According to D. E. Shaw: Strategy Reverse-Engineering Risk

“If you can’t join them, beat them.” – Mort Sahl

In accordance with Rule 24b-2 of the Securities Exchange Act of 1934 (the “Act”), D. E. Shaw & Co., L.P., on behalf of D. E. Shaw & Co., Inc. and their affiliates (collectively, the “Firm”), hereby requests confidential treatment of the information contained in the enclosed Form 13F for the quarter ended September 30, 1998 (the “Form 13F”). Such request is made pursuant to Section 13(f)(3) of the Act, which allows the Securities and Exchange Commission (the “Commission”) to prevent or delay public disclosure of information contained in the Schedule 13F. The Firm believes that the information contained in the enclosed Form 13F falls under Exemption 4 of the Freedom of Information Act (“FOIA”), which states that “trade secrets and commercial or financial information obtained from a person that is privileged or confidential” may be withheld from disclosure.

In addition, in accordance with Rule 24b-2 of the Act and with Interpretive Release No. 65 under the Freedom of Information Act, the Firm requests confidential treatment of this letter. As a result of the exceptional nature of our request, which has been discussed in telephone conversations with the Commission staff (see generally footnote 1), we have provided certain details concerning our client-based businesses and client relationships. Such details go well beyond the ordinary level of information that would regularly be revealed in a typical request for confidential treatment, but such details were viewed by the staff as necessary information in their consideration of our request. Therefore, we believe that confidential treatment of our request itself is necessary to preserve the confidentiality of the Form 13F information for which this letter requests confidential treatment.

We are requesting confidential treatment of information for items 1 through 8 of all security holdings included in the accompanying Form 13F (the “Subject Information”). As noted above, in accordance with Exemption 4 under FOIA, we make this request, in part, because the Subject Information reveals portions of the Firm’s proprietary and confidential financial algorithms, trading strategies and other intellectual property. In addition, the Subject Information contains financial information obtained from clients, such as their individual security holdings and these clients generally expect, and at times specifically request, that this financial information be kept confidential. We believe that disclosure of the security holdings on the Form 13F may enable competitors to “reverse engineer” our algorithms, strategies and other intellectual property or to obtain confidential information on positions held by the Firm’s clients. If competitors “reverse engineered” the Subject Information to simulate or even approximate our intellectual property, this would cause substantial commercial and competitive harm to the Firm. If position information of certain of our clients became publicly available, it could threaten the ability of these clients to successfully pursue their trading strategies and, in turn, impair the Firm’s relationship with its clients. The Subject Information reported on Form 13F must be kept confidential to avoid the competitive and other harms noted above, all of which, by extension, would harm the investors whose assets are under the Firm’s management.

This letter describes the business units in the Firm and how revealing the positions reported on the Form 13F will also reveal the trading strategies of the Firm or its client information. The following business units will be discussed: three US equity trading units, one US equity-linked securities unit, one convertible arbitrage unit, and one customized derivatives unit. All of these business units have been described previously by the Firm in prior letters requesting confidential treatment for Form 13F filings with the Commission, and in telephone calls with the Commission’s staff, held in connection with those letter and at the staff’s request.¹

US Equity Units

Three of the business units whose positions are reported on the Form 13F essentially rely on the same trading strategy. Traders of the business units that employ this strategy generally do not determine the particular stocks and the quantities of such stocks that should be traded to implement the strategy. Instead, positions are largely determined by a mathematical model, which takes into account certain factors relevant to the equity market. The Firm’s researchers have identified such factors over time and through detailed analysis of market information. As discussed in more detail below, the disclosure of the Subject Information creates two main risks for the US Equity Units: (1) competitors could learn which factors the underlying trading strategy analyzes and relies upon and thereby “reverse engineer” this trading strategy, and (2) competitors could use the Subject Information to verify their approximations  of this trading strategy.

Quantitative competitors may be able to “reverse engineer” significant parts of the Firm’s trading strategies by analyzing the positions reported in the Subject Information and potentially isolating factors upon which the underlying trading strategy relies. The type of information that we report in the Form 13F is not available publicly, and the Firm dedicates much time and expense to preserving the confidentiality of such information. Consequently, a competitor trying to isolate from publicly available market data the factors upon which the Firm relies would need to engage in years of research and spend significant amounts of money to develop a similar trading strategy. However, if a competitor were permitted access to the Subject Information, such access would permit a competitor to obtain the benefit of the Firm’s research without having to invest the time and incur the costs. Moreover, the use of this trading strategy by others would severely reduce the ability of the Firm to employ the strategy and thus would result in competitive harm.

