The Fear Index

13

The risk committee of Hoffmann Investment Technologies met for the second time that day at 16.25, Central European Time, fifty-five minutes after the opening of the US markets. Present were the Hon. Hugo Quarry, chief executive officer; Lin Ju-Long, chief financial officer; Pieter van der Zyl, chief operating officer; and Ganapathi Rajamani, chief risk officer, who took the minutes and in whose office the meeting was held.

Rajamani sat behind his desk like a headmaster. Under the terms of his contract he was not permitted to share in the annual bonus. This was supposed to make him more objective about risk, but in Quarry’s opinion it had simply had the effect of turning him into a licensed prig who could afford to look down his nose at big profits. The Dutchman and the Chinese occupied the two chairs. Quarry sprawled on the sofa. Through the open blinds he watched Amber leading Leclerc towards reception.

The first item noted the absence, without explanation, of Dr Alexander Hoffmann, company president – and the fact that Rajamani wanted this dereliction of duty officially minuted was, to Quarry, the first indication that their chief prig officer was preparing to play hardball. Indeed, he seemed to take a grim delight in laying out just how perilous their position had become. He announced that since the last meeting of the committee, some four hours earlier, the fund’s risk exposure had increased dramatically. Every warning indicator in the cockpit was flashing red. Decisions needed to be taken fast.

He started reading facts from his computer. VIXAL had almost entirely abandoned the company’s long position on S amp;P futures, its principal hedge against a rising market, stranding them with their plethora of shorts. It was also in the process of disposing of all – ‘I repeat, all’ – of its matching pairs of long bets on the eighty or so stocks it was shorting: in the last few minutes alone, the final remnants of a $70 million long position on Deloitte, taken up to hedge their massive short against its competitor Accenture, had been liquidated. And perhaps most troubling of all, as one by one the bets to the long side were lifted, there had been no corresponding move to buy back the stocks that were being shorted.

‘I have never seen anything like it before in my life,’ concluded Rajamani. ‘The plain fact is, this company’s delta hedge has gone.’

Quarry maintained a poker face, but even he was startled. His faith in VIXAL had always been unshakeable, but this was supposed to be a hedge fund – the clue was in the name, dummy. If you took away the hedge – if you dispensed with all the immensely intricate mathematical formulae that were supposed to ensure that you covered your risk – you might as well take the family silver and bet the lot on the 3.45 at Newmarket. It was true, the hedge put a ceiling on your gains, but it also put a floor under your losses. And given that there wasn’t a fund on earth that didn’t go through a rough patch every so often, if you didn’t put on a hedge, a run of bad calls could wipe you out. His skin felt clammy at the thought. He could taste his lunchtime filet mignon de veau rising like bile in his throat. He put the back of his hand to his forehead. I am literally breaking out in a cold sweat, he realised.

Rajamani continued to hammer away: ‘We have not merely abandoned our long position on S and P futures, we are actually shorting S and P futures. We have also increased our position on VIX futures to something approaching one billion dollars. And we are buying out-of-the-money puts that are so extreme – that presuppose such a massive deterioration in the market generally – that our only consolation is that we are at least picking them up for cents. In addition-’

Quarry held up his hand. ‘Okay, Gana. Thanks. We get it.’ He needed to take charge of this meeting quickly, before it turned into a rout. He was conscious that they were being scrutinised from the trading floor. They all knew the hedge had gone. Anxious faces kept bobbing up and down from behind their six-screen arrays like targets in a shooting gallery.

Van der Zyl said, ‘I’ll close the blinds.’ He started to rise.

Quarry said sharply, ‘No, leave them open, Piet, for God’s sake or they’ll think we’re forming a suicide pact in here. Actually, I’d like to see some smiles from you all, gentlemen, if you don’t mind – everybody smile: that’s an order. Even you, Gana. Let’s show the troops a little officer-class sangfroid.’

He hoisted his feet up on to the coffee table and laced his fingers behind his head in a parody of nonchalance, even though his fingernails were digging into his flesh so sharply the indentations would look like scars for the rest of the day. He glanced around at the personal photographs Rajamani had brought in from home to alleviate the gleaming Scandinavian gloom of the decor: a big wedding group taken at night in a Delhi garden, the garlanded bride and groom in the centre, grinning maniac ally; Rajamani as a student graduating from Cambridge, standing in front of the University Senate House; and two young children in school uniform, a boy and a girl, staring sombrely at the camera.

