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

Richard Bookstaber

3.92 · Rating details · 1,009 ratings · 60 reviews

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 th ...more

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Hardcover, 276 pages

Published April 1st 2007 by Wiley (first published January 1st 2007)

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Jul 25, 2012 Ross T rated it really liked it

Marvellous read. Bookstaber gives the reader an interesting and unorthodox theory of why financial crises occur, as well as an in-depth account of some of the scandals and failures that have been associated with financial innovation in the past few decades.

The most valuable chapter of the book is on the nature of accidents and their origins in complexity. The enabling cause of crises may be exogenous, such as through new information, but the fundamental cause is endogenous within the structure o Marvellous read. Bookstaber gives the reader an interesting and unorthodox theory of why financial crises occur, as well as an in-depth account of some of the scandals and failures that have been associated with financial innovation in the past few decades.

The most valuable chapter of the book is on the nature of accidents and their origins in complexity. The enabling cause of crises may be exogenous, such as through new information, but the fundamental cause is endogenous within the structure of markets themselves. Markets are vulnerable to crises because they consist of many interlinking parts which change quickly and uncontrollably. In such systems, small changes can lead to large effects.

In finance, the product of a complex and coupled market is liquidity. Liquidity has many benefits, not least facilitating the allocation of capital across the financial sector. However, liquidity also enables higher leverage and can therefore increase the vulnerability of the financial sector. For a highly levered firm doesn't require a large (exogenous) push to knock it over. A trivial exogenous shock could lead to the collapse of a highly levered firm, through a heightened demand for liquidity and a downward spiral of mark-to-market losses. In the context of the recent financial crisis, subprime was the straw that broke the camel's back. The exogenous causes are not a sufficient source of explanation; there was an endogenous vulnerability in the financial sector.

The downside of the book is that there are not many prescribed solutions other than applying the brakes on financial innovation every now and then and reducing leverage. Perhaps these broad guidelines follow from believing in a chaotic view of markets which makes targeted regulation ineffective (and counterproductive). Nevertheless, it doesn't make for a very satisfying conclusion.

But I am strongly persuaded to believe that Bookstaber's view of markets is right. And even if it isn't, then the book is worth reading for the fascinating insights on the structure of financial markets which you be unlikely to find in popular economics books. ...more

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Jan 18, 2009 Jeffrey rated it really liked it

This is not an easy book to understand if you are not a trader or involved with financial engineering on an everyday basis. Upon first read however, I sensed that Bookstaber's overall argument is spot-on for the historic financial crisis of 2008. For example, he explained how a liquidity crisis could be precipitated, ironically, by a demand for liquidity itself.

Once we move away from many of the technical nomenclatures in Bookstaber's book, the underlying backbone of this book argues that the fi ...more

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Jun 12, 2010 Steve rated it really liked it · review of another edition

Shelves: nonfiction, modern-history, social-theory, organizations, sociology-anthropology, the-economy, accidents

Here is where the inadequacies of the rating system comes into play. In terms of writing, I would give this book 2.5 stars. While the prose itself is acceptable (not great, but workmanlike), the book has serious problems with its structure. It is definitely NOT a book for a novice in this field. John Cassidy's HOW MARKETS FAIL or Michael Lewis' THE BIG SHORT (the latter I have *not* read) would be much better choices. Other choices would include Sorkin's TOO BIG TO FAIL (in my queue but not read Here is where the inadequacies of the rating system comes into play. In terms of writing, I would give this book 2.5 stars. While the prose itself is acceptable (not great, but workmanlike), the book has serious problems with its structure. It is definitely NOT a book for a novice in this field. John Cassidy's HOW MARKETS FAIL or Michael Lewis' THE BIG SHORT (the latter I have *not* read) would be much better choices. Other choices would include Sorkin's TOO BIG TO FAIL (in my queue but not read) and Lowenstein's THE END OF WALL STREET.

The problem is four fold.

First, the book is not written for the layman. I was able to absorb it fairly quickly because I already have extensive knowledge of the topic. A novice would find him or herself buried under a lot of jargon and all too briefly explained financial history.

Second, the book really needs a stronger narrative core at its center. It tends to drift from topic to topic and it doubles back on it self chronologically several times. This would NOT be an issue had the book possessed a clear central thesis. But practically speaking, it is the reader who is left creating a theme for the work. This is simply poor writing.

