The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (50 page)
Authors: Scott Patterson
“We consider this dangerous,” said one executive for a company that provided services to high-frequency trading firms. “My concern is that the next LTCM problem will happen in less than five minutes.”
The world of high-frequency trading leapt into the media spotlight in July 2009 when Sergey Aleynikov, a quant who’d just quit a job writing code for Goldman Sachs, stepped off a plane at Newark Liberty Airport after a trip to Chicago. Waiting for him at the airport were FBI agents. Aleynikov was arrested and charged with stealing code from Goldman’s secretive high-frequency trading group, a charge he fought in court.
Adding to the mystery was a connection to a powerful quant Chicago hedge fund: Citadel. Aleynikov had just taken a position at Teza Technologies, which had recently been founded by Misha Malyshev, who’d been in charge of Citadel’s highly lucrative Tactical Trading outfit. Six days after Aleynikov’s arrest, Citadel sued Malyshev and several of his colleagues—also former Citadel employees—alleging that they’d violated noncompete agreements and could also be stealing code, allegations the defendants denied.
The suit spelled out previously unknown details about Citadel’s superfast trading operation. The Tactical Trading offices, which required special codes to enter, came equipped with ranks of cameras and guards to ensure no proprietary information was stolen. The firm had spent hundreds of millions to develop the codes over the years and alleged that Malyshev and his cohorts were threatening the investment.
The suit also revealed that Tactical was a money-making machine, having raked in more than $1 billion in 2008, capitalizing on the market’s volatility, even as Citadel’s hedge funds lost about $8 billion. It raised questions about Griffin’s decision in late 2007 to spin off Tactical from the hedge fund operations, a move that effectively increased his stake in a unit that printed money at a time his investors were getting clobbered. Principals at Citadel, mostly Griffin, owned about 60 percent of the $2 billion fund, according to people familiar with its finances.
All of the controversy alarmed regulators and everyday investors, who’d been largely unaware of the lightning-fast trading that had become a central component of the Money Grid, strategies first devised in the 1980s by innovators such as Gerry Bamberger and Jim Simons and furthered in the following decade by the likes of David Shaw and Peter Muller. But there were legitimate concerns that as computer-driven trading reached unfathomable speeds, danger lurked.
Many of these computer-driven funds were gravitating to a new breed of stock exchange called “dark pools”—secretive, computerized trading networks that match buy and sell orders for blocks of stocks in the frictionless ether of cyberspace. Normally, stocks are traded on public exchanges such as the Nasdaq and the NYSE in open view of anyone who chooses to look. Trades conducted through dark pools, as the name implies, are anonymous and hidden from view. The pools go by names such as SIGMA X, Liquidnet, POSIT, CrossFinder, and NYFIX Millennium HPX. In these invisible electronic pools, vast sums change hands beyond the eyes of regulators. While efforts were afoot to push the murky world of derivatives trading into the light of day, stock trading was sliding rapidly into the shadows.
Increasingly, hedge funds had been crafting new systems to game the pools, hunting for price discrepancies between them in the eternal search for arbitrage or even
causing
price changes with dubious tactics and predatory algorithms. Hedge funds were “pinging” the dark pools with electronic signals like submarines hunting prey, searching for liquidity. The behavior was largely invisible, and light-years ahead of regulators.
Dark pools were also opening up to superfast high-frequency trading machines. The NYFIX Millennium pool had narrowed its response time to client orders to three milliseconds. A flier Millennium sent to potential clients claimed that traders with “ninja skills succeed” in dark pools at “dangerously high speeds for the unprepared.”
Mom and Pop’s retirement dreams, meet Ninja Hedge Fund.
Whether such developments posed a broader risk to the financial system was unknown. Users of the technology said faster trades boosted “liquidity,” making trading easier and cheaper. But as the financial
panic of 2007 and 2008 had shown, liquidity is always there when you don’t need it—and never there when you do.
Meanwhile, congressmen, President Obama, and regulators were making noise about reining in the system with new rules and regulations. Progress had been made in setting up a clearinghouse for credit default swaps to keep better track of the slippery contracts. But behind the scenes, the financial engineers were hard at work devising new methods to operate in the shadows.
Just look: exotic leveraged vehicles marketed to the masses worldwide, hedge funds gaming their returns, lightning-fast computerized trading robots, predatory ninja algorithms hunting liquidity in dark pools …
Here come the quants.
1
ALL INSimons had pocketed $1.5 billion:
Alpha
, May 2006.
That night at the St. Regis:
Several details of the poker event were gleaned from
MFA News
2, 1 (Spring 2006).
In 1990, hedge funds held $39 billion:
Based on data from Hedge Fund Research, a Chicago research group.
THE GODFATHER: ED THORPJust past 5:00
A.M
.
: I conducted numerous interviews with Ed Thorp and exchanged many emails. Many details about Ed Thorp’s blackjack career, including a description of his foray into blackjack in 1961, were found in his colorful book
Beat the Dealer: A Winning Strategy for the Game of Twenty-One
(Vintage, 1962).
Other details were found in the excellent
Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street
, by William Poundstone (Hill and Wang, 2005). I confirmed details I used from this book with Thorp.
The strategy was from a ten-page article:
“Getting a Hand: They Wrote the First Blackjack Book but Never Cashed In,” by Joseph P. Kahn,
Boston Globe
, February 20, 2008.
He’d kept his roulette strategy largely secret:
“The Invention of the First Wearable Computer,” by Edward O. Thorp (
http://graphics.cs.columbia.edu/courses/mobwear/resources/thorp-iswc98.pdf
.)
Science-fiction writer Arthur C. Clarke:
Voice Across the Sea
, by Arthur C. Clarke (HarperCollins, 1975).
