A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber
Book Summary Information
Author: Richard BookstaberEdition: Paperback
Audio: English (Original Language); English (Unknown); English (Published)
Published: 2008-12-10
ISBN: 0470393750
Number of pages: 304
Publisher: Wiley
Product features:
- ISBN13: 9780470393758
- Condition: NEW
- Notes: Brand New from Publisher. No Remainder Mark.
- Click here to view our Condition Guide and Shipping Prices
Book Reviews of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
Book Review: A fresh look on complexity and risk management in the financial markets
Summary: 5 Stars
In this book, Richard Bookstaber argues that complexity in the financial markets is an unfortunate evil, a consequence of ever more customized investment and hedging solutions. Unlike in other areas, innovation in finance does not make things safer, but instead more complex and hence more dangerous. Complexity by itself is not always bad, but combined with what Bookstaber calls "tight coupling," which means that all steps of a process are interlinked and dependent on each other with no slack, it makes for "normal accidents." Normal accidents are events that we believe to be incredibly rare - yet they occur much more frequently than expected.
How do we battle this problem? Bookstaber argues that more regulation and more transparency are both poor solutions. Regulation only increases complexity, further escalating the problem, and transparency leads to other various problems that stem from limitations of knowledge. Unfortunately, Bookstaber does not provide a clear solution. He believes we need to slow innovation in finance to reduce complexity and reduce leverage in order to give more slack to the system and hence help alleviate tight coupling. However, I don't see these as practical courses of action. Reducing complexity means being less responsive to clients' needs - something firms will never do in this industry. Reducing leverage means smaller returns, again something that the investment community overall is unlikely to agree on. Perhaps some regulation on leverage may be helpful, but hedge funds fall outside of common regulatory rules - and they have become a force to be reckoned with.
The book follows mostly a chronological format, from Bookstaber's early days at Morgan Stanley and Salomon Brothers to Ziff Brothers and Moore Capital. At Morgan Stanley, Bookstaber was involved with portfolio insurance, which was one of the major causes of the October 19, 1987 market crash, creating a downward spiral of selling due to dynamic hedging. At Salomon Brothers, Bookstaber encountered a culture totally different from that described by Michael Lewis in Liar's Poker - things have changed to a much more strict and controlled environment, one much less willing to take risks. Bookstaber describes several failures in risk management at various firms (Leeson at Barings, Jett at Kidder Peabody), and moves on to discussing merger arbitrage at Salomon, touching a bit on Jack Grubman and finally the purchase of Salomon by Sandy Weill and Citigroup.
Bookstaber spends some time describing LTCM and how it got into trouble (see When Genius Failed), and moves on to speaking about hedge funds in general. He defines hedge funds as the universe of all possible investment strategies minus the tiny slice of traditional investments. He discusses the efficient market hypothesis and explains why it doesn't fit with reality - due to liquidity constraints and the tendency of humans to have various risk preferences. He loves the concept of a cockroach, which ignores most of it senses and listens to a very simple fight-or-flight instict. Bookstaber believes this has allowed the cockroach to survive for so many millions of years. I am a bit skeptical of the argument, as it dismisses many biological issues, but it is entertaining none the less. Bookstaber thinks that we can adapt the cockroach approach to the financial markets and listen to our most basic instincts more often.
Being the risk management guru, Bookstaber also discusses how he feels risk management should be changed. He thinks it needs to be less complex and less overburdened by company politics and organization (as it was horribly so at Citigroup). Additionally, he believes that risk managers need to spend less time on known risks and invest more time looking towards unseen risk. This is somewhat paradoxical, since the whole concept of unseen risk is that... it can't be seen/predicted, but I do get the point. At the end, however, Bookstaber says that risk management is what it is - and we just have to learn to live with it, which is somewhat disappointing after his earlier ideas.
In conclusion, I really enjoyed the book. It is well written, easy to read, and provides a ton of excellent examples and history. At times, I felt it was a bit too philosophical for its own good. For example, Bookstaber spends a long time discussing the limits of knowledge (Godel vs Russell, Heisenberg vs Laplace, Lorenz's butterfly effect vs all future-prediction attempts), and it feels very Taleb-like, although much less annoying. Overall, however, the book provides a fresh way to look at risk management and some of the major recent crises. Bookstaber spends a long time discussing hedge funds and what they mean to the markets, and I particularly liked his brief ranting session on the obsolescence of modern accounting methods (including mark-to-market accounting).
Pros:
+ easy to read and understand, very well written
+ contains an excellent preface that addresses the current market crisis with concrete solutions
+ fresh views on accounting being antiquated and on the market NOT needing more transparency and regulation
+ fantastic examples, stories, and case studies
+ good discussion on complexity and tight coupling
+ interesting insights on hedge funds and their future
+ a tremendous amount of history to learn from
Cons:
- sometimes a bit too philosophical for its own good
- a lot of repetition scattered between chapters
- some of the suggestions seem too general and impractical
More A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation reviews:
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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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