Third, the writer is shackled by his roots as a financial professional. I am not sure whether he is trying to sugar-coat his conclusions such that they are accepted by 'fiscal conservatives' and his fellow Wall Streeters or if he himself is caught in an ambivalent situation mentally and philosophically between admiration for the ingenuity of the finance industry and horror at its wastefulness.

Fourth, I am very annoyed when he introduced the idea of Normal Accidents later in the book and did not attribute this concept to its originator, the sociologist Charles Perrow in the MAIN text. He relegates this information to the end notes. At best, this is an overzealous attempt to keep the theory non technical, at worst, this may be an attempt for Bookstaber to 'toot his own horn'. It would have detracted very little from the book to properly attribute this theory to the man who put it on the map. I also think that Bookstaber borrowed ideas from James Chiles' INVITING DISASTER but did NOT attribute this in the endnotes. I wouldn't go so far as to accuse Bookstaber of plagarism, but certainly he is sliding down that slippery slope.

So, given those critiques, why did I assign the book four stars? Simple, there is actually a lot of good material here for any person interested in the topic of financial crises and who is relatively proficient with the field. Bookstaber actually has a number of interesting notions, particularly about the nature of liquidity in financial markets that are VERY important. The book is worth reading precisely because Bookstaber was trained to be an economist but ended up working in the finance industry. He thus possesses practical knowledge of how financial markets ACTUALLY WORK. That is, they work NOT AT ALL as economic theory predicts.

For an expert or at least a non-novice in this area, I highly recommend this book as a source of useful ideas and information. It will, however, take a careful reader to mine this information from the flawed structure of the book.

I fully admit that I am a very hard case about the structure and editing of books. I went through such treatment for years in graduate school and I am happy to 'pay it forward'. But in truth, structure and good writing DO matter. After all, our lifespans are limited and we shouldn't work harder than we have to when we choose to read non-fiction. But that is just my opinion.

...more

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Nov 29, 2014 John rated it really liked it

Shelves: non-fiction, politi-nomics

The author, a former hedge fund risk manager, describes how the nature of our financial system makes it prone to behaving unpredictably and pathologically in times of crises due to tight coupling and systematic complexity. He predicts that attempting to overlay profligate safety regulations onto these tightly coupled, complex markets may magnify, rather than reduce risk of future crashes.

The Deeply Connected Downward Spiral
The book delivers two major points about risk in modern financial systems ...more

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Nov 09, 2017 John rated it it was amazing

This book will pop your eyes and drop your jaw. This is a report from inside the front lines emanating from a veteran financial trader who ran with the pack Back in The Day, who observed the carnage from a front row seat in 1989, 1997-99 and 2007 before all hell broke loose the next year.
Bookstaber is a very smart man, well-versed in mathematics and derivatives; however, this book translates the complex financial engineering into plain English. Having read other tales of excess and debauchery o ...more

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Apr 13, 2009 Jim rated it it was amazing

This book helps explain why the financial markets collapsed. Basically, when complex systems (like space shuttles, suspension bridges and nuclear power plants) fail, they fail catastrophically (meaning it happens fast and they stay broke). This physical principle seems as reasonable to the civil engineer as to the financial engineer.

It also helped me understand the mindset of the financial engineers (who prefer to call themselves quants) who use their particular cleverness with mathematical mod ...more

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Jul 05, 2009 Glenn rated it really liked it

Bookstaber is has a Ph.D. in econ from MIT and years of risk management experience on Wall Street during the 80s and 90s to add delightful anecdotes to his risk-philosophizing. Less heady than Taleb and more detailed than most finance-style books, Bookstaber describes positions which earned billions and/or blew up. The writing is a little disorganized, and sometimes the direction is unclear. Many of the stories are familiar as they are the epic disasters which defined Wall Street in this era. Fi ...more

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May 12, 2011 James rated it really liked it · review of another edition

This book was written in 2007, just before the recent crisis,
the author doesn't predict it,
but the book has a lot of interesting ideas, individually well presented.

Some like the authors belief that the markets move because of a demand for liquidity,
I don't accept, I think fear & greed move the markets.

But I'm open to new ways of looking at things and there's a lot of good material in the book.

