A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

Reading this book five years after its release, one has to admire how prescient the author was. He gives you a brilliant insider account of all the ways our financial system has faltered and will falter. Less than a year after the book release the financial system crashed for reasons detailed in the book including leverage, liquidity, regulatory, and complexity issues. This book is superior to Taleb's just released  Antifragile: Things That Gain from Disorder  that covers the same subject.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!

In recounting his time as risk manager at a number of prominent houses (Morgan Stanley, Salomon Brothers, Citigroup etc.), Bookstaber completes the i-banking trifecta. First there was the Michael Lewis classic, Liar's Poker, detailing the juvenile bravado and macho antics of the trading floor. Then Jonathan Knee gave an intimate portrait of the i-banker deal making culture with The Accidental Investment Banker.And now, in A Demon of Our Own Design, we get a glimpse at the risk management side of things... a sort of master plumber's walking tour through the bowels of the system, with technical descriptions of exactly what happens when pipes burst and boilers explode. (Some will find Bookstabers' level of detail intolerably dull; others will find it quite fascinating. I was in the fascinated camp.)Nature of the beastIn describing the finer points of risk arbitrage, Bookstaber explains why it's normal -- expected even -- for trading desks to take a good whack every so often. The nature of the beast is to make relatively steady profits, month in and month out, and then give back a chunk of those profits when something goes haywire. (That's how you move huge sums on an arb desk; grind out small bets that are almost guaranteed to work, juice up the returns with leverage, and try not to be in the vicinity when the rare position goes kablooey.)In light of this general modus operandi, perhaps it isn't surprising that the "quant" funds recently took a major hit (as of September 2007). They had been minting money for an extraordinarily long period, had the leverage to show for it, and now, after the recent "oops," seem to be generally back in business.In fact it appears natural for much of Wall Street to work in this "make a little, lose a lot" fashion... the key idea being that all the little updrafts make up for the once-in-a-blue-moon downdrafts. (Such calculus works better for the fee collectors than the fee payers, but that's a different kettle of fish.)Bookstaber's detail-rich description of the various trades that investment houses put on, many of them lasting years, is also enlightening. The details seem to confirm that, by and large, Wall Street is a gigantic, slow moving, conventional-returns type machine. (And what else could it be, really, with such an ocean of capital to allocate and so many jobs to fill? There is only so much creativity and contrarianism to go round.)A dangerous combinationRisk manager war stories aside, Bookstaber's goal is to hammer home a key philosophical point regarding risk. He wants readers to understand that financial markets are inherently unstable, and this reality places limits on how far we (or anyone) should go in pursuit of outsized returns.To make his point, Bookstaber uses various analogies to describe how the market is a highly complex, tightly coupled system... and to explain why the combination of high complexity and tight coupling is particularly dangerous.The counterexample Bookstaber gives of a highly complex, loosely coupled system is the US Postal Service. The USPS has countless potential points of failure and myriad moving parts, but there are no catastrophic linkages involved. A lost package does not set off a disastrous daisy chain of events in which millions of packages are lost.In contrast, the classic example of a highly complex, tightly coupled system is a nuclear reactor. The reactor is tightly coupled because any point of failure can lead to a knock-on chain reaction; one small thing going wrong can set the entire mechanism on a path to disaster. Being a highly complex, tightly coupled system, the market is less like the postal service and more like the nuclear reactor, in that the combination of aggressive leverage, complex methodologies and heavily interlocking parts leads to significant potential for catastrophe.Exquisitely adaptedAnother serious problem is Wall Street's deeply ingrained tendency to push the envelope. (Richard Lowenstein put it exceptionally well in his book Origins of the Crash: "Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier causes until it fails.")In this habit of fighting for every inch of profit, Wall Street is like a self-evolving animal overquick to embrace the particulars of its immediate environment. The more precisely an animal is attuned to a particular "fitness landscape," the better that animal can thrive... in the short term at least, as long as everything stays just so. To be exquisitely adapted (as opposed to robustly adapted) is to be vulnerable to the slightest change.Thus when the fitness landscape DOES change -- as it inevitably will -- the heavily specialized competitors tend to get crushed (if not go extinct). If a strategy-gone-sour broadsides a large enough group of market participants, the entire financial ecosystem can be thrown into turmoil. When the turmoil from this upheaval spills into the broader economy, wreaking havoc in its wake, the "demon" spoken of in the book's title is unleashed. (As this reviewer interprets it anyway.)Wisdom of the cockroachSo the problem, in sum, is Wall Street's tendency to `overadapt' to every appealing landscape it encounters, building up complexity and leverage to dangerous levels in doing so.Bookstaber's suggestion is to heed the wisdom of the cockroach.The cockroach has survived a longer time span, and a wider variety of harsh environments, than humans could ever match. It is one of the creatures man cannot wipe out no matter how hard he tries. And yet, the cockroach's key risk management strategy is embarrassingly simple... simpler, even, than putting in a stop loss. The deeper point is that simple equals robust; by refusing to get fancy, and sticking with the tried-and-true, the cockroach ensures its reign as champion survivor.Bookstaber uses the cockroach (and other examples from nature) to argue that we, too, should consider cutting back on our excessively specialized ways. The cost of a rough-edged strategy is forgoing excess profits in accomodative environments... but the benefit is increased likelihood of survival in a much wider range of environments, including the truly harsh ones. (As Jim Grant likes to joke, if so many of these credit-driven vehicles can barely handle prosperity, how are they supposed to fare when adversity hits?)Harrumphs all roundBookstaber's finger-wagging solution (be less fancy; take less risk) has the ring of common sense to it, especially in the way it frustrates all those market participants determined to have their cake and eat it too.For those who seek to wring every last nickel out of the market (as LTCM used to brag of doing), Bookstaber argues persuasively that flying too close to the sun will always be perilous. The commitment to leveraging every edge on a broad scale inevitably leads to disaster-prone configurations, no matter how smart the players.For those who think the answer is greater regulation of markets, i.e. more rules, Bookstaber shows how extra layers of bureaucracy can actually bring about the exact opposite of the intended affect. Perversely, layers of red tape can (and often do) make a situation more risky, by increasing confusion and complacency simultaneously.Nor is greater information disclosure the answer. If the market's traditional liquidity providers (traders, market makers, speculators etc.) are forced to disclose their positions to the world in real time, they will react in the manner of poker players forced to play their hands face-up. To the extent that disclosure resolves uncertainty, it also drives market participants from the game. And because "liquidity is a coward" as the old saying goes, always running away when you need it most, strict disclosure rules would likely make bad market conditions worse at the least opportune times.Some left smilingTwo groups in particular may be left smiling at the end of this book -- value investors and trend followers. In both the theory and practice of their normal operations, value investors and trend followers intuitively embraced Bookstaber's message a long long time ago, favoring longevity and robusticity over the temptations of adjusting to the moment.It is perhaps not surprising, then, that value investors and trend followers are arguably the most profitable market participants by far on an absolute-dollar basis, hauling in hundreds of billions in profit over the course of many decades. They are champion survivors too... with a touch more class than the cockroach.

