CHALK AND CHEESE
cheese
chalk
To find illustrations of the love–hate
relationship between industry and academia
in finance, one need look no further than the
software trade. Dan Tudball talks to
Ron Dembo of Algorithmics, John Hull and
Alan White about their perspective on the
place where big bucks meet big brains.
24
N
utty professors. It’s
a stereotype in
industry; academ-
ics whose lack of
business acumen is
only matched by
the faith that they
are well on their way to their first
billion. Ron Dembo, founder of
Algorithmics Inc., the risk systems
company, can well remember the
outlook many in the market had
when he was starting what is now
one of the most successful compa-
nies in the sector. “I was looked on
as a professor who had too many
Wilmott magazine
CHALK AND CHEESE
There were a lot of
academics that set up
companies but there
aren’t many that remain
researchers running around and
doesn’t know how to run a business.
Too many researchers! Another pro-
fessor’s gonna blow up, whatever!”
The finance software industry is
at its most interesting, sociologically
speaking – some might say amusing
– when it plays host to the interac-
tion between academia and
industry. What are the various ways
that these two worlds might inter-
sect? We have software companies
26
set up and staffed by academics, à la
Dembo’s Algorithmics, software
firms may bring in the academic big
guns to work on a project – in this
article Wilmott talks to John Hull and
Alan White of the University of
Toronto on their collaboration with
GFI to create the Fenics Credit prod-
uct. Software firms get involved in
academic funding, and public
bodies fund academics to produce
commercial software. The permuta-
tions are many, but worth
understanding in a field like finance
where the codependency of the two
areas is so marked.
Academia nuts?
Ron Dembo sees himself as essential-
ly an academic, that’s everything he
did until he started Algorithmics. He
taught at Yale, a combination of
computer science and operations
research, and consulting in various
areas, a lot in engineering – particu-
larly hydroelectric power. One day
he did some consulting on Wall
Street. At that time there was no
such concept as enterprise risk,
there was no function in banks of
enterprise risk, as we know it today.
“It was kind of an academic’s dream
or a Wall Streeter’s dream that you
could put all the risk of a Goldman
Sachs or a Morgan Stanley in one
place and understand it all. I had
entered it not knowing much
finance at the time and just as a
mathematician this looked like an
obvious problem to solve. The bene-
fits, intuitively, were very obvious.”
It is this academician’s eye on
the world that Dembo feels marks
his approach and thus his company
out from the rest of the field.
Algorithmics has the largest staff of
quantitatively trained personnel in
the software industry. “The kind of
people you have to attract and man-
age, are academics – how do you
attract and motivate them? “It’s
very difficult to do this if you don’t
come from an academic back-
ground. It’s no coincidence
Algorithmics has the largest num-
ber of financial engineers of any
software company and it’s also a
team where there’s no attrition.
Even during the dot.com boom and
with mega salaries on Wall Street,
this is a very cohesive group that’s
hung around. I think knowing how
to create and manage that is an
academic role. There were a lot of
academics that set up companies
but there aren’t many that remain.”
Coming from academia to indus-
try can provide blessings, but in
some cases can be a curse. “Early on
in Algorithmics we did a lot of work
on exotic options and we published
a whole library of them; way before
this was being done except for in a
very few institutions. But our
biggest contribution was to sit back
and say, due to the fact that we were
so naive and had never been tainted
by real-world big finance stuff: ‘How
would you solve such a problem if
there were no constraints, and you
could choose to do so in any way you
wished?’ That’s the way I looked on
it as an academic, I said if I was
going to look at a bank this is
how I’d do it, in a completely
generic way. That’s the
academic advantage.”
But Dembo also feels that the
downside of academic contribution
can be an inability to veer from pro-
scribed approaches, an orthodoxy
that he often rails against. “An aca-
demic approach could be to go back
to a standard academic theory of
risk management i.e. Markowitz dat-
ing back to the 1950s, and it’s quite
amazing that nothing happened
between Markowitz and the late
1980s. And they said well okay get a
framework, variance, covariance,
we’re going to measure risk this way
and out came RiskMetrics. And it
was just standard academic finance
thirty years old being applied to
those problems, without a real
understanding of what the real
issues were. We had the advantage
of starting with the real issues. The
reason why Black-Scholes is so suc-
Wilmott magazine
 But our biggest contribution
was to sit back and say, due to
the fact that we were so naive
and had never been tainted by
real world big finance stuff:
‘How would you solve such a
problem if there were no
constraints, and you could
choose to do so in any way
you wished?’