He said, ‘Okay, Gana, so what is your recommendation?’

‘There is only one option: override VIXAL and put the hedge back on.’

‘You want us to bypass the algorithm without even consulting Alex?’ asked Ju-Long.

‘I would most certainly consult him if I could find him,’ retorted Rajamani. ‘However, he is not answering his phone.’

Van der Zyl said, ‘I thought he was at lunch with you, Hugo.’

‘He was. He left halfway through in a hurry.’

‘Where did he go?’

‘Lord knows. He just took off without a word.’

Rajamani said, ‘That is just breathtaking irresponsibility. I’m sorry. He knew there was a problem. He knew we were scheduled to meet again this afternoon.’

There was a silence.

‘In my opinion,’ said Ju-Long, ‘and I would not say this except among us, I believe Alex is having some kind of breakdown.’

Quarry said, ‘Shut up, LJ.’

Van der Zyl chimed in: ‘But he is, Hugo.’

‘And you should shut up too.’

The Dutchman backed off quickly. ‘Okay, okay.’

‘Shall I minute this?’ enquired Rajamani.

‘No you damn well won’t.’ Quarry pointed an elegantly shod toe across the table at Rajamani’s computer terminal. ‘Now hear me well and good, Gana: if there’s any hint in these minutes of Alex in any way being mentally unreliable, then this company will be finished and you will have to take responsibility for that fact to all those colleagues out there, who are right now watching our every move, and to all our investors, who have made a great deal of money thanks to Alex and who will never forgive you. Do you understand what I’m saying? Let me summarise the situation in four words for you: no Alex, no company.’

For several seconds, Rajamani stared him out. Then he frowned and lifted his hands from the keyboard.

‘Okay then,’ resumed Quarry. ‘In the absence of Alex, let’s try looking at this the other way. If we don’t override VIXAL and put the delta hedge back on, what are the brokers going to say?’

Ju-Long said, ‘They are just so hot on collateral these days, after what happened to Lehman’s. For sure they won’t allow us to trade unhedged on existing terms of settlement.’

‘So when will we have to start showing them some money?’

‘I would expect we’ll need to provide a substantial level of fresh collateral before close of business tomorrow.’

‘And how much do you reckon they’ll want us to put up?’

‘I’m not sure.’ Ju-Long moved his neat, bland head from side to side, weighing it up. ‘Maybe half a billion.’

‘Half a billion total?’

‘No, half a billion each.’

Quarry briefly closed his eyes. Five prime brokers – Goldman, Morgan Stanley, Citi, AmCor, Credit Suisse – half a billion to be deposited with each: two and a half billion dollars. Not funny money, not promissory notes or long-term bonds, but the pure crystal meth of liquid cash, wired over to them by 4.00 p.m. tomorrow. It was not that Hoffmann Investment Technologies didn’t have that kind of money. They only traded about twenty-five per cent of the cash lodged with them by their investors; the rest they didn’t need to show. The last time he looked, they had at least four billion dollars stashed in US Treasury bills alone. They could dip into that whenever they needed it. But my God – what a colossal hit on their reserves; what a step towards the precipice…

Rajamani interrupted his thoughts. ‘I am sorry, but this is madness, Hugo. This level of risk is far outside what is promised in our prospectus. If the markets were to rise strongly, we would be left facing billions in losses. We might even go bankrupt. Our clients could sue us.’

Ju-Long added: ‘Even if we continue trading, it will be unfortunate – will it not? – if the board of the fund has to be notified of our accelerated risk levels just as we are approaching individual investors to put another billion dollars into VIXAL-4.’

‘They will pull out,’ said van der Zyl mournfully. ‘Anyone would.’

