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

• Essential context for understanding trading

  
  By A2F7XU97CYFHDY on 2007-06-04
  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 discrepancies and sucks up liquidity, destabilizing the market. To a University of Chicago finance guy, these are symmetrical market forces, both good. Bookstaber correctly points out how financially-supplied liquidity ushered in the Industrial Revolution by converting frozen wealth to dynamic capital. But he doesn't mention the momentum traders who forced prices quickly to their eventual equilibrium, sweeping aside those who try to stand in the way of progress. This is the creative destruction of capitalism. Economists are comfortable with the markets facilitating real economic decisions, spreading the inherent risk among willing investors. They are less comfortable with the market forcing real economic decisions, creating virtual risk and imposing it upon unwilling actors.
  
  This anti-risk bias shows in the account of Tulipmania and the reflexive comparison of financial disaster to engineering disasters. No one died at Long-Term Capital Management. It's true that some financial crises, like the 1997 Asian Crisis, impose human costs, but financial crises are virtual, and therefore less harmful than the same degree of failure with physical economic experimentation, and far, far less harmful than the retarded progress if experimentation is slowed. Bookstaber celebrates the liquidity provided by a shrewd swimsuit retailer who anticipates fashion and supplies her customers' demand without excessive price increases. Nowhere does he mention the businesses that create fads, including swimsuit fashions, and thereby the need for liquidity providers. Economists like businesses that respond to exogenous consumer preferences, they have trouble with businesses that manipulate consumer preferences. But both are needed for successful dynamic economies.
  
  None of this takes away from the fact that this is an entertaining and insightful book, essential reading for people interested in financial risk. I disagree with Bookstaber's conclusions calling for slowing market innovation and trading, but I think these are preconceptions from his early training rather than the result of his experiences since.
  
  

• The Wisdom of the Cockroach

  
  By A2JBM4IJ0ZRZ6E on 2007-09-14
  In recounting his time as risk manager at a number of prominent houses (Morgan Stanley, Salomon Brothers, Citigroup etc.), Bookstaber completes the i-banking trifecta. First there was the Michael Lewis classic, Liar's Poker, detailing the juvenile bravado and macho antics of the trading floor. Then Jonathan Knee gave an intimate portrait of the i-banker deal making culture with The Accidental Investment Banker.
  
  And now, in A Demon of Our Own Design, we get a glimpse at the risk management side of things... a sort of master plumber's walking tour through the bowels of the system, with technical descriptions of exactly what happens when pipes burst and boilers explode. (Some will find Bookstabers' level of detail intolerably dull; others will find it quite fascinating. I was in the fascinated camp.)
  
  Nature of the beast
  
  In describing the finer points of risk arbitrage, Bookstaber explains why it's normal -- expected even -- for trading desks to take a good whack every so often. The nature of the beast is to make relatively steady profits, month in and month out, and then give back a chunk of those profits when something goes haywire. (That's how you move huge sums on an arb desk; grind out small bets that are almost guaranteed to work, juice up the returns with leverage, and try not to be in the vicinity when the rare position goes kablooey.)
  
  In light of this general modus operandi, perhaps it isn't surprising that the "quant" funds recently took a major hit (as of September 2007). They had been minting money for an extraordinarily long period, had the leverage to show for it, and now, after the recent "oops," seem to be generally back in business.
  
  In fact it appears natural for much of Wall Street to work in this "make a little, lose a lot" fashion... the key idea being that all the little updrafts make up for the once-in-a-blue-moon downdrafts. (Such calculus works better for the fee collectors than the fee payers, but that's a different kettle of fish.)
  
  Bookstaber's detail-rich description of the various trades that investment houses put on, many of them lasting years, is also enlightening. The details seem to confirm that, by and large, Wall Street is a gigantic, slow moving, conventional-returns type machine. (And what else could it be, really, with such an ocean of capital to allocate and so many jobs to fill? There is only so much creativity and contrarianism to go round.)
  
  A dangerous combination
  
  Risk manager war stories aside, Bookstaber's goal is to hammer home a key philosophical point regarding risk. He wants readers to understand that financial markets are inherently unstable, and this reality places limits on how far we (or anyone) should go in pursuit of outsized returns.
  
