A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation 1st Edition
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"Mr. Bookstaber is one of Wall Street's 'rocket scientists'--mathematicians lured from academia to help create both complex financial instruments and new computer models for making investing decisions. In the book, he makes a simple point: The turmoil in the financial markets today comes less from changes in the economy--economic growth, for example, is half as volatile as it was 50 years ago--and more from some of the financial instruments (derivatives) that were designed to control risk." (The New York Times)
"Bright sparks like Mr Bookstaber ushered in a revolution that fuelled the boom in financial derivatives and Byzantine 'structured products.' The problem, he argues, is that this wizardry has made markets more crisis-prone, not less so. It has done this in two ways: by increasing complexity, and by forging tighter links between various markets and securities, making them dangerously interdependent." (The Economist)
"He understands the inner workings of financial markets...A liberal sparkling of juicy stories from the trading floor..." (The Economist)
"…smart book…Part memoir, part market forensics, the book gives an insider's view…" (Bloomberg News)
"Like many pessimistic observers, Richard Bookstaber thinks financial derivatives, Wall Street innovation and hedge funds will lead to a financial meltdown. What sets Mr. Bookstaber apart is that he has spent his career designing derivatives, working on Wall Street and running a hedge fund." (The Wall Street Journal)
"Every so often [a book] pops out of the pile with something original to say, or an original way of saying it. Richard Bookstaber, in A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, accomplishes both of these rare feats." (Fortune)
"a must-read amidst the current market chaos" (BusinessWeek.com)
"Bookstaber is a former academic who went on to head risk management for Morgan Stanley and now runs a large hedge fund. He knows the subject and has written a lucid and readable book. To his aid he calls mathematics (from Bertrand Russell to Godel's theorem); physics (particularly Heisenberg's uncertainty principle); and even -- meteorology." (Financial Times)
"The book covers a lot about risk management that is relevant to capital markets conditions today and the liquidity crisis." (Financial Times, Saturday 25th August)
"...an insider's guide to markets, hedge funds and the perils of financial innovation. We saw plenty of those in 2007." (The Sunday Telegraph, Sunday 25th November 2007)
"I cannot recommend this book too highly. It is a clear exposition of what the combination of derivatives, leverage and hedge funds can do to the markets.
In short, A Demon of our Own Design is a guide to the dangerous financial markets we have created for ourselves by the clever innovations of structured finance, derivatives, credit default swaps and other newfangled products that are a mystery to the ordinary investor and even plenty of the sophisticates in the investment business. To understand the demonic risks we're taking, read this book."--Forbes.com
From the Inside Flap
It's Wall Street's most painful paradox. Investors are more sophisticated than ever, are enabled by unprecedented technology, and protected by more government oversight and regulation than at any other time in history. Yet Wall Street is becoming a riskier and riskier place. Crashes and catastrophic losses seem commonplace. Hedge funds wreck on the financial shoals with a disturbingly familiar pattern. Worse, today's financial crises do not arise from economic instability or acts of nature, but from the very design of the financial markets themselves.
In A Demon of Our Own Design, Richard Bookstaber paints a vivid picture of a financial world that is ever edging toward disaster. As a hedge fund 'rocket scientist,' Bookstaber provides an insider's perspective to the tumultuous management decisions made by some of the world's most powerful financial figures from Warren Buffett to Sandy Weill to John Meriwether,as well as recounting his own contribution to market calamities. He designed some of the complex options and derivatives that, combined with the globalization of the world's markets and the ever-increasing speed of transactions, allow markets to slide out of control. And he explains why the best efforts of institutions on the front lines to create safeguards, manage risk, and regulate the markets may end up contributing to instability. Bookstaber argues that many of the financial innovations and regulations that are supposed to level the playing field instead make the markets more dangerous for all the players, big and small.
Drawing on his intimate knowledge of such infamous disasters as the 1987 Crash and the demise of Long-Term Capital Management, Bookstaber identifies the key areas that make markets vulnerable: liquidity that begets greater leverage; innovation that creates greater complexity; and a structure that demands a nonhuman level of rationality. The twofold solution he suggestsreducing complexity and breaking the tight coupling of transactionsgoes against the prevailing winds of Wall Street, but will lead to a more robust and survivable market.
