David Shaw, founder of D. E. Shaw & Co., wants to put a lot of his Wall Street colleagues out of work. "Finance is a pure information-processing game," he says. "A lot of people in the business are doing things that should be done by computers."
His company makes the point. D. E. Shaw & Co. uses advanced mathematical and computational techniques to play the markets. Eight years after it was founded, Shaw's investment bank has 400 employees in offices scattered around the globe and US$800 million in capital. Annual returns average over 20%. The firm has invested $100 million in a technological toolbox of secret algorithms, and on a busy day it accounts for 5% of the total shares traded on the New York Stock Exchange. Shaw is an adviser to Bill Clinton on computer technology, and he has wired a lot of people into cyberspace through Juno Online Services, which provides free email for about 700,000 subscribers.
That's just the beginning. Sometime in 1997, Shaw will launch FarSight, an audacious online financial service. FarSight will bundle automated stock trading, online checking accounts, financial data, portfolio management tools, credit card accounts, and access to ATM machines into a one-stop financial supermarket. Potential customers run the gamut from savvy investors who need point-and-click stock trading to grandparents fine-tuning their retirement accounts. "Retail customers will get the same services as institutional investors," says Harold Rhodes, FarSight's marketing director. "Why should the big guys get all the goodies?"
Ultimately Shaw wants to bundle everything to do with money into FarSight - from offering insurance and credit lines to mortgaging your house. He aims to redesign the financial world around a D. E. Shaw interface.
The potential market for online investing and banking represents a large chunk of change. In the next five years, the number of online investing accounts will grow from 1.5 million to 10 million, according to Forrester Research Inc, of Cambridge, Massachusetts. Online banking accounts are estimated to grow from 1.1 million today to 19.5 million by 2001. "The potential shift is huge," says Julio Gómez, a senior analyst at Forrester Research. "The Internet investor will be the cream of the crop, the high net-worth individual you have to get if you want to succeed in this business." Such predictions are beginning to scare the hell out of the financial services industry. "Technology isn't just changing the tools we work with; it is changing the nature of the work itself," said Morgan Stanley managing director Elaine La Roche in a speech at the Public Securities Association's annual convention in April last year. "It allows end-users to bypass the middleman. It allows them to bypass us."
Shaw not only wants to succeed, he wants to redesign the financial world from the ground up. "We're trying to find areas that are going to be fundamentally transformed by computers," he says. "Not just made slightly more efficient, but where the whole industry is going to be turned on its head."
The efficient-market hypothesis
Born in 1951, Shaw grew up in Los Angeles. His stepfather, Irving Pfeffer, was professor of finance at UCLA. Pfeffer supported the efficient market hypothesis, a keystone of modern financial theory, which claims that the stock market responds so quickly to change that no one can consistently outguess it. Shaw later made a lot of money by discovering the "inefficiencies", the little pockets of imperfections the existence of which Pfeffer questioned.Shaw's natural father (his parents divorced when he was twelve years old) was a theoretical physicist who studied plasma and fluid flows. His mother is an artist and educator. Shaw is a perfect mix of these three inherited influences. His career exemplifies the melding of physics and finance - a new way of looking at the world that might be called "phynance". Phynance studies money as a kind of fluid flow. It searches for little eddies of predictability in the great waves of speculative investment that wash daily around the globe. Like many of its best practitioners, Shaw practices phynance with the intuition of an artist.
Planning to study marine biology, Shaw went to University of California at San Diego, where he was surprised to learn that the subject was offered only to graduate students. Instead, he signed up for cognitive psychology, which turned him on to all the big questions that still intrigue him. How do people work? Will we become obsolete? Will we become immortal? Shaw became fascinated with information theory and mathematical models for pattern recognition. He also discovered neural networks - computer programs designed to mimic the parallel processing capabilities of the human mind.
"I was just amazed," says Shaw of neural nets: very simple systems that can perform exceedingly complex computations. "I was intrigued by neural networks that could automatically learn a pattern. I was very excited about finding these magical devices that, once you discovered the right design, you could turn on and they would get smarter."
Disproving the traditionalists
Shaw continued exploring the ramifications of artificial intelligence after he began graduate school in computer science at Stanford in 1973. Among Shaw's colleagues in this famous class were future company founders Len Bosack (Cisco Systems), Andy Bechtolsheim (Sun Microsystems), Jerry Kaplan (Go) and Jim Clarke (Silicon Graphics, Netscape).Until then, Shaw had little direct experience with computers. But in a year or two he had caught up with his classmates and began pushing into software consulting and computer design. To overcome the limitations of conventional computer design, he created a new, "Non-Von Neumann" computer (called Non-Von, for short). Instead of having a single central processing unit and a single path from memory to processor, Shaw's Non-Von computer was loosely based on a different model - the human brain. Its blueprint looked like a tree leafed out with thousands of computer chips. Each of these leaf-chips contained several processors, and more processors were attached where the branches met the trunk.
It was an ingenious design, similar in many ways to what Danny Hillis later built at Thinking Machines, and incredibly fast. It was also incredibly expensive. "We needed $30 million to get going and $100 million to break even," he said. Planning to start his own supercomputer company, he began shopping the idea to venture capitalists, some of whom would laugh aloud when shown the price tag. "That's not a good sign," Shaw says wryly.