With respect to the second risk presented by public disclosure of the Subject Information, if competitors collected the Firm’s Form 13F filings each quarter, they could obtain substantial information about the US Equity Units’ trading strategy and, with such a large base of information, readily verify their approximations of this strategy. Since a single Form 13F filing by the Firm may list more than 700 equity positions, our competitors could amass much information from various of the Firm’s Form 13F filings to use for this verification. The competitive harm noted in the previous paragraph would thus be exacerbated by the Firm’s competitors’ ability to verify their approximations of the US equity trading strategy.

US Equity-Linked Securities Unit

The Form 13F also contains information on the securities positions of the Firm’s US equity-linked securities unit (“US Equity-Linked Unit”). This unit resembles the Firm’s US Equity Units in that it also employs a quantitative, market-neutral trading strategy; however, the US Equity-Linked Unit’s underlying trading algorithm focuses on different instruments and market factors. Traders of the US Equity-Linked Unit generally do not determine the particular securities, and the quantities of such securities, that should be traded. Instead, positions are largely determined by a mathematical model, which takes into account certain factors relevant to the equity-linked securities market. The Firm’s researchers have identified such factors over time and through detailed analysis of market information. The disclosure of the Subject Information creates two main risks for the US Equity-Linked Unit: (1) competitors could learn which factors the underlying trading strategy analyzes and relies upon and thereby “reverse engineer” this trading strategy, and (2) competitors could use the Subject Information to verify their approximations of this trading strategy.

By analyzing the positions reported in the Subject Information, quantitative competitors of the US Equity-Linked Unit could isolate factors upon which the underlying trading strategy relies and thus “reverse engineer” significant parts of this strategy. A competitor trying isolate from publicly available market data the factors upon which the Firm relies would need to engage in years of research and spend significant amounts of money to develop a similar trading strategy. However, if a competitor were permitted access to the Subject Information, such access would permit the competitor to avoid waiting years to develop this trading strategy and to obtain the benefit o the Firm’s research without bearing the costs. Moreover, the use of this trading strategy by others would severely reduce the ability of the Firm to employ the strategy and thus would result in competitive harm.

If competitors collected the Firm’s Form 13F filings each quarter, they could obtain substantial information about the equity-linked trading strategy and, with such a large base of information, readily verify their approximations of this strategy. The competitive harm noted in the previous paragraph would be exacerbated by competitors’ ability to verify their approximations of the equity-linked securities trading strategy.

Convertible Arbitrage Unit

The Firm’s Form 13F also reflects the positions of the Firm’s Convertible Arbitrage Unit, which relies largely on a convertible arbitrage trading formula. Convertible arbitrage, the buying and selling of a convertible security and its underlying security, allows a trader to profit from perceived pricing inefficiencies between two securities. Arbitrage opportunities generally disappear as soon as other arbitrageurs become aware of the inefficiency – this may be within moments or months. The Firm’s arbitrageurs use a proprietary trading model, based on years of research and market exploration, which often identifies inefficiencies among “obscure” securities. As a result, the arbitrage opportunities in which we invest may last for months. During this period, the Firm can continue to exploit its identification of these inefficiencies (which the Firm regards as confidential and proprietary intellectual property) and increase its positions in an identified arbitrage.²

The Firm’s success in convertible arbitrage has inspired much curiosity among the other participants in this specialized market. The discovery by our competitors of our convertible arbitrage positions reported on the Form 13F would have four particular types of competitive harm. This discovery would, as further outlined below, (1) hinder the disposition of securities positions held in the strategy, (2) defeat future arbitrage opportunities in specific securities, (3) defeat the Firm’s ability to employ its model by giving competitors the opportunity to “reverse engineer” it, and (4) allow competitors to verify their “reverse engineering” efforts.

Due to the nature of the Firm’s convertible arbitrage trading strategy, public disclosure of the Firm’s securities positions would hinder, if not destroy, the Firm’s ability to dispose of these securities positions and continue to employ this strategy. Typically, the Firm participates in a given arbitrage for at least several months; thus, the information available in our recent Form 13F filings would convey the Firm’s trading model’s current convertible arbitrage selections, notwithstanding the 45-day delay between the Form 13F filing deadline and the report date. Knowledge by our competitors could severely impair, if not paralyze, the Firm’s ability to dispose of such current positions effectively. May of the particular securities traded by the Convertible Arbitrage Unit are relatively “obscure” and illiquid. If competitors become aware of our positions in these securities they could (and actually would be expected to) engage in trading to, if not hinder the Firm’s ability to liquidate these already “difficult to liquidate” securities, at the very least profit from this information at the Firm’s expense. You have indicated to us that confidential treatment has historically been granted during “programs of disposition,” since awareness of the intent to dispose of a given security can adversely affect the security’s liquidity and thereby hinder the seller’s ability to dispose of it profitably. We believe that much of our Convertible Arbitrage Unit’s trading falls under this historical basis for granting confidential treatment.

