Rogue Traders Crack Markets With Math
A new generation of math whizzes and computer scientists may have found the keys to the trading kingdom, and federal regulators are very nervous
The world's most powerful financial regulators at the Federal Reserve Bank, Securities and Exchange Commission, and Bundesbank have been rendered increasingly irrelevant by an unlikely array of adversaries -- renegade researchers from the academic world who are using complex mathematical formulae and information technology tools to dominate global money markets.
Their scientific skills helped their international trading firms, on Wall Street and other financial centers, prosper while the rest of the globe was in a panic over the Barings derivatives scandal and Mexican peso crisis. Each day, these traders move more than $1 trillion around the world at quantum speed, making more money than Saudi sheiks, American farmers and Japanese industrialists combined.
"These vandals are overwhelming the world's financial civilization," says Gregory Millman, author of the new book, Vandals' Crown (The Free Press, 1995), which details the phenomenon, in an interview. "Traders provide the only financial discipline the world knows. Because governments cannot provide financial law and order, the traders have taken the law into their own hands."
Today, a single independent international trader can alter the world financial order with a few keystrokes on his PC. Trader George Soros made a billion dollars in a few days by pushing Britain out of Europe's Exchange Rate Mechanism. Andy Kreiger, a philosopher trained at the University of Pennsylvania and independent trader, among many colorful characters in the book, provides another striking example of the trend. Kreiger caused chaos for the Bank of England in 1988 when his formulas told him to sell pounds short. His billion pound transaction forced the bank to push more pounds onto the market, in an attempt to keep its currency stable.
Firms such as CitiBank, Kidder Peabody, and Salomon Brothers also play the new trading game, but it seems that the most influential new traders work at smaller shops that are not household names.
These developments concern regulators. Federal Reserve Board Chairman Alan Greenspan on June 9, 1994 told reporters assembled in London that financial institutions would have to be "self-regulated, largely because government regulators cannot do the job." Millman says Greenspan's remarks were delivered with candor uncharacteristic of a banking official. Indeed, when Washington Technology called the Fed, the Securities & Exchange Commission and the Commodity Futures Trading Commission for comment, there was hesitancy to address the question of each agency's newfound respective irrelevance to world trading.
James T. Moser, an economist at the Federal Reserve Bank of Chicago, said, "When the DOW moves more than 50 points in a day, maybe there should be a way to throw sand in the gears of electronic trading."
The new era in global finance started for a number of unrelated reasons. Frustrated with unchallenging academic careers, or laboring in huge R&D facilities, such as AT&T Bell Labs, the new traders such as Kreiger, mathematicians, physicists and geneticists, departed for Wall Street, starting in the 1970s. When computing power, in the form of 486 PCs and Sun Workstations became readily available in recent years, they were able to remake the financial world in their own image. Now, fundamentals such as a country's economic policy, or a company's quarterly earnings, are less relevant to making money than the mathematical relationships between disparate securities.
"The financial world is becoming as much a science as any other science," says Millman. "There is no question that without computers and computer technology this could not have happened. The calculations that are used, the formulas, the models, all of these analytical tools are dependent upon the computer. It would be impossible for people to calculate the equations and resolve them in another way."
The collapse of the Bretton Woods international financial regime and the end of the gold standard in the 1970s prompted financial leaders to start looking for a way to understand what was happening in the world market. "The tools that were brought to bear were mathematical tools from the hard sciences. One researcher, Fischer Black, came up with an option pricing theory that he tells me is easily recognizable to physicists as a heat transfer equation," says Millman.
Essentially, without strict government controls of the economy, as was possible under Bretton Woods, the world financial markets have reverted to a system of pure free trade. The physicists try to understand the markets as if they were analyzing a natural physical phenomenon.
Other methods the new traders use include time decay and volatility theory. The popular question of whether the market will go up or down is irrelevant. Traders simply arbitrage based on mathematical relationships between the financial instruments themselves, relationships similar to electrons and protons and neutrons. "You simply invested in mathematical relationships that you knew to be true," says Millman.
Such arcane facts are known to only a handful of people at the world's leading financial institutions. And that concerns regulators, too. "The deputy governor of the Bank of England was issuing warnings back in 1992 about the risks that financial institutions ran if they had only a few people who understood these markets and top management didn't understand them," says Millman. "There was an English bank (Barings) about which that was quite obviously true. And it is now a subsidiary of a Dutch bank."
What then, will become of the markets if no regulation is possible and only a few people, math geniuses with Ph.Ds and PCs, understand what is happening? Is there a way to bring regulators out of their dated 18th-century economic philosophies and help them do their job in the new economy?
Federal Reserve Bank of New York President William J. McDonough in remarks at New York University on June 16, 1994 called for a "re-examination of the division of proprietary and public information" about markets and risks. Once such data is made public, then the free market itself can discipline traders such as Nick Leeson who are taking risks that are improper.
Who the traders are
Just who are the new traders, the quants and geeks, that dominate today's global financial markets? And why have they gravitated to this industry?
"You're dealing with guys who come out of MIT with Ph.Ds in math or out of the University of Chicago or Berkeley. These people are well-schooled in quantum physics or genetics. And the reason they are heading to Wall Street is that this is where the innovation needs to happen now. This is where the discoveries that are more important are. Therefore they are paying more," says Gregory Millman, author of the new book, Vandals' Crown .
The first quants who began to make the shift were in the early 1970s. Scientists such as Fischer Black left the academe for the street. "People who turned their attention to the field of finance because there are very interesting problems. For instance, they wondered whether the markets were random or not. Or how prices behaved. Very early on, it was recognized that market prices are indeed random. And the equation used to describe Brownian motion in physics can pretty well describe the behavior of market prices.
Another one of the new traders profiled in the book is Douglas Williams of Wall Street's Millburn. Williams left Bell Labs after the divestiture of AT&T. Today, he studies neural networks, which examine minute-to-minute prices for currencies and other instruments. The net is similar to previous models he developed for a robotic eye. The eye he crafted for the robot responded to light and color. The eye he is designing for Millburn responds to prices and price moves, market conditions and volumes.
"I was talking to a fellow on the plane the other day, a physicist who had been at AT&T Bell Labs, and he was saying that a number of his colleagues had taken off in recent years to join large financial institutions," says Millman. "It is definitely not only happening. Its effect on the financial world is profound. It has really changed, fundamentally, the business of finance."