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

By Richard Bookstaber
John Wiley & Sons, 2007, 288 pages

In 2005, Alan Greenspan observed that “increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.” Richard Bookstaber disagrees. In A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, Bookstaber, who is a portfolio manager with FrontPoint Quantitative Fund, uses a thoroughly systematic approach to show us how financial disasters like the sudden collapse of Bear Stearns are bound to happen. Although the U.S. economy appears to be flexible and resilient enough to weather most financial crises, in Bookstaber’s view the financial markets are in­creasingly brittle. This makes them vulnerable to shocks that can sweep through the system like wildfire through a parched forest.

With 10 years’ experience at Morgan Stanley and another eight at Salomon Brothers, Bookstaber was placed close to the epicenters of earlier disasters, notably the market crash of 1987 and the failure of Long-Term Capital Management in 1998. He also observed firsthand the evaporation of Salomon Brothers’ business after it was acquired by Travelers Group in 1997 before being folded into Citibank. He takes us through all these events, deftly interweaving stories and systems concepts as he teases out the underlying threads. Financial market complexity, Bookstaber says, cloaks catastrophe.

He traces the life cycle of that complexity. Because their tra­ditional business activities have been priced like commodities, all the players in the investment commu­nity have had to move up-market, either by developing relationship-type businesses like investment banking or by continually coming up with new financial products that may offer superior returns for a short period before others copy them. These innovations, Bookstaber suggests, are a double-edged sword: They improve market efficiency, but they also add risks that cannot be foreseen and therefore cannot be mitigated.

There’s a more subtle underlying problem: Although the general public may have enormous faith in the ability of the marketplace to allocate resources, this faith is based on assumptions about market efficiency that work well only in theory. Real markets in a granular world of space, time, and human beings be­have differently. Economists insist on maximizing the transparency of information to all players in the market, when the real problem is a lack of liquidity and an excess of leverage. The constant innovation in financial instruments since the 1980s has made it difficult to see the funda-mental dynamics. The au­thor points out that portfolio insurance, first developed in the 1980s, was really a so­phisticated hedging strategy. But for it to work effectively, the markets had to be liquid. The word insurance was a great marketing hook, but it was a misnomer — there was no insurance company standing behind the portfolio, ready to step in if anything went wrong.

Fast, complex systems that are tightly entwined can go into runaway mode. Bookstaber argues, for example, that the 1987 stock market crash occurred simply because the fast-paced futures market was more liquid than the slower-cycling market for stocks. When futures dropped sharply, arbitragers transmitted that decline to the stock market. Instead of lower prices being interpreted as a signal to buy, they were seen as a warning that bad news was coming. As a result, liquidity suppliers were paralyzed just when they should have acted. Prices fell precipitously, triggering more programmed selling. At these times, when markets morph into what the author, using an analogy from physics, calls a “plasma” of undifferentiated assets, long-standing, stable relationships among financial indices are disrupted. With these stable relationships broken, the assumptions that underpin the multiple computer models being used to track markets become invalid. The game flips suddenly from probability-based roulette to psychology-based poker, offering huge profits to those brave enough to step up to the challenge but causing disaster for others.

Efficiency and resiliency, far from being complementary, contradict each other; improvements in one variable may lead to deterioration in the other. The wrong kind of regulation may exacerbate this vicious dynamic. Bookstaber be­lieves that regulations should aim at reducing complexity in the first place, rather than trying to control it after the fact, even if this means slowing the rate of innovation. It seems that we are indeed the architects of our own misfortune.