I bought this book because, as a financial-planner, I was becoming increasingly concerned about the burgeoning market for highly-complex, geared and interlinked financial products. Back in 2007, my concerns were more focused on the inexorable rise and rise of SCARPs, and I was therefore initially a little disappointed that Bookstaber has relatively little to say on the subject. His area of expertise is hedge funds, which at that time one did not appear to come across nearly as frequently.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.

One star but worth every penny if you're interested in car-crash Wallstreet trash.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....

If this book had been titled "Memoirs of a Risk Manager" it would only have sold a copy to the author's mum. Happily, it has a snappier title, so there'll be no excuse for market supervisors to ignore its lessons. Don't be put off by the technicalities in the early chapters; if your eyes glaze over at "inflexion points of the long / short bond option" (or whatever) just keep going. You will be rewarded.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.

I was disappointed by the book: the author is wildly jumping from one topic to the next.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.

The insights provided in this book are remarkable for forecasting the first big meltdown of the market pre-2008. The insights of an obvious insider are also revealing. This is a very good book well worth adding to a traders library as a reminder of the facts that markets are cyclical and the newest technologies or trading strategies never provide full protection from a total market collapse. Ultimately mathematics and computing power fail once the psychology of the market takes over. The author is well known for his writings on option strategies and this book is refreshing in providing insights into the qualitative aspects of any market strategy.