And each was becoming part of and helping to create a massive electronic network, a digitized, computerized money-trading machine that could shift billions around the globe in the blink of an eye, at the click of a mouse.
This machine has no name. But it is one of the most revolutionary technological developments of modern times. It is vast, its octopuslike tentacles reaching to the farthest corners of civilization, yet it is also practically invisible. Call it the Money Grid.
Innovators such as Ed Thorp, Fischer Black, Robert Merton, Barr Rosenberg, and many others had been early architects of the Money Grid, designing computerized trading strategies that could make money in markets around the world, from Baghdad to Bombay, Shanghai to Singapore. Michael Bloomberg, a former stock trader at Salomon Brothers and eventual mayor of New York City, designed a machine that would allow users to get data on virtually any security in the world in seconds, turning its creator into a billionaire. The Nasdaq Stock Market, which provided entirely electronic transactions, as opposed to the lumbering humans at the New York Stock Exchange, made it quicker and cheaper to buy and sell stocks around the globe. The entire global financial system became synced into a push-button electronic matrix of unfathomable complexity. Money turned digital.
Few were as well placed to take advantage of the Money Grid as the Floridian boy wonder Ken Griffin.
GRIFFIN
Griffin’s fortress for money, Citadel Investment Group, started trading on November 1, 1990, with $4.6 million in capital. The fund, like Princeton/Newport Partners, specialized in using mathematical models to discover deals in the opaque market for convertible bonds.
In its first year, Citadel earned a whopping 43 percent. It raked in 41 percent in its second, and 24 percent in its third.
One of Citadel’s early trades that caught the Street’s eye concerned an electronic home security provider called ADT Security Services. The company had issued a convertible bond that contained a stipulation that if a holder converted the bond into stock, he wouldn’t be eligible for the next dividend payment. That meant that the bond traded at a slight discount to its conversion value, because the holder wouldn’t receive the next dividend.
Griffin and his small band of researchers figured out that in the United Kingdom, the dividend was technically not a dividend but a “scrip issue”—which meant that a buyer of the bond in the United Kingdom would be paid the dividend. In other words, the bond was cheaper than it should be.
Citadel bought as many of these bonds as it could buy. It was a trade that a number of the large dealers had missed, and it was a trade that put Citadel on the map as a shop that was on top of its game.
By then Griffin, still a boy-faced whiz kid in his mid-twenties, was juggling nearly $200 million with sixty people working for him in a three-thousand-square-foot office in Chicago’s Loop district.
Then he lost money. A great deal of money. In 1994, Alan Greenspan and the Federal Reserve shocked the market with a surprise interest rate increase. The bottom fell out of the rate-sensitive convertible bond market. Citadel dropped 4.3 percent, and assets under management fell to $120 million (part of the decline came from worried investors pulling money out of the fund). Until 2008, it was the only year Citadel’s flagship Kensington fund lost money.
Used to unstinting success, Griffin was stunned, and hell-bent on making sure his financial battlements couldn’t be breached in the future.
“We’re not going to let this happen again,” he told his patron, Frank Meyer. Citadel began crafting plans to fortify its structure, instituting changes that may have saved it from a complete collapse fourteen years later. When investors had seen the bond market crumbling, they had called up Griffin in a panic and demanded a refund. Griffin knew that the market was eventually going to bounce back, but there was little he could do. The solution: lock up investors for years at a time. He slowly began negotiating the new terms with his partners, eventually getting them to agree to keep their investment in Citadel for at least two years (and at the end of each two-year period agreeing to another two-year lockup). A long lockup meant that when times got tough, Griffin could remain calm, knowing that fidgety, fleet-footed investors couldn’t cut and run at a moment’s notice. By July 1998, the new model was in place—and just in time.