Ron Dembo, Algorithmics
CHALK AND CHEESE
cessful is that the actual Black-
Scholes theorem is a constructive
essay on how to actually hedge, so
there the proof actually gives some
insight into how to manage risk, and
it’s beautiful. Since Black-Scholes
there have been three-gazillion
papers written on three-gazillion
variations of Black-Scholes that are
completely useless. They’re nice
mathematical exercises that are like
gymnastics, but the reason that
something like Black-Scholes stands
out is that it’s a marvelous piece of
work. That’s what all applied math
should look like. The constructive
stuff, just by reading the proof you
get insight and I’d say there’s very lit-
tle of that. This is a fortunate field
that had a really early paper, a
beautiful paper.”
Thanks largely due to their
reliance on the people who paid the
piper, Dembo feels Algorithmics was
on course to accelerate beyond a
market perception of an academic’s
pipe dream. “Everybody we were
competing with in the early days
was drawing on resources grounded
in finance and we took an approach
that was more mathematical, but
our bills were paid for by guys with
a real problem to solve. We
leapfrogged, we were clean, and
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we didn’t have to use so-called mod-
ern financial theory, which was a
major advantage.”
The company didn’t work to any
model that the finance industry had
yet seen succeed. Their capital was
heavily ploughed into research and
development, “… talking real
research here and not what’s called
‘research’ in the software industry,
but fundamental finance research
was extremely highly funded rela-
tive to our revenues all the way
along, to the extent that people
thought, ‘how on earth can he han-
dle money?’ And I think in hindsight
that’s probably one of the best
things we ever did because in a field
like this that is fast evolving, having
the ability to stay ahead of the curve
on research is extremely important.”
It isn’t rare to see university or
quasi-academic institutions funded
by public money to research and
develop what will hopefully become
something with commercial value.
This approach to funding can lead to
a lackadaisical approach to business,
Dembo suggests, requiring a huge
amount of self-imposed discipline.
Market forces provide natural disci-
pline. “I think it’s the way to do
things because you get the right
problems that way, you have to be
pretty focused, you can’t just dream.
So we founded the company without
any venture capital or any debt. It
was just consulting contracts I had
that paid me enough to hire two
people, then we had more work
which paid for two more and so on
to bootstrap that way. There’s room
for pure research, a need for it, a
need to dream about very cutting
edge out-there stuff. Finance is an
applied math field and demands
that nothing is terribly way out.
Things need to be more evolutionary
than revolutionary.”
Finance is an applied math field
and demands that nothing is
terribly way out. Things need
to be more evolutionary than
revolutionary
Industrial evolution
Dembo is of the opinion that
finance is one of those academic
fields where a lot of what you see
being done today has been driven by
industrial need. Academics have not
for the most part identified the
opportunities that the finance
industry was offering. He was one of
the early converts when Goldman
Sachs began hiring mathematicians
in the late 1980s, being hired to look
at optimization problems on the
recommendation of Steve Ross.
“Steve Ross said to me what are
you doing in hydroelectrics when
you can do the same thing in
finance and get paid better? So up to
that point I was a kid of the 1960s
where money was real dirty. I used
to avoid finance, I used to have the
top people in finance just around
the corner from me at Yale and yet I
knew no finance. It was a shame in
hindsight; so I started directing my
consultancy towards that.”
“When Goldman Sachs hired me
in 1986 I just thought these were
two brilliant guys running
Goldman Sachs, Ruben and
Friedman who intuitively said the
next war in finance would be
on mathematics and they thought
they’d better gear up with
mathematical experts. I was
not hired because I knew any
finance; they hired me as an expert
in optimization.”
Dembo recalls that Goldman at
that time was better than the best
university, “It had every top star
floating around and I couldn’t
believe it. It was like going to a top-
notch university and getting paid
for it. But that was their brilliance,
it wasn’t academics that pushed, it
was a few brilliant people on Wall
Street who saw that the industry
would become more mathematical
and they never gave up.”