From the cover you'd think it was about the evils of hedge funds,
but the author thinks they are a p ...more

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Jul 28, 2012 Ernst rated it it was amazing

Shelves: investment-and-finance

I read this book before the financial crisis hit its peak, and it was astounding. Even for a non-finance person like me, the explanation of the workings of the financial markets and structured products was easily understandable, and the predictions of the market reaction to over-leveraging due to structured products, combined with a lack of liquidity proved prescient.
If you want to learn about the workings of the financial markets and how structured products work, and how both can fail, this boo ...more

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Feb 02, 2013 Zbyszek Sokolowski rated it really liked it · review of another edition

Shelves: financial

Book is good, it describes that not only small investors make very simple mistakes but also people even who have won noble prize in finances. Author shows also that any try to regulate market will eventually fail. And way is to make it simpler and less prone to break down it means that leverage of positions should be confined. Greed causes to introduce new financial instruments because they until they become more popular are source of easy money due to market ineffectiveness but this strategy en ...more

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Apr 04, 2010 Joseph rated it liked it

This book alternated between fascinating and boring page to page. I love his analogies and he had some great ideas and points but at times became overly technical and repetitive. Glad I read it for the commentary about financial regulation. He gave some great ideas about the need and dangers of more regulation of financial markets.

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Apr 28, 2009 Jonathan rated it really liked it

Good account of the financial crises earlier this decade and some pretty interesting ideas on why modern finance is going to continue to be struck by these crises.

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Aug 20, 2018 InvestingByTheBooks.com rated it really liked it

Why did I wait 10 years to read this book? It is a joy to read. Richard Bookstaber has had a long career in the financial markets. Today he is the Chief Risk Officer at the pension fund University of California Board of Regents and a senior advisor at the US Treasury’s Financial Stability Oversight Council. When he wrote this book he was a hedge fund portfolio manager and prior to that he was in charge of risk management at both Morgan Stanley and Salomon that later turned into Citigroup. The re Why did I wait 10 years to read this book? It is a joy to read. Richard Bookstaber has had a long career in the financial markets. Today he is the Chief Risk Officer at the pension fund University of California Board of Regents and a senior advisor at the US Treasury’s Financial Stability Oversight Council. When he wrote this book he was a hedge fund portfolio manager and prior to that he was in charge of risk management at both Morgan Stanley and Salomon that later turned into Citigroup. The reason for not picking the book out of the bookshelf was that the subtitle “Markets, Hedge Funds, and the Perils of Financial Innovation” gave me the impression that it was a sensationalist, hedge fund-bashing book written by an outsider. This is obviously completely wrong. Few are more qualified than the author to discuss financial risk.

There are three parts to this book although they aren’t presented chronologically. There is one extremely interesting theoretical part comprising of chapter 1, 8 and the conclusion; there is a brilliant autobiographical part covering Bookstaber’s Wall Street career (chapter 2-7) and then chapters 9 through 11 present a somewhat less vivid, semi-theoretical, discussion around hedge funds and much more. For me the chapter on the 1987 crisis was a revelation. Why are researchers still debating what triggered the downturn? Here it’s written out in black and white from someone who had the benefit of both a front row seat and the oversight and understanding to make sense of the event. In short it was a combination of investor psychology, a mismatch in liquidity between the futures market and the cash equities market to act as a trigger and the widespread usage of portfolio insurance that created a self-enforcing negative loop of selling.

In the Wall Street section the author describes the full palette of financial mishaps that he experienced at the investment banks - including the debacle of LTCM, which was closely affiliated to Salomon. In general too many think that only what has recently happened is likely to happen next or that things that seldom happen, will not happen – at least not on their watch. Combine this with the non-linear effects of a constant stream of newly invented derivatives plus complex organizations with plenty of politics and you have an accident waiting to happen. Time after time new financial products are launched without the understanding of unintended consequences. Sometimes the risks are even deliberately ignored as the gains will fall to the banks’ personnel but they will not face the losses.