In 1980, he snagged a job as an assistant professor of computer science at Columbia University in New York, where he began building a Non-Von prototype. In the course of looking for investors, Shaw became known as a local computer whiz who was good at running big projects. These skills were in short supply on Wall Street in the mid-1980s. Head-hunters started calling, and Shaw used their introductions to keep pitching his $100-million idea. He never intended to leave academia, but then Morgan Stanley put an extra zero on his annual salary, an offer too good to resist. Morgan Stanley wanted Shaw to be part of an independent, top-secret group formed to exploit anomalies in stock-market prices that could open the way to beating the market. Shaw would put together the group's computer facilities.
Shaw - long-haired, bearded, an ex-surf musician - had some qualms about working for a white-shoe Wall Street firm, but curiosity got the better of him. "What appealed to me was the challenge of trying to beat the market," he says. "I was raised to believe it was impossible, and here they were telling me they knew how to do it." Morgan Stanley was exploiting a technique called pairs trading, based on the idea that prices of related stocks should be correlated. Ford and General Motors, for instance, tend to fluctuate in price around the same news events. But what if an unusual gap - in which Ford lags in price and GM pushes ahead - develops?
Speculators might rush in to sell GM and buy Ford. If the gap persists and the entire stock market goes up or down, the hedge fund will neither win nor lose. Such strategies, in Wall Street lingo, are called "market neutral". But if the gap between GM and Ford narrows, as predicted by the statistics, then the fund will make money.
The trick is to make sure that your strategy is truly market neutral, not only for fluctuations in the stock market, but also for fluctuations in interest rates, foreign exchange movements and global economic risks - all of which can come at you faster than a shark lunging for meat.
Wall Street is filled with former employees of failed hedge funds. "This is a high-risk game at the frontier of mathematics, physics and finance," says Andrew Lo, director of MIT's financial engineering programme.
"Many correlations exist among securities at different points in time, and solving the optimisation problem that implements a successful market strategy involves the same tools we use for guided missiles. It's stochastic con-trol theory. You're trying to hit a mov-ing target."
Shaw treated Morgan Stanley like a college campus with a terrific smorgasbord of courses to be sampled. He poked his nose into every aspect of Morgan Stanley's business, pestering colleagues with questions and suggestions on how they could do their jobs better. "He is personable, but intense," says a former colleague. "He drills down on questions and won't let them go. This is great, if you're willing to die for the answer. But if all you want to do is get on with business, it can be a pain."
Shaw is more blunt: "I got on people's nerves."
RIP: tassel-loafered leeches
After a year and a half at Morgan Stanley, Shaw struck out on his own. He founded D. E. Shaw & Co. in 1988 in a loft over a communist bookshop near Greenwich Village. The company had six employees and $28 million in capital invested by Donald Sussman and three of Sussman's friends. Sussman runs Paloma Partners, a $1 billion fund-of-funds in Greenwich, Connecticut. He's a high net-worth individual, as they say on Wall Street, and a tough cookie. Sussman on the telephone sounds as if he's growling out answers to your questions while simultaneously reading The Wall Street Journal, watching his Bloomberg box and trading Euroyen futures in Zurich."Why did you decide to invest in David Shaw?"
"He's the smartest person I've ever met. I'm lightweight compared to him."
"But you're richer than he is."
"So what if his fund is now smaller than mine? By the end of our lifetimes his net worth will vastly exceed mine."
During Shaw's education at Morgan Stanley, he decided pairs trading was not the way to make his fortune. Shaw's secret is algorithmic trading, that is, trading that follows complex rules - derived from high-powered statistical analysis - which attempt to profit from tiny price differences between multi-ple markets. Maybe the stock of Sun Microsystems is selling for $50 in New York and $50.50 in Hong Kong. This is called a market "inefficiency". So you buy in New York and sell in Hong Kong, and pocket the difference.
Such discrepancies don't last long. With computers and communication links spreading market information everywhere in nanoseconds, these price gaps tend to close almost as fast as they open. You also have to juggle currency exchange rates and transaction costs. To play this game, you have to be quick and sure-footed.
Which Shaw always seems to be. He makes his investments with the aid of mathematical models the exact nature of which is more closely guarded than the recipe for Coca-Cola. Until April 1996, when Juno was launched and Shaw had no choice about developing a public persona, he rarely let visitors inside his company. The few details that leaked out were a bit scary: Shaw was a control freak who kept his own traders in the dark about how the firm's computer models worked. "We follow the same principles as the CIA or NSA," Shaw says of company security. "Information is partitioned off and distrib-uted on a need-to-know basis." When asked if he used neural networks to design his trading strategies, Shaw said, "I could tell you, but then I'd have to kill you afterwards." He was joking. I think.
Once Shaw got his hedge fund running, he realised he had enough computational models and machines to branch into other businesses. He moved into basket trading, where you buy billion-dollar stock portfolios from big investors who want to unwind their positions in a hurry. He also moved into something called the "third market". This is automated, off-exchange trading of stocks usually traded on the exchange. Volume on the third market is already 15% as large as that on the New York Stock Exchange, and Shaw is well positioned to get a big chunk of this business.
