The Death of Money

by James Rickards

  This gap in intelligence capabilities at the time is not surprising. Prior to globalization, capital markets were not part of the national security arena. Markets were mostly local, controlled by national champions in each country. Some banks, such as Citibank, were international, but they conducted traditional lending businesses and were not involved in stock trading. The CIA did not have capital markets expertise because it had not been required during the Cold War; markets were not part of the battlespace.

  As a result, when reports of possible terrorist insider trading rolled in after 9/11, practically no one at the agency had the experience necessary to evaluate how it might have occurred and its implications for national security. Fortunately, one senior intelligence analyst understood the implications quite well.

  Randy Tauss lives quietly in the upscale Washington, D.C., suburb of McLean, Virginia, not far from CIA headquarters. He retired from the CIA in 2008 after a thirty-seven-year career, mostly in the agency’s Directorate of Intelligence, the analytic branch. He is a brilliant physicist and mathematician who won numerous medals from the agency for his technical and deductive work. Although most of his work involved complex weapons systems, he won fame both inside and outside the agency for his role in solving the mystery of the 1996 midair explosion of TWA Flight 800.

  Tauss had another avocation, one not required in his day job but to which he applied the same passion he showed while working with weapons and technology. He was an avid stock and options trader who used his mathematics skills to look for small anomalies in options prices that could be traded to advantage in his personal accounts. He pursued this options trading with such vigor and over such a long period of time that he was almost as well known for it among his colleagues as he was for his intelligence analyses. When the story of insider trading surfaced in the aftermath of 9/11, it was no surprise that Tauss’s name came to the attention of CIA senior management.

  In October 2001, just weeks after the attacks, the CIA’s Office of Terrorism Analysis asked Tauss to serve as director of a project to consider whether terrorists might use advance knowledge of their actions to profit in financial markets, and whether the intelligence community could identify such efforts and possibly thwart the attack. Thus began one of the longest and most unusual analytic projects in CIA history.

  The effort was dubbed “Project Prophesy.” By the time the project wound down in 2004, almost two hundred finance professionals—including stock exchange executives, hedge fund managers, Nobel Prize winners, and floor traders, along with technologists and systems analysts—would be tapped to contribute their time and effort. Tauss led a massive undertaking that simultaneously modeled the mind of the terrorist and the mind of the Wall Street trader. He found that the two domains had more than a few things in common.

  Project Prophesy was formally launched in April 2002, and the core team assembled by the end of May. The first task was to create a threat board of potential targets for terrorist attacks and link those targets to publicly traded stocks that might provide advance warning through unusual price activity. These stocks included a broad list of airlines, cruise lines, utilities, theme parks, and other companies with symbolically important assets.

  By early 2003, the Prophesy team led by Tauss had reached out to Wall Street and other government agencies and assembled teams to participate in targeted panels to flesh out the practical details of Tauss’s theory. It was widely assumed that terrorists would strike again in some spectacular way. Would there be information leakage? Would a terrorist associate engage in insider trading? Could this trading be detected so as to identify the trader and his target? Would there be time to react and stop the attack? These were the problems Prophesy set out to solve.

  * * *

  My involvement with Project Prophesy began at the mountaintop Kaiser estate on the island of St. Croix, a site exotic enough to make the final cut of a James Bond film. The estate is a complex of three mansions connected by private roads on Recovery Hill overlooking the town of Christiansted on the north shore of the island. The centerpiece of the complex is the White House, a sprawling, multitiered, bleach-white International Style home with a large outdoor pool trimmed with the obligatory steel-post-and-Kevlar tenting reminiscent of the Denver Airport.

  I was there in the winter of 2003 for a private gathering of top financiers from the institutional, hedge fund, and private equity worlds to discuss the next big thing in alternative investing—a project to blend hedge fund and private equity strategies to optimize risk-adjusted returns.

  As typically happens at such gatherings, there was downtime for drinks and getting to know the other guests. During one such break, I chatted with the head of one of the largest institutional portfolios in the world. He asked me about my career, and I recounted my early days at Citibank on assignment in Karachi.

  That had been in the 1980s, not long after the shah of Iran had been deposed in the Iranian Revolution. Grand Ayatollah Khomeini became Supreme Leader and declared Iran to be an Islamic Republic guided by principles of sharia or Islamic law. This shift in Iranian governance placed pressure on Pakistan to burnish its own Islamic credentials. Pakistani president Zia-ul-Haq issued religious ordinances, including one that prohibited banks from charging interest on loans, something forbidden by sharia.

  Citibank had major operations in Pakistan. The idea of running the bank there without charging interest came as a shock to management. I was assigned to become expert in sharia and assist in the conversion of Citibank’s operations from Western banking to Islamic banking.

  I arrived in Karachi in February 1982 and went to work. Citibank’s country head, Shaukat Aziz, later prime minister of Pakistan, would occasionally pick me up at my hotel. In monsoon season, we would barrel through flooded Karachi streets choked with ubiquitous decorated buses and three-wheeled jitneys, speeding past vendors spitting bright red betel nuts they chewed for a buzz.