Top management at Goldman
Sachs communicated their vision
thus “Picture yourself as a general in
1910 and you’re going out to this
wild weird guy called Henry Ford
and out of this factory comes this
clunky looking vehicle off a produc-
tion line and you say, ‘my God, the
next war will be fought with tanks,
I’d better get into this.’ Meanwhile
the nay-sayers are saying people will
never want to drive cars. Those
Goldman Sachs guys were watching
the first cars come off the line.
Institutions, tier 1 banks that were
not on Wall Street were not on the
ball and did not build up their
mathematical capability, that
Wilmott magazine
came later once they saw the success
that Goldman Sachs and Morgan
were having.”
The industry visionaries had the
idea to bring in the mathematicians
and mathematicians began to
become useful. Dembo and others
were seeing problems saying, “My
God. Use some modeling here and
we can improve this!” He sees much
the same relationship in
Algorithmics’ core area of enterprise
risk. “In enterprise risk the business
needs, the regulatory needs have
driven an awful lot of research –
there’s the finance departments
being driven by what’s happening in
the industry. Software companies
have taken a big role. Look at
Alphanumeric, who Sungard bought
– they were trying to solve a prob-
lem; they said, ‘here’s credit risk, it’s
hard to calculate, maybe there’s a
way to approximate it mathemati-
cally,’ so it was driven by a real need
rather than someone just dreaming
about it.”
Enterprising initiative
Exposed to the industrial needs of
finance through his stint at
Goldman Sachs, Dembo lighted on
the area of enterprise risk as a des-
perately important one; whether the
rest of the industry knew it or not.
“The enterprise risk problem fasci-
nated me, that there wasn’t a single
institution in the world that could
look at its risk as a whole. I thought
that was fundamental.
Furthermore, no one could define
what he or she meant by risk. Risk
was synonymous with variance, a
view that was 100 years old. The area
seemed a ripe and interesting one.”
When the early partners started
to build an enterprise risk system,
there was nothing being written on
the subject, no methodology avail-
Wilmott magazine
able. “So if you said to somebody ‘I’m
going to simulate combined market
and credit risk across an entire
multinational financial institution,’
they would have said it couldn’t be
done. I had a very interesting experi-
ence wherein an academic who was
writing a book on risk management
happened to let me see an early
chapter and in it said it’s impossible
to link market and credit risk, and
this is four years ago. Today it’s like
motherhood, you can’t argue with
the fact.”
“I started Algo with a consulting
contract to Repsol Petroleum to
measure their enterprise risk. This is
1987, we’re looking at an oil compa-
ny measuring paper trading and
physical trading and you know full
of complexities that even today big
oil companies don’t do.”
In those early days exotic options
were not around in any great quanti-
ties, credit derivatives had never
been heard of, derivatives on broad-
band had never been heard of, the
Internet bubble had yet to occur.
“And yet we were trying to solve
some of those problems and also try-
ing to think of how we would actual-
ly measure risk. So, one of the things
that surprised us was I just pre-
sumed all finance people had got
their heads around risk because they
knew that to measure all this was
really an IT problem.”
Dembo recalls early forays
attempting to market his product,
“they’d look at us and say ‘why
would we need one of those?’ First
you’d have no one to talk to. Then
you’d be talking to a trader who
would say, ‘Nice, but why would I
want one of those when it’s basically
going to screw me!?’”
“So we ended up selling to banks
in South America where people had
problems they didn’t have in North
America and just couldn’t get soft-
ware to solve it. For example in
Brazil you had 3000 per cent infla-
tion and you’d wake up and the
futures market had gapped by 15 per
cent. If that happened in a major
market it would be a serious tragedy.
Those guys were selling and buying
options and asking how could they
hedge them. So we got some really
avant garde thinkers down there
who were lending money and col-
lecting at 3000 per cent! Good days.
