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11 September 2017 Financial Analysts Journal Book Review

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

  1. Martin S. Fridson, CFA

A product of the author’s long experience at investment banks and hedge funds, this masterful book paints a picture of momentous financial events of the past two decades and provides a warning about injudiciously applying advanced quantitative techniques to investment instruments.

Richard Bookstaber proudly proclaims that, although he did not personally cause the 1987 stock market crash and the Long-Term Capital Management crisis of 1998, he “was definitely one of the guys fiddling with the controls.” He certainly had the requisite experience and expertise for it. His long career in finance has included stints in research, risk management, and proprietary trading at prominent investment banks and hedge funds. The product of that experience, the masterful  A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, gives readers a front-row seat—complete with candid sketches of many key players—at some of the most momentous financial events of the past two decades.

Bookstaber was part of a mass migration of academics to the practitioner ranks in the 1980s. As a graduate student at MIT, he became fascinated with the application of advanced quantitative techniques to economics. Pioneers of that approach confidently acted on the premise that consumers and producers could be modeled in the way that physicists model planets and subatomic particles. Bookstaber’s readers will benefit from following the intellectual journey that has left him wary of injudiciously applying such methods. A recurring pattern in the book involves a financial model that works extraordinarily well—until it blows up as a consequence of effects that the modelers omitted.

Drawing on his expertise in sophisticated instruments, Bookstaber has produced the clearest explanation so far of the past several years’ financial markets derailments. Happily for readers, he is adept at explaining highly technical transactions in accessible prose.

To underscore his points, Bookstaber draws analogies from a formidable range of interests, including the ecosystem of Lake Victoria, landownership in medieval England, and Brazilian jiujutsu. These parallels are not mere digressions. For example, he describes how Southeast Asian monkey trappers place a lychee nut inside a box with a hole just large enough for the monkey’s hand:

All the monkey has to do to free its hand is let go of the lychee, because the hole is too small for the monkey’s hand if it is clinched around the nut.

The monkey refuses to surrender its prize and is captured, providing an apt image of traders’ sometimes disastrous unwillingness to give up on their bad positions.

To his further credit, Bookstaber accurately recounts two historical incidents that are frequently misrepresented in the literature, namely, the 17th-century Dutch tulip bulb speculation and Nathan Rothschild’s actions following the Battle of Waterloo.

Inevitably, minor errors creep into the text. For example, there was no Louis Bernard in Morgan Stanley’s senior management in the 1980s, although Lewis Bernard headed finance, administration, and operations.

Also, Bookstaber attaches the phrase “circling vultures” to his account of Citigroup senior management’s plan to shut down the troubled arbitrage group that it acquired with its purchase of Salomon Brothers. This metaphor perpetuates a myth about vultures’ behavior toward expiring animals. Their circular flight has more to do with the challenge of gaining altitude with their wings in a V-shaped configuration.

These small imperfections should not distract readers from the important question that  A Demon of Our Own Design  addresses: Why are financial markets becoming more prone to crises even though the underlying economy has grown less risky over time? Bookstaber argues that innovation has contributed to the instability of security prices. Although helpfully speeding up the flow of information, advances in technology and financial engineering also add complexity that multiplies the opportunities for system failure.

Bookstaber not only documents the problem but also proposes a solution:

I believe the markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have. Just because you can turn some cash flow into a tradable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so.

How “we” can be induced to refrain from excessive innovation is left unexplained. Who is the potential Czar of Innovation wise enough to determine which ideas ought to be discarded? How could global financial firms, which earn their highest margins on new products, be compelled to accept such an arbiter’s directives? The markets’ frenetic innovating cannot as easily be brought to heel as Bookstaber implies, but even so, his book is essential reading for practitioners and policymakers hoping to gain an understanding of contemporary finance.


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