  To make his point, Bookstaber uses various analogies to describe how the market is a highly complex, tightly coupled system... and to explain why the combination of high complexity and tight coupling is particularly dangerous.
  
  The counterexample Bookstaber gives of a highly complex, loosely coupled system is the US Postal Service. The USPS has countless potential points of failure and myriad moving parts, but there are no catastrophic linkages involved. A lost package does not set off a disastrous daisy chain of events in which millions of packages are lost.
  
  In contrast, the classic example of a highly complex, tightly coupled system is a nuclear reactor. The reactor is tightly coupled because any point of failure can lead to a knock-on chain reaction; one small thing going wrong can set the entire mechanism on a path to disaster. Being a highly complex, tightly coupled system, the market is less like the postal service and more like the nuclear reactor, in that the combination of aggressive leverage, complex methodologies and heavily interlocking parts leads to significant potential for catastrophe.
  
  Exquisitely adapted
  
  Another serious problem is Wall Street's deeply ingrained tendency to push the envelope. (Richard Lowenstein put it exceptionally well in his book Origins of the Crash: "Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier causes until it fails.")
  
  In this habit of fighting for every inch of profit, Wall Street is like a self-evolving animal overquick to embrace the particulars of its immediate environment. The more precisely an animal is attuned to a particular "fitness landscape," the better that animal can thrive... in the short term at least, as long as everything stays just so. To be exquisitely adapted (as opposed to robustly adapted) is to be vulnerable to the slightest change.
  
  Thus when the fitness landscape DOES change -- as it inevitably will -- the heavily specialized competitors tend to get crushed (if not go extinct). If a strategy-gone-sour broadsides a large enough group of market participants, the entire financial ecosystem can be thrown into turmoil. When the turmoil from this upheaval spills into the broader economy, wreaking havoc in its wake, the "demon" spoken of in the book's title is unleashed. (As this reviewer interprets it anyway.)
  
  Wisdom of the cockroach
  
  So the problem, in sum, is Wall Street's tendency to `overadapt' to every appealing landscape it encounters, building up complexity and leverage to dangerous levels in doing so.
  
  Bookstaber's suggestion is to heed the wisdom of the cockroach.
  
  The cockroach has survived a longer time span, and a wider variety of harsh environments, than humans could ever match. It is one of the creatures man cannot wipe out no matter how hard he tries. And yet, the cockroach's key risk management strategy is embarrassingly simple... simpler, even, than putting in a stop loss. The deeper point is that simple equals robust; by refusing to get fancy, and sticking with the tried-and-true, the cockroach ensures its reign as champion survivor.
  
  Bookstaber uses the cockroach (and other examples from nature) to argue that we, too, should consider cutting back on our excessively specialized ways. The cost of a rough-edged strategy is forgoing excess profits in accomodative environments... but the benefit is increased likelihood of survival in a much wider range of environments, including the truly harsh ones. (As Jim Grant likes to joke, if so many of these credit-driven vehicles can barely handle prosperity, how are they supposed to fare when adversity hits?)
  
  Harrumphs all round
  
  Bookstaber's finger-wagging solution (be less fancy; take less risk) has the ring of common sense to it, especially in the way it frustrates all those market participants determined to have their cake and eat it too.
  
  For those who seek to wring every last nickel out of the market (as LTCM used to brag of doing), Bookstaber argues persuasively that flying too close to the sun will always be perilous. The commitment to leveraging every edge on a broad scale inevitably leads to disaster-prone configurations, no matter how smart the players.
  
  For those who think the answer is greater regulation of markets, i.e. more rules, Bookstaber shows how extra layers of bureaucracy can actually bring about the exact opposite of the intended affect. Perversely, layers of red tape can (and often do) make a situation more risky, by increasing confusion and complacency simultaneously.
  
  Nor is greater information disclosure the answer. If the market's traditional liquidity providers (traders, market makers, speculators etc.) are forced to disclose their positions to the world in real time, they will react in the manner of poker players forced to play their hands face-up. To the extent that disclosure resolves uncertainty, it also drives market participants from the game. And because "liquidity is a coward" as the old saying goes, always running away when you need it most, strict disclosure rules would likely make bad market conditions worse at the least opportune times.
  