BEAT THE MARKETOn a typical day of desert sun:
Much like the blackjack chapter, many details of this chapter derive from interviews with Thorp,
Fortune’s Formula
, and Thorp’s second book,
Beat the Market: A Scientific Stock Market System
. That book is out of print, but Thorp kindly provided a Web-accessible version.
Huge, sudden leaps:
For more than a decade, Nassim Taleb has been criticizing quant models for leaving out huge market events, or black swans, and he deserves much credit for warning about such shortcomings of the models. I had numerous conversations with Taleb while writing this book.
Gerry Bamberger discovered stat arb:
The section on the discovery of statistical arbitrage is based almost entirely on interviews with Gerry Bamberger, Nunzio Tartaglia, and several other members of the original Morgan Stanley group that discovered and spread stat arb across Wall Street. Previous mention of this group can be found in
Demon of Our Own Design
, by Richard Bookstaber (John Wiley & Sons, 2007).
Morgan had hired Shaw:
The account of Shaw’s departure from Morgan are based on interviews with Nunzio Tartaglia and others who were at APT.
THE VOLATILITY SMILESometime around midnight:
Many details of Black Monday were found in numerous
Wall Street Journal
articles written during the time, including “The Crash of ’87—Before the Fall: Speculative Fever Ran High in the 10 Months Prior to Black Monday,” by James B. Stewart and Daniel Hertzberg, December 11, 1987.
Other details, including the description at the opening of the chapter, were found in
An Engine, Not a Camera: How Financial Models Shape Markets
, by Donald MacKenzie (MIT Press, 2006), and
The Age of Turbulence: Adventures in a New World
, by Alan Greenspan (Penguin 2007), 105.
On the evening of September 11, 1976:
The best description of the invention of portfolio insurance that I know of can be found in
Capital Ideas: The Improbable Origins of Modern Wall Street
, by Peter L. Bernstein (John Wiley & Sons, 2005). Another source is “The Evolution of Portfolio Insurance,” by Hayne E. Leland and Mark Rubinstein, published in
Portfolio Insurance: A Guide to Dynamic Hedging
, edited by Donald Luskin (John Wiley & Sons, 1988).
“Even if one were to have lived”:
The age of the universe is 13.5 billion years, not 20 billion.
When German tanks rumbled into France:
Some details of Mandelbrot’s life come from a series of interviews with Mandelbrot in the summer of 2008. Many also come from the book
The (Mis)Behavior of Markets: A Fractal View of Financial Turbulence
, by Benoit Mandelbrot and Richard L. Hudson (Basic Books, 2006).
“I realized that the existence of the smile”:
My Life as a Quant
, by Emanuel Derman (John Wiley & Sons, 2004), 226.
A squad of fifty armed federal marshals:
Certain details come from
Den of Thieves
, by James Stewart (Simon & Schuster, 1991).
He also worked as a consultant:
I learned the fascinating story of Thorp’s discovery of the Madoff fraud in several interviews with Thorp in December 2008 as the fraud was discovered. I confirmed his story with the firm involved and through several pertinent documents.
FOUR OF A KINDIn 1990, Ed Thorp took a call:
The details of Thorp’s connection to Citadel was told to me by Thorp, Frank Meyer, Justin Adams, and Ken Griffin.
Griffin set up shop:
I learned a number of details about Griffin’s and Citadel’s history during a single interview with Griffin and numerous interviews with people who worked for him. Other details were found in the following articles: “Citadel’s Griffin: Hedge Fund Superstar,” by Marcia Vickers,
Fortune
, April 3, 2007; “Citadel Returns 26 Percent, Breaks Hedge Fund Mold, Sees IPO,” by Katherine Burton, Bloomberg News Service, April 29, 2005; “Will a Hedge Fund Become the Next Goldman Sachs?” by Jenny Anderson,
New York Times
, April 4, 2007.
When he was ten years old:
I learned a number of details about Peter Muller’s life in a series of interviews with people who knew him. Other details, such as the trip to Europe, were taken from an essay he wrote in the book
How I Became a Quant
, edited by Richard R. Lindsey and Barry Schachter (John Wiley & Sons, 2007).
The muscular professor strode:
I’ve never attended a Fama course, but I did speak with a number of people who took his courses, including Cliff Asness, and I conducted several interviews with Fama. This is a depiction of what his course may have been like and what he may have said based on those interviews.
As a child, Clifford Scott Asness:
I learned a number of details about Asness’s life in a series of interviews with Asness and people who knew him. Other details about Asness’s early life were taken from an essay he wrote in the book
How I Became a Quant
.
I conducted numerous interviews with current and former employees of AQR. Other sources include “Beta Blocker: Profile of AQR Capital Management,” by Hal Lux,
Institutional Investor
, May 1, 2001, and, “The Quantitative, Data-Based, Risk-Massaging Road to Riches,” by Joseph Nocera,
New York Times Magazine
, June 5, 2005.
Born near the end of the Great Depression:
Fama interview.
Kendall found no such patterns:
Quoted from
An Engine, Not a Camera: How Financial Models Shape Markets
, 63.
Fama and French cranked up:
The paper was called “The Cross Section of Expected Stock Returns,” published in the June 1992 edition of
Journal of Finance
.
One day in the early 1980s:
Nearly all of the details of Boaz Weinstein’s life and career come from interviews with Weinstein and people who knew and worked with him.
In 1994, John Meriwether:
A number of details of LTCM’s demise were taken from
When Genius Failed: The Rise and Fall of Long-Term Capital Management
, by Roger Lowenstein (Random House, 2000), and
Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It
, by Nicholas Dunbar (John Wiley & Sons, 2000).
THE WOLF