Later that year, Long-Term Capital crashed. As other hedge funds sold indiscriminately in a broad, brutal deleveraging, Citadel snapped up bargains. Its Kensington fund gained 31 percent that year. By then, Citadel had more than $1 billion under management. The fund was diving into nearly every trading strategy known to man. In the early 1990s, it had thrived on convertible bonds and a boom in Japanese warrants. In 1994, it launched a “merger arbitrage” group that made bets on the shares of companies in merger deals. The same year, encouraged by Ed Thorp’s success at Ridgeline Partners, the statistical arbitrage fund he’d started up after shutting down Princeton/Newport, it launched its own stat arb fund. Citadel started dabbling in mortgage-backed securities in 1999, and plunged into the reinsurance business a few years later. Griffin created an internal market–making operation for stocks that would let it enter trades that flew below Wall Street’s radar, always a bonus to the secrecy-obsessed fund manager.
As Griffin’s bank account expanded to eye-watering proportions, he began to enjoy the perks of great wealth. Following a well-trodden path among the rich, he indulged his interest in owning great works of art. In 1999, he snapped up Paul Cézanne’s Curtain Jug and Fruit Bowl for $60.5 million. Later that year, he became enamored of an Edgar Degas sculpture called Little Dancer, Aged 14, that he chanced upon in Sotheby’s auction house in New York. He later bought a version of the sculpture, as well as a Degas pastel called Green Dancer. Meanwhile, in 2000, he shelled out $6.9 million for a two-story penthouse in a ritzy art deco building on North Michigan Avenue in Chicago, an opulent stretch of properties known as the Magnificent Mile.
Citadel’s returns had become the envy of the hedge fund world, nearly matching the gains put up by Renaissance. It posted a gain of 25 percent in 1998, 40 percent in 1999, 46 percent in 2000, and 19 percent in 2001, when the dot-com bubble burst, proving it could earn money in good markets and bad. Ken Griffin, clearly, had alpha.
By then, Griffin’s fund was sitting on top of a cool $6 billion, ranking it among the six largest hedge funds in the world. Among his top lieutenants were Alec Litowitz, who ran the firm’s merger arbitrage desk, and David Bunning, head of global credit. In a few years, both Litowitz and Bunning would leave the fund. In 2005, Litowitz launched a $2 billion hedge fund called Magnetar Capital that would play a starring role in the global credit crisis several years later. A magnetar is a neutron star with a strong magnetic field, and Litowitz’s hedge fund turned out to have a strong attraction for a fast-growing crop of subprime mortgages.
Citadel, meanwhile, was quickly becoming one of the most powerful money machines on earth, fast-moving, extremely confident, and muscle-bound with money. It had turned into a hedge fund factory, training new managers such as Litowitz who would break off and grow new funds. Ed Thorp’s progeny were spreading like weeds. And Griffin, just thirty-three years old, was still the most successful of them all.
The collapse of Enron in 2001 gave him a chance to flex his muscles. In December 2001, a day after the corrupt energy-trading firm declared bankruptcy, Griffin hopped on a plane to start recruiting energy traders from around the country. Back in Chicago, a team of quants started building commodity-pricing models to ramp up the fund’s trading operation. The fund also signed up a number of meteorologists to help keep track of supply-and-demand issues that could impact energy prices. Soon Citadel sported one of the largest energy-trading operations in the industry.
As his fund grew, Griffin’s personal wealth soared into the stratosphere. He was the youngest self-made member of the Forbes 400 in 2002. The following year, he was number ten on Fortune’s list of the richest people in America under forty years old, with an estimated net worth of $725 millio
n, a hair behind Dan Snyder, owner of the Washington Redskins.
He’d reached a level of success few mortals can contemplate. To celebrate that year, he got married—at the Palace of Versailles, playground of Louis XIV, the Sun King. Griffin exchanged vows with Anne Dias, who also managed a hedge fund (though a much, much smaller one). The reception for the two-day affair was held in the Hameau de la Reine, or “Hamlet of the Queen,” where Marie Antoinette lived out Jean-Jacques Rousseau’s back-to-nature peasant idyll in an eighteenth-century faux village.
The Canadian acrobat squad Cirque du Soleil performed. Disco diva Donna Summer sang. Guests dangled from helium balloons. The party in Paris included festivities at the Louvre and a rehearsal dinner at the Musée d’Orsay.
It was good to be Ken Griffin. Perhaps too good.