  As I told these tales to the fund manager, I noticed his face became taut and his stare serious. He motioned me to a corner of the deck away from the other guests. He leaned forward and said sotto voce, ��Look, it seems you know a lot about Islamic finance and you know your way around Pakistan.” My local knowledge was a little rusty since these things had happened decades before; still, I replied, “Yeah, I worked hard at that. I know Islamic banking.”

  He leaned in and said, “I’m helping the CIA on a project related to terrorist finance. They don’t have much expertise, and they’re doing some outreach. They’ve asked me to source whatever talent I can. If someone from the agency contacted you, would you take the call?” I said yes.

  For those too young to recall 9/11 and the aftermath, it is difficult to describe the mix of anger and patriotic fervor that gripped the nation, especially in the New York area, where many people lost friends or family members or knew someone who did. We all asked ourselves how we could help. The only advice we got from Washington was “get down to Disney World . . . take your families and enjoy life.” Here was the chance for me to do more than go shopping.

  A few days later the phone rang in my New York office. The caller introduced himself as part of the CIA’s Office of Transnational Issues in the Directorate of Intelligence. He asked if I would be willing to join a team looking at aspects of terrorist finance, specifically insider trading ahead of major terrorist attacks. He would send me a letter outlining the scope of the project. I agreed, the letter was soon received, and by the early summer of 2003, I was on my way to CIA headquarters to meet the rest of the Project Prophesy team.

  * * *

  Joining a project in midstream is never easy, because the rhythm and culture of the team are already established. But I fit right in because I had been on Wall Street longer than many of the volunteers and had more international experience than all but a few. Within months I became a co–project manager under Tauss’s direction.

  My first contribution
was to point out that the CIA’s objective was already being pursued every day by hedge funds, but for a different reason. The CIA was trying to spot terrorist traders, while hedge funds were trying to spot unannounced takeovers. But the big-data techniques applied to trading patterns were the same.

  Spotting suspicious trading is a three-step process. Step one is to establish a baseline for normal trading, using metrics like volatility, average daily volume, put-call ratios, short interest, and momentum. Step two is to monitor trading and spot anomalies relative to the baseline. Step three is to see if there is any public information to explain the move. If a stock spikes because Warren Buffett bought a large position, that’s not an anomaly; it is to be expected. The intriguing case is when a stock spikes on no news. The logical inference is that someone knows something you don’t. A hedge fund might not care about the origin of the hidden information—it can just piggyback on the trade. For the CIA, the observation became a clue. And the stakes were higher.

  Like any development project, Prophesy had its geek squad of programmers and systems administrators to design protocols for security, interconnectivity, and the user interface. The team combined the joy of a Silicon Valley garage start-up with the can-do culture of the CIA in a unique effort to preempt terrorism using the same information that viewers see every day on Bloomberg TV.

  The climax of Project Prophesy was a red team exercise in September 2003. Red teaming is a classic way of testing hypotheses and models by recruiting a group of experts as the “enemy,” then asking them to role-play scenarios designed to expose flaws in the original assumptions.

  Our red team membership was like a Pro Bowl squad, with all-star traders from the biggest banks, hedge funds, and institutional investors in the world along with some noted academics. In addition to John Mulheren, the team included Steve Levitt, a professor at the University of Chicago and an author of Freakonomics; Dave “Davos” Nolan, a hedge fund billionaire; and senior figures from Morgan Stanley, Deutsche Bank, and Goldman Sachs. In the somber days after 9/11, it was inspiring to see the private sector respond to requests for help. Hundreds of calls went out for expert advice, and no one ever refused. There was an awkward moment when one Wall Street CEO asked if he could travel to the CIA by private helicopter and land on the grounds at Langley, but he was politely informed this would not be possible.

  The red team was given a terror scenario and asked to think like terrorists and devise a way to trade on the inside information. We wanted to anticipate which markets they would trade in, how long before the attack they would execute the trades, the size they would trade, and how they planned to get away with the money. All this real-world expertise would be lined up against the theoretical results of Project Prophesy to see if we were on the right track and whether our proposed systems could catch what our designated bad guys were actually plotting.

  The assignments and plans were handled individually outside the agency like a take-home exam. The results were debriefed in a group session at CIA headquarters on a crisp day in late September 2003. The debriefing lasted all day. The investment mavens relished their chance to be bad guys and attack our models and assumptions.

  The most out-of-the-box approach came from John Mulheren. He said he would not trade before the attack but would wait until the moment of the attack and begin his insider trading after. He knew markets can be slow to react and that breaking news is often misreported or sketchy. This produces a window of thirty minutes or so after the attack when the terrorist could engage in insider trading while markets struggled to comprehend events taking place around them. The beauty of trading after the attack was there would be no telltale tape. Authorities might not even investigate that part of the time line. This approach closely mirrored what Mulheren had actually done on 9/11, as he later told us.