Quarry was unable to sit still any longer. He jumped up and would have paced around the office but there wasn’t sufficient room. That this should happen now, after his two-billion-dollar pitch! The unfairness of it! He clawed the air and grimaced at the heavens. Unable to stomach Rajamani’s expression of moral superiority for a moment longer, he turned his back on his colleagues and leaned against the glass partition, his palms spread wide, staring out at the trading floor, heedless of who was watching. For a moment he tried to visualise what it would be like to manage an uncontrolled, unhedged investment fund exposed to the full force of the global markets: the seven-hundred-trillion-dollar ocean of stocks and bonds, currencies and derivatives that rose and fell ceaselessly against one another day after day, whipped by currents and tides and storms into vast maelstroms that no one could fathom. It would be like trying to cross the North Atlantic on an upturned dustbin lid with a wooden spoon for a paddle. And there was a part of him – the part that saw existence itself as a gamble that sooner or later one was bound to lose; the part that used to bet $10 K on which fly would take off first from a bar table, just to feel the thrill of fear – that side of his personality would have relished it, once. But nowadays he also wanted to hold on to what he had. He enjoyed being known as a rich hedge-fund manager, the cream of the elite, the financial equivalent of the Brigade of Guards. He was ranked 177 in the latest Sunday Times rich list; they had even printed a picture of him on the bridge of a Riva 115 (‘Hugo Quarry leads the dream bachelor life on the shores of Lake Geneva – and why not, as CEO of one of the most successful hedge funds in Europe?’). Was he really going to jeopardise all that, just because some bloody algorithm had decided to ignore the basic rules of investment finance? On the other hand, the only reason he was on the rich list in the first place was because of the bloody algorithm. He groaned. This was hopeless. Where was Hoffmann?

He turned and said, ‘We really need to talk to Alex before we put on an override. I mean, when was the last time any of us actually did a trade?’

Rajamani said, ‘With respect, that’s not the point, Hugo.’

‘Of course it’s the point. It’s the whole point and nothing but the point. This is an algorithmic hedge fund. We’re not manned up to run a ten-billion-dollar book. I’d need at least twenty top-class traders out there with steel balls, who know the markets; all I’ve got are quants with dandruff who don’t do eye contact.’

Van der Zyl said, ‘The truth is, this issue should have been addressed earlier.’ The Dutchman’s voice was rich and deep and dark, marinated in coffee and cigars. ‘I don’t mean that we should have thought about it earlier today – I mean we should have done it last week or last month. VIXAL has been so successful for so long, we have all become dazzled by it. We have never put in place adequate procedures for what to do if it fails.’

Quarry knew in his heart that this was true. He had allowed technology to enfeeble him. He was like some lazy driver who had become entirely reliant on parking sensors and satellite navigation to get him around town. Nevertheless, unable to conceive of a world without VIXAL, he found himself rising to its defence. ‘Can I just point out that it hasn’t failed? I mean, the last time I looked, we were up sixty-eight mil on the day. What does the P and L say now, Gana?’

Rajamani checked his screen. ‘Up seventy-seven,’ he conceded.

‘Well, thank you. That’s a bloody odd definition of failure, isn’t it? A system that made nine million dollars in the time it took me to shift my arse from one end of the office to the other?’

‘Yes,’ said Rajamani patiently, ‘but it is a purely theoretical profit, that could be wiped out the moment the market recovers.’

‘And is the market recovering?’

‘No, I accept that at the moment the Dow is falling.’

‘Well, there is our dilemma, gentlemen, right there. We all agree that the fund should be hedged, but we also have to recognise that VIXAL has demonstrated itself to be a better judge of the markets than we are.’

‘Oh, come on, Hugo! There’s obviously something wrong with it! VIXAL is supposed to operate within certain parameters of risk, and it isn’t, therefore it is malfunctioning.’

‘I don’t agree. It was right about Vista Airways, wasn’t it? That was absolutely extraordinary.’

‘That was a coincidence. Even Alex acknowledged that.’ Rajamani appealed to Ju-Long and van der Zyl. ‘Come on, you fellows – back me up here. To make sense of these positions, the whole world would have to crash in flames.’

Ju-Long put his hand up like a schoolboy. ‘Since the subject has been raised, Hugo, could I just ask about the Vista Airways short? Did anyone see the news just now?’

Quarry sat down heavily on the sofa. ‘No, I didn’t. I’ve been rather busy. Why? What are they saying?’

‘That the crash was not a mechanical failure after all, but some kind of terrorist bomb.’

‘Okay. And?’

‘It seems that a warning was posted on a jihadist website while the plane was still in the air. Understandably there is a lot of anger that the intelligence authorities missed it. That was at nine o’clock this morning.’

‘I’m sorry, LJ. I’m being a bit slow on the uptake. What does it matter to us?’

‘Only that nine o’clock was exactly the time we started shorting the Vista Airways stock.’