MULLER
Just as Griffin was starting up Citadel in Chicago, Peter Muller was hard at work at Morgan Stanley in New York trying to put together his own quantitative trading outfit using the models he’d devised at BARRA. In 1991, he pulled the trigger, flipping on the computers.
It was a nightmare. Nothing worked. The sophisticated trading models he’d developed at BARRA were brilliant in theory. But when Muller actually traded with them, he ran into all sorts of problems. The execution wasn’t fast enough. Trading costs were lethal. Small bugs in a program could screw up an order.
He’d set up shop on the thirty-third floor of Morgan’s headquarters inside the Exxon Building at 1251 Avenue of the Americas, the same skyscraper that had housed Bamberger and Tartaglia’s stat-arb experiment, with several Unix workstations, high-end computers designed for technical applications and complex graphics. His first hire was Kim Elsesser, a programmer with a master’s degree in operations research from MIT. Elsesser was thin, tall, blond, and blue-eyed: a perfect target for the testosterone-soaked Morgan traders. She was also a highly gifted mathematician and computer programmer. She’d first joined Morgan in January 1987 before leaving for grad school in Cambridge, then returned to the bank in 1992. Within a few months, she signed up with Muller. He dubbed his new trading outfit Process Driven Trading, PDT for short. “Process-driven” was essentially shorthand for the use of complex mathematical algorithms that only a few thousand people in the world understood at the time.
Muller and Elsesser built the operation from scratch. They wrote trading models in computer code and hooked up their Unix workstations to Morgan’s mainframe infrastructure, which was plugged into major exchanges around the world. Muller designed the models, and Elsesser, familiar with Morgan’s system, did most of the programming. They started trading in the United States, then added Japan, followed by London and Paris. They would trade once a day, based on their models. They worked crazy hours, but it all seemed for naught.
Muller was able to glean tidbits of information from other fledgling groups of mathematicians who were trying to crack the market’s code. In 1993, he paid a visit to a little-known group of physicists and scientists running a cutting-edge computerized trading outfit from a small building in Santa Fe, New Mexico. They called themselves Prediction Company, and they were reaching out to Wall Street firms, including Morgan Stanley, for seed capital. Muller’s job was to check them out.
A founder of Prediction Company was Doyne Farmer, a tall, ropy physicist and early innovator in an obscure science called chaos theory. Given more to tie-dyed T-shirts and flip-flops than the standard-issue Wall Street suit and tie, Farmer had followed in Ed Thorp’s footsteps in the 1980s, creating a system to predict roulette using cutting-edge computers wedged into elaborate “magic” shoes. Also like Thorp, Farmer moved on from gambling in casinos to making money using mathematics and computers in financial markets around the world.
Muller and Farmer met at the company’s office on 123 Griffin Street in Santa Fe, otherwise known as the “Science Hut.” Muller’s questions came quick and fast. When Farmer would ask for information in return, Muller, poker player that he was, held his cards close to his vest. Eventually Farmer had enough.
“We had to kick him out,” Farmer later recalled. “If you give someone a piece of information that they can use, you expect to get something in return that you can use. It makes sense. But Pete didn’t give us anything.”
Farmer didn’t realize that Muller didn’t have much of anything to give. Not yet.
Later that year, Morgan’s management was looking to trim the fat. PDT was in the crosshairs. The firm had paid a lot of money to Muller, and he wasn’t delivering. John Mack, the bond trader who’d recently been named president, called a meeting to hear managers defend their businesses.
Muller wore a suit to the meeting. His hair was oiled and combed, rather than in its usual floppy-banged tangle. A team of tight-lipped Morgan execs sat around a long table in a warm, dusky conference room. Muller had to wait as several managers made their survival pitches. Their desperation was evident. Muller made a mental note: Stay calm, look cool, be confident. When his turn came, he flatly admitted that PDT hadn’t succeeded yet. But it was on the edge of great things. Computerized trading was the future. He just needed more time.
As he stopped speaking, he looked at Mack, who gave him a confident nod back. Mack had bought in.
