In a sense, Morgan Stanley and Pick are reaping gains from a prescient bet made two decades earlier. When Pandit took over equity trading at Morgan Stanley in 1994, he noticed that the cost of computing power was collapsing. That, combined with abundant data on public exchanges that would enable automated trading, convinced Pandit of the need to prepare for a post-human equities market.
“We realized that the human touch was interesting but actually a hindrance to what it took to really trade these markets correctly,” Pandit, who served as CEO of Citigroup Inc. for five years, says in the Midtown office of his investment company, Orogen Group. “The only thing you could do is figure out how you automated all the human aspects of trading, understanding what drove stock prices, and then used those algorithms to make markets.” So Pandit gathered math and science experts to open the Equity Trading Lab, or ETL, whose initial mission was to automate the trading floor.
It helped that at the time Morgan Stanley was already known as a hotbed for innovation; in the 1980s, the bank instituted an early quant strategy called pairs trading. Employees from that era included a computer scientist named David Shaw, who later founded a legendary quant hedge fund. In the early 1990s, Peter Muller founded an in-house quant fund called PDT Partners that minted money for the bank until it was spun out after the financial crisis.
Heeding the needs of its early quant clients—several of whom were former employees—the ETL team built version 1.0 of its electronic-trading operation. The guiding principle was to reduce friction for hedge funds: The team later created the Trading and Position System, or TAPS, which helped prime brokerage clients to receive automated reports. Because of these innovations, quant funds such as Renaissance Technologies gravitated toward Morgan Stanley.
Morgan Stanley hugged its quant clients close. Instead of merely offering to execute trades, prime brokerage provides all-important leverage and custody of assets. “Prime brokerage is really the lifeblood,” says ETL co-founder Michael Botlo. “This is the oxygen. This is what you’re immersed in. If all of a sudden prime brokerage becomes terrible, then you’re toast. If you can’t short anymore, you’re dead. If you can’t access your swaps, you’re dead.”
As much as Pick talks up the bank’s people and culture, the trading algorithms—an early form of artificial intelligence—are its secret sauce, according to Pandit. “Imagine the accumulated learning of having done it for the last 20 years,” he says. The algorithms, he adds, are rules that essentially gather “all the things you did wrong that informs what you should do today that’s right. They’re so far ahead of the game, it’s going to give them an edge for a while.”
Goldman’s dominance among Wall Street’s active traders all those years ago didn’t happen by accident. In the 1950s and ’60s, the legendary trader Gus Levy helped establish the white-shoe investment bank in the rough-and-tumble world of trading. Known as “the Octopus,” because he wanted a tentacle gripping every transaction, he flew into a rage whenever a competitor won a coveted block trade. These were deals in which Goldman used its balance sheet to purchase chunks of stock to profitably peddle off to clients. He was also a pioneer in the practice of risk arbitrage, or using the company’s money to bet on takeover targets.
Levy, who died in 1976, instilled in the company an intensity and risk appetite that would live long after him. A generation of traders followed in his footsteps and burnished Goldman’s reputation in markets. Robert Rubin, who later became President Clinton’s secretary of the Treasury, got his start in risk arb under Levy and later ran the equities desk. Rubin, in turn, helped train Richard Perry, Eric Mindich, and Daniel Och, all of whom would go on to found successful hedge funds. Goldman alumni typically stay close to their old colleagues, and this group was no different, making Goldman the top choice for investors in search of market intelligence, smart sales coverage, or financing.
In 1998 the tectonic plates of finance shifted. That year the SEC allowed a new breed of alternative trading platforms to compete with traditional stock exchanges. In one stroke, regulators fostered the rise of electronic-trading networks and weakened the grip of human traders.
Perhaps recognizing that the low-margin, unfashionable business of electronic market making wasn’t a part of its heritage in the way it was at Morgan Stanley, Goldman just went out and bought the capability.