It took Quarry a moment or two to react. ‘You mean to say we’re monitoring jihadist websites?’

‘So it would appear.’

Van der Zyl said, ‘That would be entirely logical, actually. VIXAL is programmed to search the web for incidences of fear-related language and observe market correlations. Where better to look?’

‘But that’s a quantum leap, isn’t it?’ asked Quarry. ‘To see the warning, make the deduction, short the stock?’

‘I don’t know. We would have to ask Alex. But it is a machine-learning algorithm. Theoretically, it’s developing all the time.’

Rajamani said, ‘Then it’s a pity it hadn’t developed enough to warn the airline.’

‘Oh, come on,’ said Quarry, ‘stop being so bloody pious. It’s a machine for making money; it’s not meant to be a sodding UN goodwill ambassador.’ He leaned his head against the back of the sofa and looked at the ceiling, his eyes darting, trying to absorb the implications. ‘God in heaven. I mean, I’m simply staggered by that.’

Ju-Long said, ‘It could be a coincidence, of course. As Alex said this morning, the airline short was just part of a whole pattern of bets to the down side.’

‘Yeah, but even so, that’s the only short where we’ve actually sold the position and taken the profit. The others we’re holding on to. Which poses the question: why are we holding on to them?’ He felt a tingling along the length of his spine. ‘I wonder what it thinks is going to happen next?’

‘It does not think anything,’ said Rajamani impatiently. ‘It is an algorithm, Hugo – a tool. It is no more alive than a wrench or a car-jack. And our problem is that it is a tool that has become too unreliable to depend on. Now, time is pressing and I really must ask this committee formally to authorise an override on VIXAL and start an immediate rehedging of the fund.’

Quarry looked at the others. He was good at nuances, and he detected that something had just shifted slightly in the atmosphere. Ju-Long was staring ahead impassively, van der Zyl examining a piece of lint on the sleeve of his jacket. They seemed embarrassed. Decent men, he thought, and clever, but weak. And they liked their bonuses. It was all very easy for Rajamani to order VIXAL to be shut down; it would cost him nothing. But they had received four million dollars each last year. He weighed the odds. They would give him no trouble, he decided. As for Hoffmann, he took no interest in the personnel of the firm apart from the quants: he would back him whatever he did. ‘Gana,’ he said pleasantly, ‘I’m sorry, but I’m afraid we’re going to have to let you go.’

‘What?’ Rajamani frowned at him. Then he tried to smile: a ghastly nervous rictus. He tried to treat it as a joke. ‘Come on, Hugo…’

‘If it’s any consolation, I was going to fire you next week whatever happened. But now seems like a better time. Write it down in your minutes, why don’t you? “After a short discussion, Gana Rajamani agreed to relinquish his duties as chief risk officer, with immediate effect. Hugo Quarry thanked him for all he had done for the company” – which as far as I’m concerned, by the way, is sod all. Now clear your desk and get off home and spend more time with those charming children of yours. And don’t worry about money – I’m more than happy to pay you a year’s salary just for the pleasure of not having to see you again.’

Rajamani was recovering: afterwards Quarry was forced to give him credit for resilience at least. He said, ‘Let me be clear about this – you’re dismissing me simply for doing my job?’

‘It’s partly for doing the job, but mostly for being such a pain in the ass about doing it.’

Rajamani said, with some dignity, ‘Thank you for that. I’ll remember those words.’ He turned to his colleagues. ‘Piet? LJ? Are you going to intervene at this point?’ Neither man moved. He added, slightly more desperately, ‘I thought we had an understanding…’

Quarry got up and pulled the power cable out of the back of Rajamani’s computer. It emitted a slight rattle as it died. ‘Don’t make copies of any of your files – the system will tell us if you do. Turn in your mobile phone to my assistant on your way out. Don’t speak to any other employees of the company. Leave the premises within fifteen minutes. Your compensation package is conditional on your abiding by our confidentiality agreement. Is that understood? I really would prefer not to call in security – it always looks so cheap. Gentlemen,’ he said to the other two, ‘shall we leave him to his packing?’

Rajamani called after him, ‘When word of this gets out, this company will be finished – I’ll see to that.’

‘Yes, I’m sure.’