Additionally, competitors would be able to defeat the Firm’s ability to pursue future arbitrage opportunities in the particular convertible securities reported. Competitors could establish positions in these securities, which would cause the prices of these securities to adjust to eliminate further arbitrage opportunities. Competitors could also alter the natural price discovery process in securities markets by making purchases and sales that anticipated dispositions of securities by the Firm to liquidate or adjust its positions or that anticipated acquisitions of securities by the Firm to establish or adjust its positions.

Moreover, by analyzing the positions reported in the Subject Information, competitors could gain broader insight into the Firm’s convertible arbitrage selection model by gaining insight, for example, into certain classes of securities, historically isolated by this model for arbitrage and from which the Firm continues to profit. The type of information that is on the Firm’s Form 13F is not available publicly, and the Firm devotes significant time and expense to preserving the confidentiality of such information. Because the Subject Information filters out much of the irrelevant information present in publicly available market data, our competitors, if allowed access to the Subject Information, could “reverse engineer” parts of the Firm’s Convertible Arbitrage Unit’s trading strategy without having to undertake the years of research and suffer the expense that would otherwise be necessary to develop this strategy. Our competitors could unfairly obtain the benefits of the Firm’s research without bearing its costs.

Finally, as is also the case with the positions of the Firm’s US Equity Units and US Equity-Linked Securities Units, if competitors collected several of our Form 13F filings, they could amass substantial information about the Firm’s convertible arbitrage strategy and, with such a large collection of position information, readily verify their approximations of our strategy. The competitive harm noted in the preceding paragraphs would be exacerbated by other arbitrageurs’ ability to verify their approximtions of the Firm’s convertible arbitrage strategy.

Customized Derivatives Unit

Another business unit whose positions are reported on the Form 13F is Customized Derivatives Unit. With regard to activity that results in reportable positions, the Customized Derivatives Unity primarily writes a specialized type of over-the-counter call option to a relatively small number of clients (currently 10 to 15), who generally hold positions for several months to a year. The Firm is one of a handful of firms that deal in this particular investment product. The Customized Derivatives Unit takes long securities positions exclusively as a hedge against its clients’ option positions; therefore, its equity holdings directly reflect its clients’ positions. As more fully discussed below, clients of the Customized Derivatives Unity tend to have specialized interests, are generally aware of each other’s interests, and typically are known by the other Customized Derivatives Unit clients to transact business through the Firm. Therefore, clients of the Customized Derivatives Unit would be able to determine each other’s positions from the Subject Information, if such information were made available to them.

The Firm therefore believes that disclosure of the Customized Derivatives Unit’s positions on the Form 13F would have two deleterious effects. Such disclosure would (1) threaten the confidentiality of our clients’ positions, and (2) discourage clients from doing business with the Customized Derivatives Unit if the confidentiality of their positions cannot be preserved.

The Firm’s customized derivatives clients generally expect, and at times specifically request, that the Firm keep their position information confidential. In general, clients of the Customized Derivatives Unit are investors who are also members of the same social community one which shares certain philosophical tenets that appear to be reflected in the clients’ investment philosophy. This, the clients often are interested in investing in companies or industry sub-segments that operate in areas or manners consistent with the clients’ philosophical views. In addition, the clients are often interested in the same or similar specialized investment products and typically have been referred to the Firm’s Customized Derivatives Unity by other Customized Derivatives Unit clients. While our derivatives clients may discuss with other members of their community various companies or industry sub-segments which might be of interest to them, our clients generally do not, to the best of our knowledge, discuss with other members of their community the names or amounts of securities they actually purchase, the timing of such purchases or the exercise or other disposition of positions held, and often have represented to the Firm that they do not want their positions (and thus the investment decisions reflected thereby) made known to others. However, because customized derivatives clients generally are aware that they each transact business with the Firm, they would be able to determine one another’s positions from the Subject Information, if such information were made available to them. Since the Customized Derivatives Unit’s clients typically hold positions for at least several months, the information available in the Firm’s recent Form 13F filings would convey the Firm’s individual clients’ current holdings, notwithstanding the 45-day delay between the Form 13F filing deadline and the report date. Public availability of the derivative unit’s positions on the Form 13F would compromise the confidentiality expected by, requested by and due the Firm’s clients.

Further, if the Firm’s Customized Derivatives Unit’s holdings are publicly revealed, thus revealing the derivatives client’s positions clients might cease to do business with the Firm. Therefore, disclosure of the Subject Information could severely damage this specialized business, which the Firm’s Customized Derivatives Unit has developed over the past several years, and cause competitive harm to the firm.

For the above reasons, the Firm requests confidential treatment of the Customized Derivatives Unit’s positions on the Form 13F.

.          .          .

