A Demon of Our Own Design:
Markets, Hedge Funds, and the Perils
of Financial Innovation by Richard
Bookstaber
A Fresh Look On Complexity And Risk Management In The Financial Markets
Inside markets, innovation, and risk Why 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.
Personal Review: A Demon of Our Own Design: Markets, Hedge
Funds, and the Perils of Financial Innovation by Richard
Bookstaber
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
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