Book Review: A Demon of Our Own Design

Richard Bookstaber has been in some interesting places that have given him a sage perspective on financial markets and innovation: he watched the 1987 market crash from Morgan Stanley; joined Salomon Brothers for the high-flying early 1990s and stayed until the arb trading unit was shut down after the Citigroup merger; watched his fellow MIT grads (and Salomon colleagues) blow up LTCM from a front-row seat; and then he managed to work for "hedge funds" before Congress knew what they were. All those qualifications led Congress to ask him to testify about the currrent mortgage/credit mess last fall. Since he has spent a career trying to figure out what portfolios of derivatives mean in the real world, he seems like a good choice. He has no less than three basic observations about financial markets today.

1) Liqudity is the defining characteristic of financial markets and provides a pertinent contrast to other aset markets. Liquidity allows leverage, which has abetted recent financial crises. Traders leverage assets because they can and because they need to to make small-return bets worthwhile. But liquidity can disappear in a crisis, squeezing those in leveraged positions.

2) Financial derivatives are good insofar as they allow risk to be borne by those more willing to bear it. However, exotic derivatives create additional layers of complexity in financial markets. In concert with tight coupling resulting from leverage, this complexity can lead to instability. Bookstaber suggests that a less sophisticated market structure might be more robust in times of crisis--like a cockroach, which has a very coarsely evolved survival strategy.

3) Accounting practices are antiquated and cosntructed with illiquid markets in mind. Without sufficient statistics for the types of exposure, strategies, and positions that financial firms face, standard accounting practices are not useful in assessing risk. It should come as little wonder that firms like Enron and Tyco were able to manipulate accounting concepts in the context of far more dynamic strategies.

Bookstaber's background as a risk manager lends some interesting context to the above observations. Citing Knightian uncertainty, he emphasizes unknown risks as the primary blind spot of markets, in subtle contrast to Taleb's fat tail risks. While unforthcoming on how to deal with unknown risks (just as Taleb is coy about living with fat tails), this observation should catch the attention of any quantitative trader. The narrative is generally very good, but does lag in places. He is less windy than Taleb, but also takes time to relate personal stories, some of which are illuminating. On the whole an interesting read, and Wendy deserves credit for finding it.