They had money to spend on soft-
ware to look at risk in a different
way. We tapped that market and in
Nice, but why would I want one
of those when it’s basically
going to screw me!?
fact the guy who runs our business product although we wouldn’t rec-
there is one of our original clients. ommend that they do that. But it’s
It’s thanks to people like because RiskMetrics was in some
RiskMetrics, Goldman Sachs, sense stamped and the way to go
Morgan who legitimized what we early on that some clients still decide
were doing, by that stage we had a to do it that way. We had a brand as a
product. But if they hadn’t we’d have risk supplier. They took our machine,
been struggling somewhere in but if we were going to be religious
South America to this day.” we’d never do RiskMetrics. What’s
funny is we came out with a standard
Voltaire 2.0 which to this day is the only pub-
Dembo’s particular ax to grind is the lished standard of how you might
topic of blind faith and inflexibility. integrate the market to credit risk
He feels it is the death of industry called Mark-To-Future. We were peed
and knowledge. But he’ll defend to on from every corner on this one.
the death someone else’s right to And what’s funny about this one is
practice whatever religion they that if you look at the way that risk
wish.” We have clients who use the systems are evolving in banks and
RiskMetrics VaR, which is one of the outside banks, they are in fact evolv-
options that you can pull out of our ing towards Mark-To-Future.”
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CHALK AND CHEESE
Things go wrong when people ment. The worst mistake I’ve seen is
get too religious, he avers. “You get people get too religious. It happens
an academic who’s got a particular all the time.”
religion and they try to get a square
peg in a round hole, they keep on Credit due
pushing the peg ignoring the fact Matt Woodhams, Global Product
that the hole is round. They beat Manager Analytics at GFI , is a disci-
stuff and it dies in the process. You ple of flexibility. He has the pleasure
can’t be too religious. Being non-reli- of working with John Hull and Alan
gious you can still have your own White on GFI’s Fenics Credit offer-
view, and make money too – agnosti- ing the pricing and portfolio
cism works best in this environ- management tool for CDS, FDS,
options on default swaps and cance-
lable default swaps. The tool
includes exclusive models built in
SKOOL RULES cooperation with Hull and White
A number of commercial entities make it a point to and utilizing the GFI credit deriva-
interact with academia as often as possible. tive data feed.
Working with the two award-
“We have a project that we started quite a long time ago called Risklab – winning Toronto-based academics is
we offered a deal, universities are offered free access to our software, a breeze – no nasty religious clashes
everything, if they put in enough effort to actually run it. There was no here. Woodhams explains just why
contract, the research belonged to them and there was no need for the two are so suited to these kinds
them to do stuff for us. That was based on the idea that no matter how of partnerships. “Alan and John’s
much research we did internally we could never do enough, so we work is noted for its applicability
wanted to create a leverage research environment with academia. We’ve and this has been de”monstrated
got a fairly successful group of Risklabs around the world. The problem whilst working on version one of the
is it’s not a zero-cost thing. The university has to put up significant product. We didn’t intend to
money to put in place an enterprise risk system and we don’t have the include options on CDS but as we
money to do that. So universities or sponsoring banks have to come up were developing and working
with the money. One of these is the University of Toronto. In addition to through the product the market
that we get involved in setting up a math finance program in Toronto, was starting to take some interest in
one of the earliest ones. We helped fund that. We lend our people, Dan the area. We had a conference call
Rosen lectures there; I lecture there, Andy Aziz lectures there. We’ve with one of the senior broking man-
had a constant contact with academics probably not enough. I’d like agers here, and from that John and
to do more.” Ron Dembo, Algorithmics Alan went off and started to build a
“We have sponsored seminars at the Courant Institute in New York. model or a framework that would
It’s part of our commitment to keeping abreast of leading-edge actually work with Fenics so we
approaches. Through involvement of this kind we hope that we help to were able to react to the market
facilitate further development in the field.” Thorsten Schmidt, Instinet changing very quickly, and that is
“A large number of our guys are coming from some kind of engineer- very attractive to a company like GFI
ing discipline. They are essentially academics. What’s exciting about which is working in a fast-moving
working in the Software industry is that no one day replicates another – environment.”
there is variety and that helps to keep it engaging. This is an important Fenics Credit’s calculations are
motivation. At a company level we support an academic program in made from the underlying credit
Canada called MITACS which is a network of math related academics default swap market rate as opposed
looking at various policy applications.” to the equity or bond based models.