- Publisher : Wiley; 1st edition (April 6, 2007)
- Language : English
- Hardcover : 276 pages
- ISBN-10 : 0471227277
- ISBN-13 : 978-0471227274
- Item Weight : 1.07 pounds
- Dimensions : 6.3 x 1.06 x 9.3 inches
- Best Sellers Rank: #636,526 in Books (See Top 100 in Books)
- Customer Reviews:
Top reviews from the United States
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The author explains numerous financial crises that occurred since the early eighties in technical details. However, on pg. 241, he synthesizes his analysis in just a few concise sentences. The 1987 crash was a vicious downward spiral caused by hedging actions (selling futures short associated with portfolio insurance) that reinforced the decline in stock values causing further hedging actions. The LTCM meltdown was caused by the forced asset sales at liquidation price triggered by creditors that resulted in further asset price decline. The dot.com bubble was due to the majority of traders being on the buy side of a very limited supply of hi-tech stocks that created a feedback loop of self-fulfilling prophecy. When dot.com IPOs met and exceeded investor demand, the market collapsed. In other parts of the book, he spends tens of pages on each of those crises. But, in a nutshell that is pretty much what they were about.
The key explanatory chapter is chapter 8 titled "Complexity, Tight Coupling, and Normal Accidents." Here the author explains how systems that are complex with many interconnected variables with unpredictable, nonlinear effects, that in turn are associated with tight coupling (denotes a chain-like reaction without much time to react or adapt to the consequence) are recipes for disasters. Those are called "normal accidents" meaning they are to be expected; but, you can't expect what they will be. So, you can't prevent them. "The more complex and tightly coupled the system, the greater the frequency of normal accidents." The author depicts numerous failures of complex systems with various levels of tight coupling including nuclear plants disasters (Three Mile Island, Chernobyl) and aerospace disasters (Challenger and Columbia missions that both killed seven crew members).
Financial derivatives make for perfect complex systems with tight coupling. They have numerous unpredictable nonlinear outcomes, high leverage, and lightning quick trading. Those characteristics make for what Warren Buffet called "financial weapons of mass destruction."
Adding to the vulnerability of financial complex systems is the "Butterfly Effect" (reference to Chaos theory). As financial models make even fractionally small errors, those tiny errors over multiple iterations compound and generate huge intractable outcome errors.
Another cause of complex vulnerability is scale. The business world has focused on economies of scale to extract a cost competitive edge. But, beyond a certain point scale does not contribute to economies but instead to complexities. In chapter 7 titled "Colossus" Bookstaber describes the forming of a financial conglomerate monster: Citigroup. He headed a market risk management group at Salomon that got acquired by Citi. And, he describes how the risk management function became unmanageable. Externally, tracking risk exposures globally in so many instruments, businesses, and geographies became impossible. Internally, the change in corporate scale expanded his risk management group to a dysfunctionally large level.
Bookstaber indicates that regulations does not work in reducing the risk within financial complex systems. By forcing banks to reduce existing risk exposures, they are forced to sell assets. Those forced sales cause asset values to drop further forcing further asset sales. This relates to Fisher's The Debt-Deflation Theory of Great Depressions . "Trying to control the risk ends up creating a liquidity crisis."
Forcing hedge funds towards increasing transparency is a self-defeating proposition. Hedge funds competitive edge are proprietary strategies. If their accounts become transparent, they pretty much go out of business.
Bookstaber makes an interesting connection between Heisenberg's Uncertainty Principle and finance (pg. 223). In the quantum world, you can't improve the measurement of an electron's speed without impairing the measurement of its location. In the finance world, you can't increase transparency without decreasing liquidity. As mentioned, transparency would impair the hedge fund sector. And, the latter is the major liquidity provider for illiquid assets. Without hedge funds many such markets would not be viable.