The theoretical part and especially the chapter “Complexity, Tight Coupling, and Normal Accidents” should be required reading to be eligible for employment at financial regulators. A combination of complexity and tight coupling creates unforeseen events that often cascade through the financial system as a crisis. The complexity arises as the agents in the system change their behavior depending on others behavior and events are often triggered by the use of derivatives – and this is written before the 2007/08 crash. Due to the constant need for liquidity when using derivatives - and the often high leverage - agents in the financial system are critically interdependent and the speed of the market gives little room for error or time for adjustment when things go wrong. That accidents occur in such a system is according to the author to be expected – they are so-called normal accidents that arise by the design. The need for liquidity, not new information, is the main driver of short-term price movements. Less leverage and an incubation period for financial innovation is suggested to tame the system.

The text is colorful, quick-witted and written with a self-irony that adds to the readability. Bookstaber is a quant with a splendid way with words! At this point the book merits a 5-star rating. Unfortunately the hedge fund part isn’t fully up to par. It’s untidy, a bit defensive about hedge funds, searching, and the author doesn’t seem to have fully completed his thoughts. In contrast to earlier parts, no colorful interior from the hedge fund world is offered - pity. In all, if you are to understand financial calamities you should have read this book. ...more

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Feb 07, 2021 Jeffrey rated it it was amazing

Shelves: finance, trading

One of the better financial and trading books that I have read in a while - Bookstaber provides an excellent book that is a bit biography, financial history and also theoretical exposition. Written by an experienced market participant, there is something for everyone here.

A Demon of Our Own Design framed roughly around Bookstaber's own career - he uses his experiences trading around various financial panics (Black Monday, LCTM, the dotcom bubble, etc) to provide insight. Generally after providin One of the better financial and trading books that I have read in a while - Bookstaber provides an excellent book that is a bit biography, financial history and also theoretical exposition. Written by an experienced market participant, there is something for everyone here.

A Demon of Our Own Design framed roughly around Bookstaber's own career - he uses his experiences trading around various financial panics (Black Monday, LCTM, the dotcom bubble, etc) to provide insight. Generally after providing some context, Bookstaber will then return to provide his explanation of the mechanisms that caused the bubbles - the depth of his analysis is never in question, even taking us on a history lesson to the Dutch tulip mania. It helps that Bookstaber was close to the action, with his time at Salmon Brothers yielding some fantastic anecdotes - you can't beat his recollection of Munger saying: "A spread trade is like a stick with shit on both ends."

The last sections of the book are dedicated to giving some different ways to think about markets and risk. Gone is the textbook view of markets as being conveyors of information, rather the price action is a reflection of liquidity demands by different participants. But the greatest strength comes in Bookstaber's exposition of risk - rather than being obscure and impenetrable, Bookstaber draws of different analogies and other disasters that make his arguments accessible. In short, he berates the complexity of financial markets, they are like the furu fish - highly adapted to a specific context, but outside this do we really know how they will respond or will they be resilient. The answer is likely no - hence the constant repeats of financial crises. Indeed the only useful analogy from physics may be: “Just as high-energy physics creates a state that is no more differentiable than to say that is is matter, so the high energy in financial markets created a world where securities were no more differentiable than that they contained risk. ... As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is you cannot always predict ahead of time if the correlation will be positive or negative.”

Instead Bookstaber argues perhaps markets should draw more from biology, taking the humble cockroach as an example - its resilience (in contrast to the furu fish) comes from the fact that it is not overly specialised - instead its simple rule to move away from the wind gust has allowed it to survive over many periods and in many environments. Bookstaber here is a proponent of more coarse behaviour - simpler behaviour that is more robust and would provide the system with more slack. Drawing from Brazilian Jiu Jitsu, he provides yet another fantastic analogy: "What became over time was that having a firm understanding of the actual application of a set of controlled techniques through live training and real fights was superior to having a quiver filled with techniques that were powerful in theory but could not be tried and refined until an actual fight occurred." Innovation for innovation's sake is not necessarily good for society: "Just because you can turn some cash flow into a tradable asset doesn't mean you should..."

In short, anyone reading A Demon of Our Own Design will definitely have something to learn, while being entertained. It's not often that can be said about books about markets. ...more

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Feb 13, 2013 Ian Robertson rated it really liked it

With its publication predating by a year the financial meltdown of 2008, this well written book about “the perils of financial innovation” promises an insider’s view of what ailed the system; neither a postmortem nor a prediction, but rather a detailed diagnosis of the corpus financius. For the most part, Bookstaber, a former trader and head of risk management at several major Wall Street firms, delivers a very entertaining thirty year history of financial innovation and folly. Over time, risk i With its publication predating by a year the financial meltdown of 2008, this well written book about “the perils of financial innovation” promises an insider’s view of what ailed the system; neither a postmortem nor a prediction, but rather a detailed diagnosis of the corpus financius. For the most part, Bookstaber, a former trader and head of risk management at several major Wall Street firms, delivers a very entertaining thirty year history of financial innovation and folly. Over time, risk is sliced or packaged in ever more innovative ways, leading to profits for traders and firms, and ultimately and inevitably outsized losses for shareholders when a bet turns bad.

