A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber
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Book Summary Information
Author: Richard BookstaberEdition: Hardcover
Audio: English (Unknown); English (Original Language); English (Published)
Published: 2007-04-06
ISBN: 0471227277
Number of pages: 276
Publisher: Wiley
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Book Reviews of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
Book Review: Essential context for understanding trading
Summary: 5 Stars
This is an entertaining account of 25 years of financial disasters by a smart insider who is also a keen observer and witty storyteller. Some authors take simple ideas and cloud them with hairsplitting definitions and complex equations, real mathematicians like Bookstaber effortlessly work in deep concepts like sufficient statistics and state variables without any equations or formal mathematics.
The best part of this book is the context. If you read books on individual disasters the situations come across as complex and the people as tragic geniuses. If you read the one paragraph versions favored by the business press, the underlying trades seem impossibly simple, and the protagonists seem to be morons. This book shows the euphoria of winning trades when money flows in like magic, and the confusion and shock that result from unanticipated losses. There are many reactions to these losses: cut them quickly, ride out the storm, even double up the bets. Each of these sometimes works and sometimes makes the situation worse. Only after reading all the permutations and outcomes can you understand the stark choices posed as the disasters unfold. The players are neither idiots nor geniuses, they are smart but ordinary people, facing understandable human dilemmas.
This context is precisely what is missing in the chapter on engineering disasters. If you look only at disasters, when by definition all the safety precautions failed, it's no surprise that you'll conclude safety precautions are worthless. If you only look at the most dramatic disasters, it's no surprise you'll conclude that the most ambitious, advanced, complex and tightly-coupled systems are the most prone to catastrophe. Bookstaber relies on writers I call the dismal engineers. I think optimists like Duke civil engineering professor Henry Petroski have more to say to financial risk managers. Petroski wrote "no one wants to learn from mistakes, but we can't learn enough from successes to advance the state of the art."
The chapters on biological, mathematical and quantum mechanical limits on rationality are interesting speculations. Bookstaber appears to know, or perhaps to care, more about these fields than about engineering. However even in these cases his thesis is not entirely convincing within the realm of discussion, nor is the analogy he wants to draw to finance compelling. There's another good book (or three) in these ideas, this book gives only a taste of the arguments.
Despite being a very smart guy with a quarter century of experience in cutting-edge trading, Bookstaber cannot overcome the disadvantages of being trained as an economist, especially an MIT economist. In the final analysis, he believes risk is bad. Trading is defended as socially useful when it provides liquidity, when traders exploit pricing discrepancies caused by short-term supply and demand forces. These traders stabilize the market. But at least half of trading is trend-following, which exacerbates pricing discrepancies and sucks up liquidity, destabilizing the market. To a University of Chicago finance guy, these are symmetrical market forces, both good. Bookstaber correctly points out how financially-supplied liquidity ushered in the Industrial Revolution by converting frozen wealth to dynamic capital. But he doesn't mention the momentum traders who forced prices quickly to their eventual equilibrium, sweeping aside those who try to stand in the way of progress. This is the creative destruction of capitalism. Economists are comfortable with the markets facilitating real economic decisions, spreading the inherent risk among willing investors. They are less comfortable with the market forcing real economic decisions, creating virtual risk and imposing it upon unwilling actors.
This anti-risk bias shows in the account of Tulipmania and the reflexive comparison of financial disaster to engineering disasters. No one died at Long-Term Capital Management. It's true that some financial crises, like the 1997 Asian Crisis, impose human costs, but financial crises are virtual, and therefore less harmful than the same degree of failure with physical economic experimentation, and far, far less harmful than the retarded progress if experimentation is slowed. Bookstaber celebrates the liquidity provided by a shrewd swimsuit retailer who anticipates fashion and supplies her customers' demand without excessive price increases. Nowhere does he mention the businesses that create fads, including swimsuit fashions, and thereby the need for liquidity providers. Economists like businesses that respond to exogenous consumer preferences, they have trouble with businesses that manipulate consumer preferences. But both are needed for successful dynamic economies.
None of this takes away from the fact that this is an entertaining and insightful book, essential reading for people interested in financial risk. I disagree with Bookstaber's conclusions calling for slowing market innovation and trading, but I think these are preconceptions from his early training rather than the result of his experiences since.
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Summary of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
Inside markets, innovation, and riskWhy do markets keep crashing and why are financial crises greater than ever before? As the risk manager to some of the leading firms on Wall Street?from Morgan Stanley to Salomon and Citigroup?and a member of some of the world?s largest hedge funds, from Moore Capital to Ziff Brothers and FrontPoint Partners, Rick Bookstaber has seen the ghost inside the machine and vividly shows us a world that is even riskier than we think. The very things done to make markets safer, have, in fact, created a world that is far more dangerous. From the 1987 crash to Citigroup closing the Salomon Arb unit, from staggering losses at UBS to the demise of Long-Term Capital Management, Bookstaber gives readers a front row seat to the management decisions made by some of the most powerful financial figures in the world that led to catastrophe, and describes the impact of his own activities on markets and market crashes. Much of the innovation of the last 30 years has wreaked havoc on the markets and cost trillions of dollars. A Demon of Our Own Design tells the story of man?s attempt to manage market risk and what it has wrought. In the process of showing what we have done, Bookstaber shines a light on what the future holds for a world where capital and power have moved from Wall Street institutions to elite and highly leveraged hedge funds.
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