Hedge fund Two Sigma, which holds more than US$60 billion in assets under management, took more than four years to address investment model vulnerabilities, the SEC has found.
Two Sigma employees were aware of vulnerabilities in some of the firm’s algo investment models which could negatively impact client returns in or before March 2019, the SEC reported in its investigation. Concerns were raised that staff had complete read and write access to a database holding the parameters for some live-trading models, and could therefore make changes to these metrics without approval.
Initially, model code for Two Sigma’s live trading system was stored in the ‘Jar’, a secure file that could only be updated by the company’s engineering team. However, as the parameters needed to run the models grew, researchers began to store larger samples in a database called celFS. This database was accessible by researchers and various other personnel, the SEC said.
Connecting these parameters to code in the Jar, some researchers altered the impact of the ‘official’ parameters. “This use of model parameters was important to Two Sigma because it removed redundancy that could result in Two Sigma buying or selling more or less of a specific security than it otherwise desired or intended,” the SEC stated in its report.
In early 2019, employees alerted senior management to this practice. Various individuals and groups, including a TwoSigma co-founder, proposed solutions, but a consensus was not reached on how to best deal with the issue.
The subject was considered a number of times over the following years, including by a senior engineer who wrote in January 2022 that “[i]t is […] dangerous to allow this and efforts are in place to limit and eventually allow only data engineering to have write access”.
Two Sigma did not take action on the issue until June 2022, after an employee accidentally overwrote several models’ parameters. The changes were reversed before market open, and Two Sigma limited access to model parameters stored in celFS to certain engineers. Changes to the models would have to be submitted by written request.
Regardless, between November 2021 and August 2023, a modeller with this access made changes to the decorrelation parameters of 14 live-trading models – many of which he had developed or assisted on himself. Some of the alterations were executed without detection, increasing expected correlation to other Two Sigma models.
However, the modeller also submitted requests for changes as Two Sigma required. “He knew, based on his understanding of the ticket process, [that these] would not be substantively reviewed or questioned,” the SEC said.
These changes prompted investment decisions that would not otherwise have been made, and as a result, some client funds and separately managed accounts overperformed by more than US$400 million – while others underperformed by US$165 million.
It was not until August 2023 that Two Sigma began monitoring the celfS database, and identified the alterations.
In November 2023, senior vice president and quant trader Jian Wu was accused of making these unauthorised changes.
Wu subsequently petitioned the Supreme Court of the State of New York to release the names of those who informed Two Sigma of the action, claiming defamation. The case was disposed in March 2024.
In the petition Wu’s attorney stated: “In truth and in fact, as Two Sigma […] well knew, Two Sigma had no policy or practice covering the changes that petitioner made and any purported loss was a result of Two Sigma’s abysmally weak controls and reckless investment decisions.”
Two Sigma failed to introduce written policies and procedures and to supervise employees, the SEC stated. It also noted that departing employees were asked by Two Sigma to “state as fact that they had not filed a complaint with any governmental agency” between 2019 and 2024. These actions were in violation of the commission’s whistleblower protection rule, it said, discouraging individuals from contacting the authorities at risk of their post-separation payments and benefits.
Two Sigma Investments and Two Sigma Advisors (Two Sigma) neither admitted nor denied the SEC’s charges, but has agreed to a cease and desist order imposing a censure and a US$45 million penalty to both its investment and advisory businesses. Impacted funds and accounts were repaid the US$165 million during the investigation.
On the SEC’s announcement, a spokesperson for Two Sigma said: “After proactively reporting the issue in 2023 and promptly remediating negatively impacted clients, Two Sigma is pleased to have reached a resolution with the SEC, putting this matter behind us. We are committed to acting with the utmost integrity and have made a range of enhancements to our operational policies, procedures, and oversight. We are focused on the future and delivering value for our clients.”
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