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

As a stockbroker for the last 25 years, it has become ever more clear that our markets (both equity and fixed income) are increasingly driven by the activities of the big traders (hedge funds and investment banks). But what is driving their trades? What are their systems? What are they thinking? Bookstaber's book answered many of my questions, illuminating the world of hedge funds. This book sheds light on the market crises of the last two decades (the 1987 crash and Long Term Credit) and essentially predicts and explains the present subprime loan fiasco and private equity crisis. This is the best, most useful book I've read about our current markets. It's quite readable to boot (though the language is not simple). Bookstaber has the unusual gift of making the complex understandable if not simple. So, at the end of the book I understood "statistical arbitrage", portfolio insurance's mode of operation, and the central importance of liquidity in today's markets, and even, by way of bonus, Heisenberg's uncertainty principle.

Extremely well-written and thought-provoking. The author has a wide range of interests and knowledge, from yield curve behavior to cockroach survival traits, and explains them all lucidly, simply and in an entertaining and practical manner. He has a deep understanding of the workings of the financial markets, and shares several unique perspectives in this book which I have not read elsewhere, and it is extremely valuable for that reason alone. He is one of those rare geniuses who can keep his autobiographical urge to an interesting, useful and entertaining minimum, only mentioning his personal experiences when they provide insights into larger themes (cf. Black Swans). The author does occasionally use the book as a platform for payback to former colleagues who have done him wrong, but this is done with a stiletto, not a blunderbuss, and is fun to watch. Always well-written, occasionally entertaining. Very highest recommendation.

I had the chance to read Richard Bookstaber's new book "A Demon of Our Own Design" recently. Bookstaber touches on some rarefied territory with his Market memoir. Bookstaber is very open about his roles in designing and pricing derivatives. He believes that some of these derivatives facilitated the Crash of '87, and the collapse of LTCM in '98. Most of his commentary reveals examples where liquidity, the blood of trading, simply disappeared during a financial crisis. Given that the entire treatise is written historically, we are left wondering, who is holding the bag in today's Markets? Is it hedge funds themselves for taking on excess, undefined risks? That question is open. Bookstaber asks questions about Markets today- is risk alive more than ever? The general Market opinion seems to be that the Fed will always bail out these types of financial entities. At least we can have confidence in Bookstaber's assessment and risk in todays markets, as he continues to run a firm called FrontPoint Partners, bought last year by Morgan Stanley. For a more thorough review of Bookstaber, read "A Street Pioneer Fears a Blowup" in the Friday, May 18th Wall Street Journal.

This is an entertaining account of 25 years of financial disasters by a smart insider who is also a keen observer and witty storyteller. Some authors take simple ideas and cloud them with hairsplitting definitions and complex equations, real mathematicians like Bookstaber effortlessly work in deep concepts like sufficient statistics and state variables without any equations or formal mathematics. The best part of this book is the context. If you read books on individual disasters the situations come across as complex and the people as tragic geniuses. If you read the one paragraph versions favored by the business press, the underlying trades seem impossibly simple, and the protagonists seem to be morons. This book shows the euphoria of winning trades when money flows in like magic, and the confusion and shock that result from unanticipated losses. There are many reactions to these losses: cut them quickly, ride out the storm, even double up the bets. Each of these sometimes works and sometimes makes the situation worse. Only after reading all the permutations and outcomes can you understand the stark choices posed as the disasters unfold. The players are neither idiots nor geniuses, they are smart but ordinary people, facing understandable human dilemmas. This context is precisely what is missing in the chapter on engineering disasters. If you look only at disasters, when by definition all the safety precautions failed, it's no surprise that you'll conclude safety precautions are worthless. If you only look at the most dramatic disasters, it's no surprise you'll conclude that the most ambitious, advanced, complex and tightly-coupled systems are the most prone to catastrophe. Bookstaber relies on writers I call the dismal engineers. I think optimists like Duke civil engineering professor Henry Petroski have more to say to financial risk managers. Petroski wrote "no one wants to learn from mistakes, but we can't learn enough from successes to advance the state of the art." The chapters on biological, mathematical and quantum mechanical limits on rationality are interesting speculations. Bookstaber appears to know, or perhaps to care, more about these fields than about engineering. However even in these cases his thesis is not entirely convincing within the realm of discussion, nor is the analogy he wants to draw to finance compelling. There's another good book (or three) in these ideas, this book gives only a taste of the arguments. Despite being a very smart guy with a quarter century of experience in cutting-edge trading, Bookstaber cannot overcome the disadvantages of being trained as an economist, especially an MIT economist. In the final analysis, he believes risk is bad. Trading is defended as socially useful when it provides liquidity, when traders exploit pricing discrepancies caused by short-term supply and demand forces. These traders stabilize the market. But at least half of trading is trend-following, which exacerbates pricing disc

A wonderful book! I especially appreciated Richard Bookstaber's labor of love because I have been studying developments in trading and risk since about '93 and really benefited from the way he chronicled so many developments. Bookstaber probably says `demons' tongue in cheek, because for people who have followed the growing sophistication of financial instruments, the real demons are within us. And Bookstaber does a pretty good job of explaining how that has played out in the recent past. All-in-all, I felt like I got to spend a number of most enjoyable evenings with a long-lost friend, catching up on developments in the market in areas where I wasn't as fully involved. Since I have probably spent a couple thousand overtime hours with tick-by-tick data, I can verify he has also done his homework and paid his dues. While not dwelling on dishonesty and greed, he shows the many ways those factors have played out disastrously, and how, with the increasing sophistication of structured finance in combination with poorly managed large corporations, there are ever more places for rascals to hide. He has experienced a lot more disasters than I had considered, and he fills in the details. For example, he outlines how the reckless abuse of leverage at LTCM subjected the markets to their most serious test to date. These details add weight to the theme of his book. By the time you reach the end of this book, you will have heard about most of the major investment strategies that have been tried, and how they worked out (or are working out). The author thoughtfully does not hype the results. You feel pretty much everything is there, if you are careful to pause and reflect at the right places, or occasionally read between the lines. Refreshing also is the author's frank treatment of his own learning process. I found Bookstaber's book consistently well written right to the end. Never did I feel that he rushed through a section, or wrapped up the book quickly because he was tired of the effort. It answered all my questions about hedge funds (you'll have to read it for yourself; maybe the answers will have different meaning for you). Just as importantly for me, he talked about what it would take to make the financial system more stable; including what an appropriate level of regulation might be. You'll have to read carefully to pick up his thoughts there, but they are accurate and to the point. His book was also well written in the sense that, although a number of stories and points could have mean made with fewer words, anything `extra' in the mathematical sense could certainly be appreciated in the sense of good music, since it added luster and clarity to the theme.