If upcoming regulatory constraints do not impair the hedge fund sector, Bookstaber anticipates it could become a dominant force within the institutional investment world. His take is that if you take two equally brilliant investors, and the first one is limited to "long" strategies only and the other one is not and can avail himself to all sorts of other investment strategies, the latter one should prevail. And, that describes the difference between a traditional mutual fund and a hedge fund.
However, that is one instance where I may question Bookstaber's opinion. The hedge fund has to deliver gross returns that are so much higher than the mutual fund because it charges so much more (1% operating expense and 20% of profits vs only the 1% for the regular mutual fund). Bookstaber suggests the hedge fund compensates for that because of the inherent leverage in hedge fund strategies. But, by doing so a hedge fund takes on risk that renders it much more fragile than a regular fund. Earlier, Bookstaber states that many hedge funds "win a little, win a little, than lose a lot." Thus, hedge funds blow ups are more frequent than mutual fund ones. Additionally, there is already too much money in hedge funds to chase too few market inefficiencies. This ultimately makes a case for neither hedge funds or regular mutual funds but index funds instead.
Bookstaber addresses the Efficient Market Hypothesis (EMH) in a most interesting way. He understands the subject better than most as he wrote his economics PhD thesis on the transmission of information through the markets. Bookstaber states that stock prices are driven by two components: one is information, and the other is liquidity factors. The EMH covers only partly the information component. That's because it makes some liberal assumptions such as that traders are perfectly rational, and that their actions do not affect the markets. But, the EMH does not cover the liquidity factors. Those include the actual float or supply of each stocks, transaction costs, and leverage constraints. And, often liquidity factors are the predominant drivers of investment prices. Bookstaber states on pg 213 "[liquidity] is the primary driver of crashes and bubbles as well." This makes sense. The information component is disseminated instantly and should be fully reflected in stock prices at all times (the EMH take). But, liquidity factors can get markets out of whack. As Bookstaber explained, the dot.com bubble was mainly fueled by a very small float (short supply) of hi-tech stock at the onset.
Bookstaber describes interesting statistical arbitrage strategies (paired stock trading) devised to differentiate between the information component of a stock price, that typically does not mean revert in the short term, vs the liquidity component that does. He indicates that this is easier said than done. As usual, the early traders who devised those strategies made a lot of money. But, the market is a rapidly learning machine and those Alpha returns were pretty much arbitraged out a long time ago. So, that's the puzzling thing about the EMH. The theory is far from perfect. Yet the markets are brutally efficient. Alpha returns depend on traders coming out with new investment strategies until they are replicated. At such point, they are forced to uncover Alpha returns some place else. So, efficiency is a moving target.
In the conclusion, Bookstaber makes recommendations on how to reduce the fragility of our financial system. We should reduce the tight coupling within the system. He proposes to do that by reducing leverage which in turn reduces liquidity and the speed of market activity (tight coupling). He also recommends selective evaluation of financial innovations to prevent dangerous complexities. Insiders will not like Bookstaber's recommendations and will argue that financial innovation has greatly improved wealth creation worldwide. But, you have to distinguish between benign vs complex financial innovations. It is easy to argue in favor of ATMs, debit cards, new mobile payment mechanisms, and online banking innovations. But, did we benefit from MBS, CDOs, and SIVs? Certainly not lately!
Top reviews from other countries
Of course, with all the horrendous financial upheaval from 2008 through to 2009, this book begins to take on a strongly prophetic tinge. The "just because we can do it, is wise TO do it?" question has become highly relevant, albeit somewhat sidelined by the big financial product-providers who have returned to the fray with ever more complex instruments, in the pursuit of that perennial holy grail - higher returns for lower risk.
This is an excellent, and very readable book. It clearly satisfies the needs of the techie, but I suspect that Bookstaber makes himself relatively accessible to a wider range of readers, by using memorable chapter-headings: "Long-term capital management rides the leverage cycle to hell" is one that stands out.
This book has value to the financial-planner because it makes you think very carefully about what you are prepared to put in your client toolbox. And the fact that the author's experience is primarily in the context of Hedge Funds is now less of a problem to me than it was - given the inexorable rise of the new 'smoke and mirrors' financial instruments - Absolute Return funds.