‘You said VIXAL could fly us all into a mountainside, and that’s exactly what it’s doing…’

Quarry put his arms around Ju-Long and van der Zyl and guided them out of the office ahead of him. He closed the door without looking back. He knew that the entire drama had been played out to an audience of quants, but that could not be helped. He felt quite cheerful; he always felt good after he’d fired someone: it was cathartic. He smiled at Rajamani’s assistant: a pretty girl; she would have to go too, unfortunately. Quarry took a pre-Christian view of these rituals: it was always best to bury the servants with the dead master in case he might require them in the next world.

‘I’m sorry about that,’ he said to Ju-Long and van der Zyl, ‘but at the end of the day we’re innovators in this shop, are we not, or we are nothing. And I’m afraid Gana is the kind of chap who’d have turned up on the quayside in 1492 and told Columbus he couldn’t set sail because of his negative risk assessment.’

Ju-Long said, with an asperity Quarry had not expected, ‘Risk was his responsibility, Hugo. You may have got rid of him, but you have not got rid of the problem.’

‘I appreciate that, LJ, and I know he was your friend.’ He put his hand on Ju-Long’s shoulder and gazed into his dark eyes. ‘But don’t forget that at this precise moment this company is about eighty million dollars richer than it was when we came in to work this morning.’ He gestured to the trading floor: the quants had all returned to their places; there was a semblance of normality. ‘The machine is still functioning, and frankly, until Alex tells us otherwise, I think we have to trust it. We have to assume VIXAL is seeing a pattern in events that we can’t discern. Come on – people are looking.’

They moved off, along the side of the trading floor, Quarry taking the lead. He was keen to get them away from the scene of Rajamani’s assassination. As he walked, he tried yet again to get Hoffmann on his mobile number; yet again he was put straight through to voicemail. This time he didn’t even bother to leave a message.

Van der Zyl said, ‘You know, I was thinking.’

‘What were you thinking, Piet?’

‘That VIXAL must have extrapolated a general market collapse.’

‘You don’t say.’

But van der Zyl missed the sarcasm. ‘Yes, because if you look at the stocks it’s shorting – what are they? Resorts and casinos, management consulting, food and household goods, all the others – these are just right across the board. They are not at all sector-specific.’

‘Then there is the short on the S and P,’ said Ju-Long, ‘and the out-of-the-money puts…’

‘And the Fear Index,’ added van der Zyl. ‘You know, a billion dollars of options on the Fear Index – my God!’

It certainly was a hell of a lot, thought Quarry. He came to a halt. In fact, it was more than a hell of a lot. Until that moment, in the general welter of data that had been thrown around, he had rather missed the significance of the size of that position. He stepped across to a vacant terminal, bent over the keyboard and quickly called up a chart of the VIX. Ju-Long and van der Zyl joined him. The graphic showed a gentle wave pattern in the value of the volatility index as it had fluctuated over the past two trading days, the line rising and falling inside a narrow range. However within the last ninety minutes it had definitely started trending upwards: from a base of around twenty-four points at the US opening, it had now climbed to almost twenty-seven. It was too early to say whether this marked a significant escalation in the level of fear in the market itself. Nevertheless, even if it didn’t, on a billion-dollar punt, they were looking at almost a hundred million in profit right there. Once again Quarry felt a cold tremble run down his back.

He pressed a switch and picked up the live audio feed from the pit of the S amp;P 500 in Chicago. It was a service they subscribed to. It gave them an immediate feel for the market you couldn’t always get from just the figures. ‘Guys,’ an American voice was saying, ‘the only buyer I have on my sheet here, guys, from about nine twenty-six on, is a Goldman buyer at fifty-one even two hundred and fifty times. Other than that, guys, every entry I have has been sell-side activity, guys. Merrill Lynch I had big-time seller. Pru Bache I had big-time seller, guys, all the way from fifty-nine to fifty-three. And then we saw Swiss Bank and Smith coming in big-time sellers-’

Quarry switched it off. He said, ‘LJ, why don’t you make a start on liquidating that two-point-five billion in T-bills, just in case we need to show some collateral tomorrow?’

‘Sure, Hugo.’ His eyes met Quarry’s. He had seen the significance of the movement in the VIX; so had van der Zyl.

‘We should try to talk to one another at least every half hour,’ said Quarry.

‘And Alex?’ said Ju-Long. ‘He ought to see this. He would be able to make some sense of it.’

‘I know Alex. He’ll be back, don’t you worry.’

The three men went their separate ways – like conspirators, thought Quarry.