  Some left smiling
  
  Two groups in particular may be left smiling at the end of this book -- value investors and trend followers. In both the theory and practice of their normal operations, value investors and trend followers intuitively embraced Bookstaber's message a long long time ago, favoring longevity and robusticity over the temptations of adjusting to the moment.
  
  It is perhaps not surprising, then, that value investors and trend followers are arguably the most profitable market participants by far on an absolute-dollar basis, hauling in hundreds of billions in profit over the course of many decades. They are champion survivors too... with a touch more class than the cockroach.
  
  
  
  

• Treatise + autobiography + payback of former colleagues

  
  By AAP7PPBU72QFM on 2007-08-07
  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.
  
  

• Accurate, relevant and complete.

  
  By A1NUQ43K3RT7GY on 2007-04-26
  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.
  
  
  
  

• Some interesting insights within

  
  By A3EQQP0LD4Z375 on 2007-04-30
  It is always interesting to observe and study how humans cope with calamities or uncertainty, whether it is in the context of the financial markets, a tornado, hurricane, or tsunami, or armed conflict. The reaction to disasters, it might be fair to say, is usually limited, in the sense that the tools that it deploys are not usually extensive in their conceptual scope. When facing situations that cause great anxiety, simple solutions are to be preferred over complex ones, for the latter usually take too much time to conceptualize or to implement. Constructing complex systems, situations and scenarios is an activity that is best done in periods of calm, when long-range planning is necessary, and there are no fires to be put out.
  
  The contemplation and explanation of financial disasters, such as stock market crashes or hyperinflation have resulted in a large amount of literature in the last decade, due in part to the participation of a large section of the populace in financial deal making, stock trading, and real estate speculation. The rise of the Internet and the resulting ease of information flow have democratized the financial markets to a scale that is unprecedented in economic history. Embedded in this literature are extensive discussions on the financial debacles that have subjected market participants to strong perturbations, emptying their pocket books and bank accounts, implanting in their brains a large amount of aversion to risk, and instigating them to find excuses or blame for their economic decimation.
  
  But the financial markets, like all other systems in the twenty-first century, are enormously complex, and finding the culprits behind these fiascos is difficult, despite the confidence of many who profess to their understanding. This book is one of many that make claims to this understanding and to a fair degree and despite the purely qualitative nature of its contents it offers some interesting insights. For those who work in the financial and banking industry, some of the claims made by the author are difficult to accept, particularly those where his personal involvement is thought to be responsible for financial meltdowns or debacles. It is easy to fall into this trap, since expertise and over-confidence can result in an intellectual myopia or confabulation that reinforces beliefs that one's actions are having direct effect on scenarios or events that are in reality very entangled and very difficult to decipher. As an example of this, the author claims early on in the book that he participated in "knocking the legs out" of the October 1987 market, and "started things rolling" in the 1998 crisis for Long Term Capital Management.
  
  The author points to the `complexity' of the financial markets as being the root cause of the crises that have occurred without warning in the last two decades. But defining complexity quantitatively is somewhat difficult, at least from the standpoint of arriving at a definition that is practical. The author does not do this in the book, but instead gives the reader a notion of complexity that he feels can be readily understood by the targeted readership, who are assumed not to have a background in advanced statistics or mathematics.
  
  Very interesting along these lines is the notion of `interactive complexity' that the author discusses in the book. This concept is proposed as a measure of the manner in which the components of a system are interrelated and connected. The components of a system that is interactively complex can interact in such a way as to cause surprises to observers or at least violate their expectations, in that they can fail in ways that are "unfathomably improbable". Even though this definition is not on the surface sharp enough to distinguish an "ordinary" system from one that is "interactively complex", the author gives enough elaboration to encourage the reader to investigate the concept in more detail. This reviewer first encountered this notion in the study of networks, these having their share of `normal accidents' but also considered to be "high-risk" technologies. Some failures in networks can indeed be explained by an appeal to the systems that is constructed from as being `tightly coupled', and thus interactively complex in the manner in which the author discusses. He gives other examples of such systems, and ones that are not.
  
