional races - Trading volumes surged, with election contracts becoming some of Kalshi's most popular products - Media coverage of prediction market prices reached unprecedented levels - Other DCMs began considering their own event contract offerings

Lessons for Future Platforms

Lesson 1: Regulatory Strategy Is Product Strategy

Kalshi's decision to pursue DCM registration was not just a compliance choice — it was a product strategy. By operating within the regulatory framework, Kalshi could: - Serve US customers legally (unlike offshore platforms) - Accept larger positions (unlike PredictIt's $850 limit) - Access banking services (unlike unregulated platforms) - Build institutional credibility - Create a defensible competitive moat

Lesson 2: Invest in Compliance Infrastructure Early

Kalshi built institutional-grade compliance systems before submitting its DCM application. This upfront investment paid off in two ways: it shortened the approval process (by addressing CFTC concerns proactively) and it created operational capabilities that are difficult for competitors to replicate.

Lesson 3: Choose Your Battles Carefully

Kalshi's initial contract offerings were carefully chosen to avoid controversy. The platform launched with economic and weather contracts — categories where the hedging rationale was clear. Only after establishing a track record did Kalshi pursue the more controversial election contracts.

Lesson 4: Be Prepared to Litigate

The election contracts case demonstrated that regulatory approval is not always achievable through the administrative process alone. Kalshi was prepared to challenge the CFTC in court — a costly and uncertain strategy, but one that ultimately proved successful.

Lesson 5: Timing Matters

Kalshi's success was partly a function of timing. The platform applied for DCM registration during a period when: - The CFTC was led by commissioners open to innovation - Public interest in prediction markets was growing - The legal landscape (particularly the decline of Chevron deference) was shifting in favor of challengers to agency determinations - Technology had matured to support institutional-grade exchange operations

Lesson 6: Regulatory Approval Is Not the End

Even after obtaining DCM registration and winning the election contracts case, Kalshi faces ongoing regulatory challenges: - Continued CFTC oversight and examination - Potential legislative changes that could affect event contract authority - State-level regulatory challenges - Competition from both regulated and unregulated platforms - The need to continuously update compliance programs as regulations evolve

Analysis Questions

1. Strategic alternatives: Could Kalshi have achieved its goals through a different regulatory pathway (e.g., seeking a no-action letter, operating offshore, or registering as a SEF instead of a DCM)? What would the trade-offs have been?

2. Competitive dynamics: How does Kalshi's DCM registration affect competition in the prediction market industry? Does regulatory approval create an unfair advantage or a level playing field?

3. International implications: How does Kalshi's US regulatory approval affect the global prediction market landscape? Does it encourage or discourage regulatory harmonization?

4. Contract design: How do CFTC requirements affect the design of prediction market contracts? Are there types of contracts that Kalshi cannot offer because of regulatory constraints that an unregulated platform could?

5. Future expansion: What new categories of event contracts should Kalshi pursue next? How should it evaluate the regulatory risk of each new category?

Computational Exercise

See code/case-study-code.py for a Python simulation that models the DCM application process as a multi-stage decision tree, calculating the expected value of pursuing DCM registration versus alternative regulatory strategies under different assumptions about approval probability, litigation outcomes, and market size.