Perseverance paid off, and soon there were signs PDT was beginning to grasp the Truth, or at least a small corner of it—they turned a profit. The day they made their first million dollars, Muller and Elsesser tossed themselves a party (consisting of cheap wine in plastic cups). In short order, a million would be a sleepy morning yawn, a blink of the eye.
In early 1994, Muller put together his dream team of math and computer aces: Mike Reed, soft-spoken geophysicist with a Ph.D. in electrical engineering from Princeton; Ken Nickerson, the ultimate number cruncher, a tall, brooding math expert with a Ph.D. in operations research from Stanford; Shakil Ahmed, a skin-and-bones computer programming whiz from Princeton; and Amy Wong, who sported a master’s in electrical engineering from MIT. This small group would form the core of what soon became one of the most profitable, and little known, trading operations in the world.
Aside from deep pockets, Muller had another advantage in working for a giant investment bank. Other trading outfits, such as hedge funds, funneled their trades to exchanges such as the NYSE through regulated broker dealers, including Morgan. One hedge fund that used Morgan as its brokerage for stocks was a trading group at Renaissance Technologies called Nova, run by Robert Frey, the mathematician who’d worked under Nunzio Tartaglia at Morgan Stanley.
In the mid 1990s, the Nova fund had a bad stretch. PDT took the positions off Renaissance’s hands and folded them into its own fund. It worked out quite well, as the positions eventually became profitable and also gave Muller a rare glimpse inside Renaissance’s secret architecture. Renaissance, for its part, retooled Nova into a profit-generating machine.
By 1994, the stage was set. Muller had the money and the talent to go to work. They didn’t have much time. Mack would slam the door shut in a heartbeat if he thought the group wasn’t delivering.
Working late hours and weekends, PDT’s dream team built an automatic trading machine, a robot for making money. They called their robot Midas—as if everything it touched would turn to gold. Nickerson and Ahmed did the fine-grained number crunching, searching for hidden signals in the market that would tell the computer which stocks to buy and sell. Nickerson focused on the U.S. market, Ahmed overseas. Reed built up the supercomputer infrastructure, mainlining it into financial markets around the world. The strategy was statistical arbitrage—the same strategy Bamberger had devised at Morgan Stanley in the 1980s. PDT’s quants had largely discovered how to implement the strategy on their own, but there’s little question that by the time Midas was up and running, the idea of stat arb was in the air. Doyne Farmer’s Prediction Company was running a stat arb book in Sante Fe, as were D. E. Shaw, Renaissance, and a number of other funds. Over the years, however, few stat arb funds would do nearly as well as PDT, which in time became
the most successful proprietary trading desk on Wall Street in terms of consistency, longevity, and profitability.
Midas focused on specific industries: oil drillers such as Exxon and Chevron, or airline stocks such as American Airlines and United. If four airline companies were going up and three were going down, Midas would short the stocks going up and buy the stocks going down, exiting the position in a matter of days or even hours. The tricky part was determining exactly when to buy and when to sell. Midas could do these trades automatically and continuously throughout the day. Better yet, Midas didn’t ask for a fat bonus at year’s end.
By the fourth quarter of 1994, the money started piling up. Midas was king. Just flip on the switch and zzip-zip-zip … zap … zap … zooing … bapbapbapbap … zing … zing … zap! The digitized computerized trades popped off like firecrackers, an electronic gold mine captured in upward-flying digits on PDT’s computer screens as the money rolled in like magic.
It was amazing, exhilarating, and at times terrifying. One night Elsesser was riding home in a taxicab, exhausted after a long day’s work. The buildings and lights of the city flashed by in a blue blur. The driver’s radio was an annoying fuzz in the background. A piece of news broke through the static: a radio announcer was describing unusual trading activity that was wreaking havoc in Tokyo’s markets.
Elsesser’s ears pricked up. Could that be us? Shit.
Frantic, she ordered the taxi to take her back to Morgan’s headquarters. She was always worried that some glitch in their computer program could unleash tsunamis of buy or sell orders. You never knew if the system would go haywire like some kind of computerized Frankenstein. PDT wasn’t responsible for the chaos in Tokyo that day, but the possibility always lurked in the background. It could be hard to sleep at night with the computers whirring away.
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It Page 14