  Given the time and resources, it is somewhat straightforward to administer and control interactively complex systems like networks due to the locations of their components, which without too many exceptions are fixed. This allows a study of networks to proceed without too much trouble, in that some, if not all, of the information that flows into the components can be measured and studied. But the financial markets consist of computers, trading desks, networks, and most importantly people. One can study the information flowing into computers and trading desks quite easily, but technology is not yet advanced enough to peer into a trader's brain in non-laboratory conditions and study real time how it is processing information. So a financial system is without doubt interactively complex in the sense that the author defines it, but it must be remembered that this is because of the lack of technology (to study brain processing and predict subsequent trading behavior), not because of something intrinsic to the system itself (there is a branch of cognitive neuroscience called `neuroeconomics' that has as its goal this type of understanding however). This lack of knowledge about how human's process financial knowledge is the primary reason for the interactive complexity of the financial markets. Failures do seem "to come out of nowhere" as the author writes, and if viewed from a statistical framework have an extremely small probability of occurrence.
  
  The author does believe however that systems that are tightly coupled and interactively complex can be managed if there is enough time available. If there is not, then such a system cannot be managed either by a centralized authority or by some sort of adaptive approach that learns on the fly. This is a crucial point, since it seems all bets are off when it comes to the risk management of these kinds of systems. This of course will trouble those individuals who are responsible for managing risk, for there seems to be no reasonable approach to softening the pain produced by such systems. The author's solution to this is expected but still somewhat puzzling: he wants to reduce the complexity of these systems in order to make them manageable. This is an odd proposal since it diminishes or trivializes the ability of the human brain to understand the complexities of these systems using the tools of science and technology. Advanced technology, particularly the use of artificial intelligence, will be able to handle the small time scales involved in the financial markets and take appropriate action if necessary. There is every reason to be confident in this kind of technology, and this reviewer believes that it will evolve into a kind of surrogate risk management, performing functions that humans are not able to handle effectively due to their biological limitations.
  
  
• 4 Stars for the Stories
  By AZGPL09QX60JE on 2007-05-29
  As the title of my review suggests, this book has great stories from a great insider. I am only in my 30s but already have 12 career years on the sell side of Wall Street. If I were captain of a Wall Street team, I would choose Bookstaber first. After reading this book my insight of the inner annals of opportunistic proprietary, arbitrage and hedge fund trading is drastically realized. Nevertheless, I found the pre-tense hype of the book leading to an unrealized end. Let's talk about the book:
  
  Before reading the book, I thought the modern day global coupling of highly leveraged derivative strategies would be identified with respective consequences. It took me to almost the last chapter to realize this wasn't going to happen. The book was ripe with timeless stories of innovation & disaster. Bookstabers stories and recollections were an important piece of a puzzle put together by countless other books and reports. Richard's career is fascinating and he belongs in the Hall of Fame of Wall Street maybe for reasons other than why Soros or Buffet would be there. I could almost hear Richard's voice in his first person authorship and appreciated his consistent tone. I only wish the book followed the stories with modern day references, respective leveraged strategies and how Richard thinks they can blow up. I guess you can say he laid out foundations which we could apply to modern day wind-up bombs but this isn't enough.
  
  The stories stop midway through the book where the biggest beef can be found. "The interplay of complexity and tight coupling that comes from combining liquidity with its derivative and leverage offspring is a formula for disaster." Alright! Let's start talking about carry trades, relative value in a razor thin risk premium environment and a synthetically low yield curve due to foreign reserve buying! It doesn't happen. The book goes mostly academic, albeit for lehmans, by laying out several caricatures, analogies and non-financial historical events which all masterfully lead to his arguments of what is bad and why it can go wrong. Bookstaber truly does a great job doing this at the expense of providing modern day meat.
  
