With gross annual returns of over 60% on average, Renaissance Technologies’ (“RenTech”) famed Medallion Fund’s performance dwarfs that of most other funds, let alone the S&P 500. Yet despite its fame, little is known about how it operates and generates its industry-leading alpha. The fund, helmed by ‘The Man Who Solved the Market’ Jim Simons, derives much of its allure from its secretive quant techniques that few are privy to.
However, a patent application by RenTech in 2015 offered a window into the firm’s operation. The subject of the application was the firm’s “novel” invention that is capable of executing time-synchronized trades in multiple exchanges.
The Problem:
Commonly, when a trader places a large order for a financial instrument that cannot be filled cost-effectively by a single financial exchange, the order is divided into smaller orders that are then routed to multiple different exchanges. Unfortunately, the orders arrive at the different exchanges at different timings due to latency differences and congestion of networks. This allows high frequency traders who detect the smaller orders that arrive at faster exchanges to ‘front-run’ the smaller orders that arrive at slower exchanges (by purchasing the financial instruments at the slower exchanges and selling those instruments at a higher price to the trader when the smaller orders arrive).
The Solution:
To tackle the problem, RenTech strategically installs a plurality of servers co-located near the respective financial exchanges. The firm then sends trade instructions containing the smaller orders with an execution time from their trading server to these co-located servers. These co-located servers then submit the smaller orders at the execution time whereby the orders are received at the different exchanges simultaneously (partly due to the sheer proximity of the co-located servers and the various exchanges), thus addressing the problem of time lag between different exchanges.
The Trading System that RenTech Filed a Patent for
The Verdict:
If you’re thinking “this system doesn’t seem too complicated, RenTech’s simply locating their co-located servers near the various exchanges and coordinating trades from there so as to circumvent the time lag between exchanges”, you’re not alone. In fact, the Judges think so too – RenTech’s patent application have been unsuccessful across the globe (US, Canada, Japan, Great Britain, etc.)
In the decision released by UK’s Intellectual Property Office, the Judge and examiners classified RenTech’s system as a business method and computer program that does not address the technical problems of network congestion and latency but instead circumvents it. As no contribution is made to making the computer operate in a new and more efficient way, RenTech’s system is no more than an “administrative step regarding the timing of transactions”.
“Sending of a transaction execution time in the instructions concerning each smaller transaction order so they are received substantially simultaneously amounts to no more than an administrative step regarding the timing of transactions, which falls solely within the business method exclusion”
Our Takeaway
Behind the mysterious gates of RenTech’s mysterious dungeon does not lie a magical solution incomprehensible to all but the firm’s employees. While it has to be acknowledged that their funds have been the market-leader for data-driven quant returns, one must not fall prey to deifying anything and everything they touch. Sometimes, all it takes is a curious mind to debunk the mystery – one question at a time.