Bookstaber writes about the stock market crash of 1987 (outlining both the cause and his role), the rise and fall of bond giant Solomon Brothers, the financial colossus that was Citigroup, and the rise of hedge funds. He includes many interesting anecdotes, at one point describing an innovative product developed by UBS which readers will recognize as index-linked CDs (in Canada GICs) offered a few years later by many retail bank branches, as well as some historical detours that provide context or an introduction to the issue at hand.

Readers shouldn’t worry about the seeming complexity of the subject matter, as Bookstaber explains complex ideas and market mechanics very well, without jargon or condescension. Along the way he takes the accounting profession to task (echoing former SEC chair Arthur Levitt’s critique of a few years earlier), provides an explanation of efficient markets and the mathematical underpinnings of economics, and offers an excellent introduction to hedge funds by outlining different trading strategies and the importance of liquidity.

Bookstaber writes with wonderful turns of phrase, and more than once I found myself smiling at his witty but understated delivery. Describing the new market hotshots called risk arbitrageurs, he writes, “During the takeover boom of the 1980s, they were voracious, sharks that preyed on other sharks. They bet on who would take over whom. The most prominent names in this business included Ivan Boesky, who would later be arrested, and Robert Rubin, who would later be Secretary of the Treasury.” As we know now, Rubin would later preside over Citigroup’s risk mismanagement and its financial collapse. It seems the only shark with its reputation unsullied is the Long Island resident introduced to us a few years earlier by Peter Benchley.

Despite the excellent content and storytelling, I have a few small quibbles. First, and an issue which applies equally to the stock market reports on our daily news as it does to Bookstaber’s book; references to stock market point drops are meaningless unless readers know the starting index level (and it’s different for each of the Dow Jones, S&P500 and NASDAQ). All market movements should be reported in percentages. Second, history has proved some comments inaccurate. For example, Bookstaber’s comment that “mortgages have little in the way of default risk” may have been true historically, but of course has been proved disastrously wrong since. Third, his defense of hedge funds and their beneficial role in markets too seems biased, perhaps owing to his previous employment at a hedge fund. Hedge funds may well provide market liquidity, but their benefits and costs to the financial system are much more complex than Bookstaber pretends. Read for example the ongoing debate about today’s high frequency trading and its impact on the transparency and stability of markets; liquidity run amok, and to whose benefit?

Two larger issues, unfortunately, prevent the book from being truly outstanding: its divergent focus and its weak conclusion. Bookstaber may have been aiming to demonstrate our financial demon by recounting his involvement in various events, but unfortunately the high level of detail about the people involved gives it the feel at times of a memoir rather than a book with important lessons. Readers can skim much of the personal detail without losing any of the terrific content, but the lack of focus does detract from the overall effect. Bookstaber could have taken a lesson from Peter Bernstein’s landmark book Against the Gods: The Remarkable Story of Risk in how to retain only the important details and remain both engaging and on message.

Curiously, despite his chronicles of others’ bets gone bad, he remains confident that his own trades - shut down by senior management - would have paid off handsomely. Bookstaber’s hubris ultimately limits the book’s full potential, and after an excellent description of the symptoms, he unfortunately concludes with an unreflective diagnosis and an uncritical prescription. His prescription is for simpler financial products and less leverage. Prescient given the incredibly leveraged financial system and undecipherable mortgage based securities at the root of the following year’s crisis, but vague and unhelpful. He is on firmer ground in his caution to regulators (is he talking directly to Alan Greenspan here?) that “it may be dangerous to assume that institutions behave rationally,” and more solid ground still when, after introducing the notion of uncertainty and the impact of observation on the outcome (Heisenberg’s Uncertainty Principle), he cautions that increased regulation may be counterproductive as it could have large, unforeseen and unintended consequences on the market.