This request for confidential treatment is motivated by two factors. First, the Firm seeks to protect its intellectual property from those quantitative firms, like itself, that pursue highly specialized areas of research and employ sophisticated techniques of data analysis. Since the Firm depends heavily upon complex, quantitative trading, the competitive harm potentially caused by making public the Subject Information is expected to be expensive. If others were able to deduce the Firm’s confidential and proprietary information from the Subject Information, the Firm would expect, among other things, to suffer losses, to be unable to profitably pursue many trades determined by the Firm’s trading models, to suffer the devaluation of such trading models and to lose the benefit of years of research. In addition, the Firm believes that such a result would, among other things, discourage others from engaging in research to determine latent market efficiencies.

Second, this request for confidential treatment seeks to protect the interests of the Firm’s cleints. These clients have no interest in having their position information publicly known. In the case of the Firm’s Customized Derivatives Unit, the Subject Information could directly reflect the individual positions of the Firm’s clients. Therefore, if the Subject Information were made public, this would threaten the confidentiality of our clients and the relationships we have built with them. By damaging the Firm’s competitive position, this negative effect and the others noted above would ultimately harm the persons whose assets are invested in the Firm.

The Firm takes all reasonable and lawful measures to protect the confidentiality of information regarding the Firm’s intellectual property and other proprietary information, including its trading positions, by, among other things, entering into confidentiality agreements with certain employees, dealers and counter parties; limiting information provided to certain owners of the Firm; an refraining from any public discussion of such information. Similarly, the Firm takes all possible measures to protect client confidentiality.

The Firm therefore respectfully requests confidential treatment of the information on the Form 13F.

The Firm’s trading strategies and models have been and are expected to be used for an extended period of time. In addition, the Firm’s derivatives clients will continue to expect that information on their positions be kept confidential. Therefore, the Firm’s request for confidential treatment is being made for a period of one year. It is our belief that, after a one-year period, we will make further request for confidential treatment, unless, for example, the Firm’s current trading strategies will have changed sifficiently to render disclosure of the Subject Information relatively innocuous.

In accordance with paragraph b (2)(iii) of Rule 24b-2, the Firm consents to the furnishing of the confidential portion of the Form 13F to other government agencies or bodies and to the Congress. This material is not being filed with any Exchange at this time.

Again, please note that, as described above, we have requested confidential treatment of this letter in accordance with Rule 24b-2.

We thank you for your time and consideration in reviewing this request for confidential treatent. Please feel free to contact the undersigned at (212) 4**-0*** should you have any questions or require additional information.

 

 

 

 


Footnote 1: See letters from D. E. Shaw & Co., L.P. dated February 23, 1996; May 14, 1996; August 13, 1996; November 13, 1996; February 10, 1997; March 31, 1997; May 15, 1997; August 13, 1997; November 13, 1997; February 13, 1998; and August 14, 1998 regarding the Firm’s requests for confidential treatment of Forms 13F. The Firm further discussed its concerns in telephone calls with Eric Freed, Daniel Burton, Judy Gechter, and Karen McMillan, of the Division of Investment Management’s Office of General Counsel. Subsequently, the staff approved the Firm’s requests for confidential treatment of its Form 13F filings for the quarters ended December 31, 1995; March 31, 1996; June 30, 1996; September 30, 1996; December 31, 1996; and March 31, 1997 (letters from Daniel Burton, dated October 31, 1996 and April 25, 1997, and letter from Sarah Buescher, dated October 28, 1997).

Footnote 2: Two additional positions reported on the Form 13F are held by another business unit, which trades securities similar to those traded by the Convertible Arbitrage Unit.



At this stage in its development, Alphacution has processed hundreds of 13F filings across dozens of trading and asset management firms, most of which having earned significant financial success and status throughout the industry. Granted, few firms possess the length of history to have been around when 13F filings were still being posted by the SEC in PDF format. However, this letter – and the dramatic stamp, “Confidential Treatment Denied” – is unique among all others we have found so far, and an absolutely fascinating and informative peek inside one of those legendary firms as it seeks to protect its competitive advantage.

We will have more to say about the inherent tension between the need to protect intellectual property in the form of trading strategies and the need for transparency into certain aspects of key market actors later. In the meantime, please refer to our initial analysis of D. E. Shaw Group in the Feed post, The Legend of David E. Shaw: Hiding in Plain Sight.”


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By | 2019-08-09T09:42:12+00:00 August 6th, 2019|Alphacution Feed|

About the Author:

Paul Rowady is the Director of Research for Alphacution Research Conservatory, the first digitally-oriented research and strategic advisory platform uniquely focused on modeling and benchmarking the impacts of technology on global financial markets and the businesses of trading, asset management and banking. He is a 30-year veteran of the proprietary, quantitative and derivatives trading arenas with specific expertise in strategy research, risk management, and techno-operational development. Contact: feedback@alphacution.com; Follow: @alphacution.