The devil’s in the details

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In “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation,” Richard Bookstaber draws on his ample experience in managing financial risk to perform exhaustively detailed autopsies on a series of modern financial crises. He uses the assumptions and failures of the crises’ participants to illustrate an array of dizzyingly complex trades and strategies. But the effort of reading his analysis pays off. Financial companies are almost weekly accused of exploiting investors and Demon, a 2007 release, still feels plenty timely.

The foundation of all of the complex and mysterious finance products and strategies in the world is in the maxim (or cliche, if you’re not a trader) that for every seller in a market there is a buyer. This applies to commodities, equities and debt, but also risk and even liquidity. Since risk and liquidity can only be transferred by way of a security, those buyers and sellers have to get creative. That’s the peril and payoff of creating and using the derivative instruments Bookstaber examines.

Companies have made fortunes and fomented disaster by buying what everyone wants to sell and selling what everyone wants to buy. The contortions required to profit from this give rise to the much maligned “financial innovation” in the title. After he takes the reader through a lot of real-world evidence that seems to suggest finance exists chiefly to enrich people engaged in finance at the expense of the rest of the world, Bookstaber comes around to a typically cerebral but coherent defense of the importance of so-called liquidity providers.

There are two themes to this book; the one in the title and the one that Bookstaber not-so-subtly presents on page one: his central role in everything (everything important, at least).

Bookstaber, an egghead’s egghead, is an MIT economics PhD who was a risk management executive at a host of big name hedge funds, including Morgan Stanley’s, and Salomon Brothers’. He takes credit, more than blame, for creating computer trading programs that contributed to the 1987 stock market crash and the failure of a giant hedge fund. And that’s in the first several sentences of the book.

Bookstaber draws on economics, history, physics, meteorology — even entymology with a well-executed metaphor comparing cockroaches to successful investors (and not in the way that might first spring to the mind of anyone listening to recent congressional testimony). I wouldn’t be surprised if he would describe finance in terms of music or free open verse just for the challenge or lark of the endeavor.

A Demon of Our Own Design might be a casual read only for the Bookstaber’s MIT PhD’s colleagues whom he sprinkles throughout the book but it can still be gratifying for the lay reader willing to put in the attention. The payoff for mustering the attention for 260 hard-fought pages is more than a peek at how trading strategies and positions get built up from an idea, to a full-blown trend and, often, right on through the explosion.

Able though he is, Bookstaber is not quite charismatic enough to pull off as many appearances as he tries, and his unwavering command of the subject is authoritative enough that he could have dispensed with so many reminders of his presence at the scene. But his voice is a mild distraction at worst and the personality that otherwise animates the writing succeeds more than it fails.

If you’re worried about the book being too brainy for real life, turn to page 123 and read Bookstaber’s description of the way traders profit from the difference in treasury bonds in all ways equal except for the month of their issue. Sure, it’s complicated. But if you really want to be shown, not told, what is going on out there, Bookstaber reveals himself to be a more than competent guide.

Authors of books about financial crises can’t resist a description of the 17th century Dutch tulip crash and I can forgive Bookstaber for his because he also includes less-known, and therefore more interesting examples such as the Baron of Rothschild profiting by manipulating English sovereign bond markets based on his early information about the outcome of the Battle of Waterloo. The fact that Rothschild’s market manipulation involved a speedy messenger on horseback and his loafing at a well-traveled corner reminds the reader that human behavior is at the heart of markets, supplemented though they may now be by lightning fast computers.

Having built a career on complexity, Bookstaber here makes a case that complexity is the kernel of the crises he describes and the cure he advocates is simplicity, which means not more regulation which has in the past only engendered further complexity. Perhaps more comfortable with the forest than a tree, he doesn’t offer as robust a description of this simple solution as he does of the complex problem that precipitates its need.

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