Bookstaber is an expert on risk, an insightful and edifying guide, and a first rate storyteller who has delivered an entertaining and educational and tour of the risk of markets. Despite the criticism noted above, A Demon of our Own Design is a worthwhile read and a welcome addition to our understanding of risk in capital markets. ...more

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Jun 06, 2017 David rated it really liked it

well..it is another great book focusing mainly on LTCM blow out, Russian default and mainly from the background story of Citigroup failure: Weil, Prince, etc..although towards the end of the book, author did mention all of the so called natural self protection mechanism, and the rules of the nature and all...slowly guide us to the direction that hedging, investment, arbitrages are no safe bet...HFT was mentioned in one short paragraph..also mentioned hedge funds are not making profit coincide wi ...more

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Sep 07, 2017 Rob Mills rated it really liked it

Bookstabber has been on the ground floor (and or partially responsible) for all of the terrific market crashes we've seen in our time. He writes about them and tells great first hand stories of things like Charlie Munger castigating Salomon mgmt at a BoD meeting or Dimon aggressively demanding a zeroing out of Russia exposure (ahead of the default!).
The author does a great job with his analogies and tells wonderful historic anecdotes that he then ties into modern day finance.
He makes some effo ...more

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Nov 14, 2020 Grace Cao rated it it was amazing

Shelves: finance-economics

Five-star content, four-star writing.

The question posed by this book is: why can’t the financial markets seem to get their act right? Why, in spite of reduced risk in the underlying economy, in spite of the march of innovation and the contributions of financial engineering, do we not enjoy reductions in financial risk that we find in other areas of our lives? Why are markers actually becoming more crisis-prone?

One answer is the effects of innovation. The positive effects of innovation comes at a ...more

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Aug 01, 2020 Arup rated it really liked it

Shelves: business

Another insider take into Salomon, LTCM, 90s' Wall St. Fun stories. Book ends with concluding that "normal accidents" are unavoidable in complex systems that are also tightly coupled. To break the chain of recurring financial crises we have to forgo our desire to invent new securities and everyone's favorite - reduce leverage. Slowing the speed of transaction (a la bank holidays of the good old bank-run days) is also recommended - anything that reduces the "liquidity" of investments and the leve ...more

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Feb 26, 2019 Greg rated it liked it

So much I didn't know about economics. The systems approach to his explanations of both complexity and liquidity are something an ex-engineer could appreciate. Also makes me realize how little hope there is for regular players (read: people with full time jobs doing things other than finance) to reliably hope to achieve better than average in the market. I'm much more happy now making average returns on the markets! ...more

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Nov 22, 2018 Lawrence FitzGerald rated it liked it

Shelves: economics, 2000-s

A quick read with some useful insights.

The supply and demand for liquidity in markets is a useful insight.

Complexity is a necessary condition for chaos.

I don't think either originates with Bookstaber, but I carried it away none-the-less. ...more

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Apr 09, 2020 Robin Michael rated it it was amazing

as relevant now as in the GFC
identified and reasoned, contextual examples from history of finance
demystifying the BS
demonstrating the limits of statistical predictions, and a warning against over complicating market structure and backward looking regulation

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Jan 26, 2018 Novice rated it it was amazing · review of another edition

Easy to read, hard to put down.

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May 02, 2010 Guy Posts rated it it was amazing

This review has been hidden because it contains spoilers. To view it, click here. Simplifying complex, intricately linked events, people, and decisions into a few take away messages is at once the primary task and the biggest challenge an author faces. In A Demon of Our Own Design, Richard Bookstaber adroitly conquers the complex question of "why do our markets keep crashing?" by using decades of first hand experience and observation to show that our so called efficient markets are actually "built to crash".

Having been the managing director of firm-wide risk management at Sal Simplifying complex, intricately linked events, people, and decisions into a few take away messages is at once the primary task and the biggest challenge an author faces. In A Demon of Our Own Design, Richard Bookstaber adroitly conquers the complex question of "why do our markets keep crashing?" by using decades of first hand experience and observation to show that our so called efficient markets are actually "built to crash".

Having been the managing director of firm-wide risk management at Salomon Brothers and a hedge fund manager, Bookstaber knows his stuff. While most pundits and market professionals consider the most recent developments to be an event beyond predictability, Bookstaber saw it coming all along.