  Accepting the book for what it is, and putting it on the "great read" bookshelf, my closing thoughts were somewhat open ended. Having bought into Bookstaber's arguments and premise, I wanted to know what his personal long term investments are. Bookstaber's Wall Street career was purely focused on generating returns from everything that is not Fundamental and Long Term. His career was to capitalize on the inefficiencies and phenomena of our trading institutions, with either his firm's or other peoples capital, while the average Joe was using the same market to buy General Electric based on the American Dream. Bookstaber did not execute (or oversee) trillions of dollars over his career with the same long term objectives and beliefs his retail counterparts were piping to their clients. Bookstaber calls the players involved in this high-stakes corporate game "Liquidity Providers" rather than what they are, "Greedy." How can you claim that a proprietary trader is providing liquidity when these same individuals caused the '87 crash? How can you say a Liquidity Provider can be the cause of billions of dollars of losses because their game caused a downward spiral in our markets? I was a little disturbed when Bookstaber quoted Karl Marx in context of his innovation argument (which his argument aside of the Marx reference was right on the mark). I think Karl Marx's quote is better applied to why greater populations will lead more people to buy more tooth brushes; Hence why the stock market over the course of Dow charted history has gone up. Before I drift to far away on my soap box, I want to know more about the first person Author. If he believes a Liquidity Provider is good for capatilism, then what does he think is a good long term investment strategy for his family. I think this is only fair if we are going to judge his argument that high stakes speculative trading, hence liquidity providers, are a good thing.
  
  Bookstaber is the best steward of Hedge Funds I have ever seen and unfortunately the book in the closing chapters became the coke bottle in the Tom Cruise movie. I found great value and belief in Richard's outlook for hedge funds as well his structure of how to categorize them. I just don't believe in the reality of his argument that a hedge fund manager will do better then his equal investment fund manager because of their greater flexibility to engage in unlimited risk transactions (i/e short). This argument mirrors the faulty assumption that greater risk equals greater return. In reality, risk is defined as losing money. I guess Murphy's law of, "What can happen will," is my premise here. I don't think Bookstaber is prepared to defend that a greater return will always prevail as a result of having greater risk flexibility versus the potential of greater loss resulting from greater risk taking. After all Wall Street loves to mask the geometric relationship of losses (To get back to par, you need a 100% return to cover a 50% loss). The restrictions of a common mutual fund manager might be the saving grace for an unsuspecting investor.
  
  I am friends with a couple authors and know their addiction to "Amazon Rankings" and book reviews. If in fact Richard reads this review, I am humbled and only wish I could invite him to dinner. I will forever be a Richard Bookstaber fan and buyer of every book he publishes. I am sure his sons know how lucky they are.
  
  
  
• File under "finance books" not "pop science bestsellers"
  By A1NUA9J2JJQW0C on 2007-05-23
  I don't want to trash this book or to sing its praises but merely to note that as a layperson I found it a bit difficult to relate to. I have perhaps been spoiled by the recent outpouring of pop finance books like Aaron Brown's "Poker Face of Wall Street" and Nassim Taleb's "Black Swan." Prospective readers should be aware that this book is of a different breed. It is clearly directed at the finance community. If you are interested in war stories about the persons and personalities of the big investment banks then this book is likely to be highly appealing. If, like me, you are a generalist looking for pure high-concept argument, then you may be disappointed to find that only about 1/3 of the book consists of ideas.
  
  In a nutshell, the author uses a biological metaphor to argue that financial complexity is dangerous. Highly specialized and intelligent organisms (say...elephants) are more more vulnerable to changes in habitat than simple, stupid generalists (the author uses the example of the cockroach). Similarly, the more highly specialized a financial instrument is, the less it will be able to confront wide variety of conditions and the more vulnerable it will be to catastrophe. It is, in other words, better to be adapted for change than to try to prevent it, anticipate it, or react to it. Worse still, when ALL of the players in the game adopt highly sophisticated strategies, the system itself becomes unstable. And this is the demon Bookstaber argues we have created: a fragile and homogenous ecology of highly-specialized financial instruments.
  
  I enjoyed this argument a great deal, but I thought it deserved to be developed more fully. Specifically, I thought that the author could have done a better job relating his ideas to the literature in the other sciences of complexity. The point that complexity increases the risk of catastrophe has been made by many others working in other fields. I was hoping that this book would survey that literature and then apply it to the financial world in a way that financial outsiders could easily digest. It does not do that, but it succeeds in other ways. It is very clearly-written and -although the author presumes a strong financial vocabulary- there is no symbolic math.
  