Like a previous reviewer, my one serious reservation about the book is that, whilst Bookstaber does admirably highlight the real dangers in the marketplace, he appears to have little to give us in the way of positive advice.
Having myself worked in the industry for over 15 years, I am occasionally temped to read the financial equivalent of a Mills & Boon novel, and I really enjoyed reading Michael Lewis's Big Short and Zuckerman's The Greatest Trade Ever, but "demon's of our own design", is not in that league. Maybe Bookstaber and me got off on the wrong foot, when he started blaming Mark-to-Market for the credit crisis.
The 'I was in the room when...' anecdotes are hilarious. Bookstaber seems to have been involved in every disaster in the last 25 years, mostly in positions where his chief responsibility was to avoid disaster. He is the Wall Street equivalent of Blackadder. Richard describes a situation at Citi, where a particular transaction is discussed in a risk committee. A transaction that had already lost the firm approx $100mln. As chief risk manager, Bookstaber suggests to increase the position ("I have a cunning plan" springs to mind) and then describes with surprise that "Charlie Scharf, Salomon Smith Barney's Chief Financial Officer, looked at me like I had three heads". Bookstaber to this day, clearly doesn't understand the role he was supposed to fill. This is 'jaw on the floor' reading for anyone who has ever wondered what the risk manager at LTCM was thinking.
When towards the end of the book, the much referred to cockroach anecdote finally comes, it illustrates Bookstabers shortcomings as a writer. The cockroach has survived through "many unforeseeable changes - jungles turning to desserts, flatlands giving way to urban habitat...". How? Wait for it "it's defence mechanism is limited to moving away from slight puffs of air, puffs that might signal an approaching predator." . Right, the puff of air that was the last ice-age....
Overal, the book is a hotchpotch of anecdotes from his career, and gives limited insight in actual risk management. Enjoy, but please don't think we're all like bookstaber....
We generally think of risk managers as "Don't do that, Maud" types. In fact the reverse is true. Far from preventing the firm from betting the farm, the risk managers job is to help to bet the farm, but only on a sure thing. Hence the development of risk strategies which allow firms to profit from market imperfections.
Bookstaber gives a history of these strategies, enlivened often by amusing anecdotes and a dry wit. Some of them (statistical arbitrage, for example) appear to have been invented almost by accident. All of them lose their edge over time and become just another part of the market with very low returns for the risk. Most users of these risk strategies provide liquidity to the market, which Bookstaber shows is necessary and (less convincingly) under-rewarded.
By this analysis the financial markets were almost programmed to blow up. Recessions and depressions come always from the financial markets to the real economy, not the other way round as Galbraith alleged.
Now that the crisis is upon us, what does Bookstaber recommend? If he had a good plan I'd elect him world president right away, but this is unsurprisingly the weakest part of the book. But he's good on what won't help. More regulations? Useless, because they'll only control the obvious. Ban short trading / hedge funds? Likewise. Better risk management? Of limited use, because some risk is unpredictable and so unmeasurable. He recommends eschewing the more exotic derivatives. No doubt they are already untradeable (and so worthless) but if someone wants to buy one you can be sure that Wall St will find a way to sell it. Less leverage? Well, we've already got that with a vengeance, without any new legislation.
I repeat: this is a terrific book, buy it. The author should be congratulated for not mentioning Faust or Prometheus once in 260 pages.
From nuclear disasters to plane crashes (still reasonable when talking about risk), but then on to Gödel's theorem and even to Heisenberg's imprecision principle. In my humble opinion, the writer fails to make the connection to financial risk and then goes on to make a quick turn to Jiu Jitsu.
As Bookstaber has gathered tremendous experience on Wall Street, I was hoping for more anecdotes and more detail in his narrative. Unfortunately, he remains on the surface.
To give one example to the point I am making: it is at different times requested in the book to reduce financial risk by making financial instruments simpler. But, not a single time does the author make a concrete suggestion as to what kind of financial instruments he is thinking about. For example go through a list of asset types and say which instruments are simple enough and which aren't. This is missing, so the reader is left with her own imagination as to what the author means by simpler financial tools.
Lacking clarity is a recurring theme of the book.