Despite the growth in the world GDP, life expectancy, and overall improvement in just about every global indicator, the financial markets seem to be missing this memo. Or, perhaps more accurately, doing too much with it. It isn't for lack of enough information that the markets seem so fragile Bookstaber claims, but because we drape layers of complexity over our markets in the form of options, portfolio insurance, leverage, statistical arbitrage, regulations, etc. As a result, the financial system becomes "tightly coupled" whereby stability depends on many components all working in harmony. While the failure of any one component in isolation is unlikely and inconsequential, the same failure within the context of a larger system can trigger a catastrophic unwinding of the system. Correcting the death spiral becomes more difficult, as actions taken to stem the crisis actually end up accelerating the meltdown. For instance, in a flight to liquidity mass selling of an asset begets even more selling.

Challenging academic economic theory seems to be a running theme these days, but in the spirit of progress, the evidence is growing that theories concerning the rational agent and the profit maximizing firm may need revision. Bookstaber gives the reader insight into an intuitive sense he had in graduate school "that the culprit leading to our apparent nonresponsiveness to optimality was a lack of knowledge, a realization that the world could change in ways we could not anticipate or model." Merely having a "sense" got him nowhere in a field dominated by theoretical mathematics, so he took his idea into the world of biology.

He was most interested in identifying behavioral patterns that would increase a species' probability of survival and applying these lessons to the world of finance. Bookstaber notes, "Because the cockroach has survived through many unforeseeable changes—jungles turning to deserts, flatland giving way to urban habitat, predators of all types coming and going over the course of the countless millennia—it can provide us with a clue for how to approach unanticipated risks in our world of financial markets." So, what makes the cockroach so survivable? Simple, really. It moves away from slight puffs of wind, wind that might indicate an approaching predator. By keeping the algorithm simple, the cockroach can respond to whatever environoment he's thrown into. On the other hand, species that develop behaviors optimized for their current environment flourish while the ecosystem remains constant, but perish when confronted with a new predator or ecosystem. Bookstaber concludes, "The coarse response although suboptimal for any one environment, is more than satisfactory for a wide range of unforseeable ones."

In the long run, the best approach is to hedge against the unknown. But the time horizon of the inidividual is much shorter than the firm's. Where's the incentive to hedge against something that doesn't exist when it's possible to own your own island in a few years? Why not squeeze every possible dollar out of the system now, and let someone else worry about the consequences? This is precisely the rigorous wealth maximizing attitude that Bookstaber cautions against. "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... Each innovation adds layers of increasing complexity and tight coupling."

What is his prescription for fixing the system? In a single word, simplify.
...more

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Nov 09, 2017 Aaron rated it really liked it

Had A deamon of our own design been published 2-3 years after 2007, it would just be another book on our troubled financial system. However, the fact that it was released on the critical date of 2007 on the eve of the largest Financial crisis since the great recession, makes this book stand out from it's piers.

Although short on solutions to the issues we currently face in building a better Financial system (a glaring issue worthy of striping it of a single star in what would otherwise be a brill Had A deamon of our own design been published 2-3 years after 2007, it would just be another book on our troubled financial system. However, the fact that it was released on the critical date of 2007 on the eve of the largest Financial crisis since the great recession, makes this book stand out from it's piers.

Although short on solutions to the issues we currently face in building a better Financial system (a glaring issue worthy of striping it of a single star in what would otherwise be a brilliant piece), the book is still relevant after all these years.

To me, the most important lesson from the book is the consequence of having a heavily coupled complex Financial system. Systems that are tighty coupled have components that heavily rely on one another to function. When one fails, the entire system tends to break down horribly. In a non complex system, it is easy to step back, find the problem, and fix it. In a complex system, this is impossible. Fixing things will be difficult to impossible, and catastrophic failure will hard to avoid when "normal failures' occur. Attempts to fix this with more rules/regulations can just as easily contributed to the problem by adding greater complexity. This lesson from the book, to me, is it's best hidden gem of knowledge.

The other useful bit of information in the book is Bookstaber's take on the efficient market hypothesis, which is simply that it is NOT efficient. This observation may not seem so strange to some who see bubbles in asset prices or irrational manias and panics routinely bring us to the brink, but insisting that Markets can fail (ie, are not always efficient) is still a rather controversial statement today (and even more so back in 2007). His take on the subject is unique: he relates economics to 2 harder sciences, mathematics and physics. In both subjects, painstaking work has been done to push the predictive power of each subject, only to later be proven to be impossible.