  Notwithstanding such creativity, the actions of the red team “terrorists” tended to confirm the Prophesy team’s own thinking regarding how real terrorists would behave. We had modeled terrorist trading from start to finish, anticipating that the insider traders would be not the terrorists themselves but rather members of the terrorist social network. We also concluded the insider trade was likely to be executed in the options market less than seventy-two hours before the attack to minimize risk of detection.

  We conceived an alarm system, too, compiling a list of the four hundred most likely target stocks. Baseline stock behavior was programmed so that anomalies were well defined. We created an automated threat board interface that broke the markets into sectors and displayed tickers with red, amber, and green lights, indicating the probability of insider trading. The system was complete, from the terrorist order entry to agents breaking down the terrorist’s door with a warrant in hand.

  By late 2003, we were nearing the end of the strategic study. It was a bit melancholy because our Wall Street brain trust would be breaking up. Due to the number of people involved and the degree of talent, it seemed unlikely there would be any such group assembling at the CIA for some time to come. The complete records of the red team exercise were compiled and added to our main Project Prophesy archives.

  Our job wasn’t quite finished, as by early 2004, Project Prophesy was ready to build a prototype watch center. When integrated with other classified sources, the system, ideally, would have the capability of interpreting, say, a scrap of pocket litter picked up from a suspected terrorist in Pakistan. The words cruise ship scrawled on it would be integrated with a red signal from the watch center on a public company such as Carnival Cruise Lines to bolster the case for a planned attack on a Carnival vessel. Either clue is revealing, but the combination is exponentially more telling.

  We found our project’s angel investor in one of the more unusual corners of the CIA’s universe. A firm called In-Q-Tel had been organized in 1999 to allow the CIA to tap into cutting-edge technology incubated in start-ups in Silicon Valley. There’s no faster way to be on the inside of innovation than to show up with a checkbook ready to back the next big thing. In-Q-Tel was conceived as an independent, early-stage venture capital firm—which just happened to be funded by the CIA.

  ■ MARKINT

  With In-Q-Tel funding a scaled-down team, Project Prophesy formally ended, and our group launched into a new phase called MARKINT, for market intelligence. This was a new branch of intelligence gathering to go along with human intelligence (HUMINT), signals intelligence (SIGINT), and a short list of other -INTs. MARKINT was a new milestone in the long history of intelligence collections.

  Over the course of 2004 and 2005, the team refined its behavioral models and created the code and network needed for a working prototype. In addition to the CIA’s Randy Tauss, our partners were Lenny Raymond, a visionary technologist, and Chris Ray, a brilliant applied mathematician and causal inference theorist.

  My role was to provide the market expertise, behavioral modeling, and target selection. Chris designed the algorithms and the signal engine. Lenny would weave it all together with a cool user interface. Randy ran the traps inside the agency and made sure we got funding and support. Together we had our own capital markets skunk works, after the famous black site in California where highly classified spy planes were designed and built. By early 2006, the system was running, and signals started coming in.

  The system performed beyond our expectations. We routinely picked up signals that indicated insider trading. These signals were from regular market players; there was nothing yet to indicate that the insider trading was terror related. Our project had no legal enforcement powers, so we simply referred these cases to the SEC and otherwise ignored them. We called this our catch-and-release policy. We were hunting terrorists and would leave ordinary Wall Street crooks to others.

  On Monday, August 7, 2006, the system flashed red on American Airlines at the open of trading. A red light was a way to spot a signal in a sea of sectors on the threat board. The metrics behind the signal showed thi
s one was extremely powerful, something like an 8.0 earthquake on the Richter scale. A quick scan of the news showed absolutely nothing on American Airlines. There was no reason for the stock to behave the way it was—a sure sign of insider trading on news not yet public.

  Chris Ray was operating the signal engine that day and sent me an e-mail that said, “There’s a possible terrorist-related event today. We did get a red signal on the open in AMR (American Airlines).” Chris and I were careful to document and time-stamp the signals and analyses in real time. We both knew that if a terror event occurred, it would not be very credible to look at the tape in hindsight and find something suggestive. We wanted to see things in advance and record them to prove the value of the signal engine.

  As it was, the day came and went, and the day after that, and there was no news of any terrorist threat. The signal started to look like a false positive.

  On the third day after the signal, Thursday, August 10, I was writing in my library at two a.m., not an unusual hour for me to work. A small television on a bookshelf a few feet from my desk was tuned to CNN with the sound muted. I glanced over and noticed a breaking news scroll across the bottom of the screen, together with images of London bobbies taking suspects into detention and exiting buildings with boxes of documents and computers. The scroll said that a terrorist plot to blow up airplanes was being taken down by New Scotland Yard.

  I quickly turned up the sound to take in the few details that were available. It was daylight in London, and the takedown of the planes operation had been proceeding for some time and was now being widely reported. It became apparent that the plot involved transatlantic airlines flying from London to the United States and targeted those with the most American citizens likely to be aboard. American Airlines was a prime target, although apparently a large number of planes had been threatened.