Stock trading for Shaw is nothing more than a network in which computers match buyers and sellers, and store unfilled orders until the next customer dials in. Order flow is key. Unlike market makers on the major stock exchanges, who charge money for the finger-wagging and yelling required to fill your order, D. E. Shaw & Co. pays money - between one and two cents a share - to brokers who send them their business. (It makes its money not on commissions, but on the spread, the difference in price between buy and sell orders.)
"I find a lot of finance highly amusing," says Shaw. "There's a lot of hocus-pocus practised by people with fancy suits. Quite often they're selling you financial products that are terrible deals or providing very mechanical services at inflated prices."
One such group of fancy suits are the market makers, specialists and brokers who run America's stock exchanges. "Many of them are doing something that should be done by computers," he says. "It's just not very complicated. All you have to do is match a buyer and a seller. In serving this middleman function, you collect exorbitant amounts of money for a very simple process."
In Shaw's view, once computers have replaced these tassel-loafered leeches, a new financial era will dawn. He envisions the possibility of an Internet exchange in which market makers no longer pocket hefty fees for matching buyers and sellers. No longer will investment bankers suck up 6% of the capital raised when companies sell stock during initial public offerings. Shaw admits that his visionary ideas, if carried far enough, might put him out of business, at least the market-making business - but he calls this "a historical inevitability".
Shaw's preference for redesigning the world from the ground up has been applied to his Internet activities as well, including Juno. Juno is free in the sense that network television is free. A subscriber gets targeted by advertising in exchange for connection, and soon subscribers will get targeted by D. E. Shaw, which wants to lure them into using its online financial service, FarSight.
Although Juno has been weak on the revenue side (advertisers are just beginning to climb on board), Shaw says he is carrying on an "incredible programme of experimentation. We watch over the shoulders of paid experimental subjects by trapping their inputs and looking at all the places they make mistakes," he says of designing the system. "Then we experiment with moving buttons around or changing their colours, which results in a dramatic drop in errors."
Good design is a critical factor for Shaw. Another environment bearing his signature is D. E. Shaw's headquarters, which moved in 1992 to the top two floors of a skyscraper near Times Square. The company logo is inspired by an electronic switch, and its office, with its shiny black floors and cut-out walls bathed in reflected light, is meant to evoke the feeling of sitting inside a computer chip.
D. E. Shaw's stock-trading room is a gear-filled, black, hexagonal chamber that makes the cockpit of the Challenger look antiquated. Shaw sits at a brushed-aluminum, wing-shaped table, ergonomically designed so that his neck swivels no more than 15ª between computer monitor and desk surface.
The icy atmosphere belies Shaw's populist sensibilities. Amid the cynical, profit-driven world of Wall Street, it's hard to believe that Shaw has motives other than profit for offering the world free email - but I think he has.
"From a business viewpoint, it's not ideal to offer free email to subscribers who aren't demographically appealing to advertisers," he says. "But even if we don't make any money on these subscribers, I think for political and social reasons it has to be done."
"I actually believe that technology, including email, can be harmful if it serves to drive a wedge between information haves and have-nots," says Shaw. "Even if we get parity of computer access within the schools, we're still seeing an incredible gulf in terms of home access to computers, and this gulf is now beginning to show up educationally."
Despite FarSight's lofty ambitions, it needs to clear some formidable hurdles. "D. E. Shaw has little experience dealing with consumers or partnering with financial behemoths," says Forrester's Gómez. "And it remains to be seen how a company whose stock-in-trade is secrecy will interface with online investors."
Fidelity Investments, E*Trade and Charles Schwab are already selling stock online in the US, while in Britain, Electronic Share Information offers both share information and a gateway to online trading services. Bankers from Citibank to American Express are creating "thin branches" as fast as they can. But the Web may, in the end, prove no match for Wall Street's very human, very hard-selling brokers. The trick to FarSight succeeding, like Shaw's other ventures, will be extreme integration, efficiency and ease of use.
To the winner, the fun
For people like Shaw, money is a puzzle, a way of keeping score. It reveals a lot about people's personalities and preferences. In the end, though, it's just another form of information, which can be reduced to bits and bytes and zapped around the world at the speed of light. If one sits in the middle of this information, processing it, routing it from point A to point B, the view from this central vantage point is ever changing and always fascinating."Sometimes I think I'm going to wake up and discover there's been a clerical error - that we're really losing millions of dollars instead of making them," says Shaw. "Then I pinch myself and get back to reality."
Various people have offered to buy Shaw out. " 'We'll never sell the firm,' I tell them. 'That's not in the cards. It doesn't matter what the price is.'
" 'Come off it,' they say. 'Everyone has a price. Would you sell it for $5 billion?'
" 'No,' I tell them. 'My lifestyle would not change if I had more money. This is the most fun I've ever had.' "
Thomas A. Bass is the author of Vietnamerica and The Eudaemonic Pie, and is writing a new book on the world financial markets.