Each science learned that there predictions would always have a level of failure and should be taken with a grain of salt. Economics never quite committed the part "with a grain of salt", and despite some really knowing not to take economic model forcasting with a grain of salt, many mostly ignored such trivial small failures as irrelevant (ignorant that the compounding of these small failures eventually lead to huge cases of market failure). Bookstaber is appealing to economists vain desire to be treated as the greatest of the Social sciences, on par with hard science like mathematics or physics. If such hard sciences can admit to the limitation of there studies, than there is no reason economists cannot do the same. This is a interesting, and honnestly brilliant observation by the author.

The only part of the book I have a serrious problem with is his argument that regulation of Financial Markets is impossible, or at best should not be relied upon. Maybe I'm just hopelessly optimistic, but I cannot accept that to be true. I feel that his criticisms are fair: markets change, and can quickly adapt to make rules fail to accomplish there goals. Over time, regulators get captured by the groups they are meant to police. And the power vested in financial interests will always make it hard for regulators to adapt to keep consumers safe. He is correct in his observation that the traditional means of regulation will never solve our current problems.... But that does not mean that, new simpler means of Financial regulation cannot solve the problem. Bookstaber would probably agree (the goal of simple regulation fits his arguments for making the highly coupled system less complex), but he never quite makes that connection (5 years later, Luigi Zingales book does).

Obviously, I liked this book. It gave me a lot to think about, and will probably end up being on my reread list in the near future. Definitely a necessary read for anyone interested in financialy policy and the study of economics.

4.25/5 ...more

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May 11, 2010 gekko100 rated it liked it

well written and very relevant. has particularly good description the blossoming and subsequent tailing off of statistical arbitrage -- with insight you won't find in some of the other recent, dime-a-dozen journalist books ("The Quants" springs to mind).

The author also makes a cogent argument for a simpler financial marketplace and against yet more layers of regulations. His point is that extra regulation merely adds more complexity, thereby increasing rather than decreasing the chances of a fu ...more

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Oct 05, 2008 Kent rated it liked it

A timely and worthwhile read for anyone interested in learning more about derivatives and hedge funds. The book is a bit uneven and would have benefit from tighter editing. While readers with a background in financial services may find some of the explanations to be overly simplistic, all readers will appreciate Bookstaber's anecdotes from his years on Wall Street - especially those spent at Salomon Brothers. Much like Michael Lewis' Liar's Poker, this is where the book is at it's entertaining ...more

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Jan 22, 2009 Jamon rated it really liked it

Shelves: business

Caveat is that I grew up with the Author's older sons. This is a slow book at first, and has some nice wall street cliff claven-esque factoids. But I liked it...but I am a finance guy. I learned alot about how institutional banks work, trading. The author gives great analogies to understanding the fiancial crisises from the 1980's to 2007. Things that stuck out to me are: 1. It is easy to see why all banks do the same thing (hey if he is making a profit..so should I), and 2. That trying to regul ...more

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Jan 23, 2017 Philipp Muellauer rated it liked it

Shelves: finance

So so. Starts out strong with some interesting anecdotes about the personalities of high finance in the 80s and 90s and provides a perspective on what was going on inside iconic trading firms and investment banks at the time. His story of Three Mile Island really drives the point home that excessive complexity eventually results in disaster. That said, Bookstaber starts to waffle and goes off on tangents from that point on. The ideas he's trying to convey in the latter half of the book are not s ...more

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Jun 28, 2008 Matt rated it really liked it

Recommends it for: those interested in finance

This is an interesting read for someone who wants the inside story of someone who has worked for proprietary trading desks of big firms and hedge funds and understands how hedging and derivatives and synthetic products have added to the risk and volatility of the market rather than reducing it. Probably not a lot of interest to someone who doesn't enjoy reading about investments. ...more

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About Richard Bookstaber

Richard Bookstaber

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Richard Bookstaber is the author of A Demon Of Our Own Design, a book highlighting the fragility of the financial system that occurs from tight coupling and complexity. The book is noted for its foreshadowing of the financial crisis of 2007–08.