Owen Walsh, VP Analytics, FinancialCad “Right throughout the derivatives
market what people want from a
30
derivatives model is to price new
deals consistently with deals that
they can observe the prices of out
there in the marketplace,” explains
Hull. “The sort of idealized notion
we have of a model is that we give
the model parameters in order to get
a price. But that’s not really the way
that models are used in practice. In
practice models are used to price one
deal consistently with other deals.
An example is the Black-Scholes
model where you imply volatilities
from the price of deals that trade
actively and you use those to imply
volatility to price other deals and the
big advantage of the GFI software is
that it does exactly that. Quotes
come across GFI’s desk every minute
of every day and form the database
of where the market is as far as the
credit default swaps are concerned.
That database is the basis for our
modeling. That’s a very direct use of
data to come up with the price of
instruments. Using equity markets
and Merton’s model and that sort of
thing is not really what the market’s
looking for as far as pricing is con-
cerned. ‘how much should I pay
right now for a seven-year CDS for
Ford Motor Company? Seven-year
CDS on Ford don’t trade that actively
but we know that five-year CDS
where they are right now and we
have some other information where
the term structure on credit spreads
on the market are right now. So
therefore we can deduce a seven-year
should be about there. That’s our
approach – it’s very much feeding
off market data than a sort of model
such as a model feeding off equity
prices which are one stage removed
from the credit market.”
The process
The production process is testament
to the power of telecommuting.
Wilmott magazine

I don’t know if you’ve ever
worked in the software
industry but you have these
customers who are not the
easiest group of people
“There’s a team of programmers in
New York who develop the code and
we communicate with those pro-
grammers In the past we provided
C++ code – but the providing VB
code is working well as far as the GFI
relationship is concerned.” says
Hull. White adds a little more detail
as to how this process works. “We
mark it up in Excel spreadsheets.
We talk to Matt quite extensively as
to what the job requires. The
theoretical development is marked
up in an Excel spreadsheet and we
transmit those to John and Matt
who pass them onto the program-
mers; we use the spreadsheets as
test frames to make sure the theory
works properly.”
This isn’t the first collaboration
that Hull and White have made with
a software firm.
The first of these was
Renaissance Software, which were
taken over by Sungard and merged
with Infinity. There was FNX
bancware and now GFI. The
Renaissance and FNX contracts ran
their course. “They were not
renewed due to various reasons,”
Hull explains, “in Renaissance’s case
it was due to the Sungard takeover.
FNX never really got its interest rate
product off the ground. Bancware is
a long-standing relationship in the
Wilmott magazine
CHALK AND CHEESE
Alan White
asset liability area.” But there must
be other advantages for an academic
getting involved with a large com-
mercial operation. White chuckles
as he says, “ I don’t know if you’ve
ever worked in the software
industry but you have these cus-
tomers who are not the easiest
group of people. And I would say
anyone getting into this line of
business without knowing about
the customers is in for a rude awak-
ening. Organizations like GFI have
built a large customer-support
group, have a lot of experience inter-
acting with customers and as a
result they take care of those
thorny problems.”
Hull and White perfectly
represent the sort of virtuous circle
that can develop out of an inclusive John Hull
view on the relationship between
industry, academia and commerce.
“Virtually everything we’ve ever
done has been aimed at applica-
tion,” says White,”and so to paper for the Journal Of Derivatives derivatives, then VaR stuff, now
commercialize the projects is a about first to default credit default we’re working on Credit Default
fairly straightforward and natural swaps, at the same time we’re devel- Swaps. We tend to move with the
thing. A lot of academic research is oping software with GFI and we may market – whatever the market
not terribly applied there would be be getting some consulting work thinks is a hot area at any given time
quite a lot of difference there.” “In done elsewhere. There are certain and that’s the big advantage we get
fact there is not a lot of difference; “ topics that become, shall we say, hot this synergy because it’s also the
expands Hull,” it’s amazing how at any given time, our services are in area where people want consulting
much synergy there is between the demand across the board. If we go and want software development. So,
different activities. We may write a back, it used to be interest rate we don’t run into conflicts.”
W
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