  
• not introductory level
  By ANBEFZNSUSSQI on 2007-12-17
  Just a warning - if you don't know what LTCM stands for or have never heard of a "swap spread", you may want to read some other books first - Peter Bernstein's book on risk, or "When Genius Failed". The title is somewhat of a misnomer - this is more a collection of Wall Street war stories than an explanation of modern financial instruments and innovation. If you have the background to follow it, though, it is entertaining and scary.
  
  
• The right book for the times
  By AW26N4WEAE4D5 on 2007-04-05
  This is a great and important book about financial crises (past and future) by a guy who has been there. A must read for (at the least) financial professionals of all stripes.
  
  
• Eye Opener on how our Present Markets Work
  By AVCBDAOKG8QQT on 2007-08-15
  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.
  
  
• Bleccch
  By AX75U9UMJFA0U on 2007-12-27
  If your interest is first person experiences told by "I this" and "we that" relating to events that are stale and bear little relation to the title of the book, then this text is for you.
  
  Filled with cliche and innuendo Bookstaber does little to address the issues of hedge funds today. There are powerful lessons to be learned from the past yet the author draws no conclusions from investing in the 1980s and 1990s to the proliferation of hedge funds today.
  
  The one steady commentary running through the book is liquidity and its importance to functioning markets. If you have a reasonable knowledge of markets you will learn little from this book. In story after story after story there are no conclusions reached that could help the hedge fund or private investor today.
  
  And who, by the way, edited the text. There were numerous textural errors where sentences had been restructured but words and text left dangling. Wiley should go back and fix the errors and re-issue another edition.
  
  In short, a true disappointment. Judging by the length of some of the other reviews it is clear Bookstaber enlisted some of his academic friends to write ridiculously detailed reviews to juice the ratings. After all, the ratings system is an inefficient mechanism to drive book sales (the market) and one would expect him exploiting this defect.
  
  
• Flat out or Flat Broke for Financial Innovation
  By AQ5VTL82VW14L on 2007-06-11
  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.
  
  
• Lightweight, a conversational biography, good
  By A2RM5Z9LO295E6 on 2007-07-29
  This is not a heavy theoretical work, contrary to some of the reviews here. This book is more of an autobiography along the lines of Barton Bigg's "Hedgehoging" (also pretty good) or something by Andy Kessler or Michael Lewis (excellent writers) but not as funny or good. But it gets interesting if you read it carefully: basically the author makes the somewhat implausible and incredible claim that the financial institutions that come up with exotic finanical products don't really understand these products themselves, or, equally incredibly, that they market simplistic versions of these products (that can fit on an Excel spreadsheet--however the author was talking about the late 1980s, so perhaps it's possible), or, more credibly, that even when these exotic financial products are used successfully, their profit potential only lasts a few years since they become widely imitated. The author closes with some interesting but speculative parallels between biology and financial markets, arguing that more looseness and 'slop' be allowed in a financial system, because if it is too "tightly coupled" and precise, too many things can go wrong. The analogy between the success of a cockroach, which filters information and is actually pretty simplistic, and a robust financial system is interesting. Interesting tidbits of history are thrown in, for example how primogeneture from the medieval ages prevented liquidity and thereby wealth creation (Peruvian economist Hernando De Soto would agree). Also some good scuttlebutt is disclosed about various famous Wall Street personalities, and the clash of cultures between Citibank and Salomon Brothers, as well as the characters like Paul Mozer and John Merriwether [who seems to take disaster with him whereever he goes, as he ended up leaving Salomon for the ill-fated LTCM] that got Salomon into trouble in bond trading. For example, I did not realize that Salomon chief John Gutfreund lost a good part of his fortune as a result of the bond trading scandal. Contrary to the subtitle, except at the very end of the book hedge funds are not really discussed much; this is more of a quant/ financial engineering book. Insofar as writing style goes, it is easy to read first person passive voice. All in all a good book you can finish in a few days, and it captures your interest.
  
  
• Unsatisfying Mix of "Liar's Poker" and "Remarkable History of Risk"
  By A21QJ6WV3K2X74 on 2007-08-18
  Mr. Bookstaber appears to have set out to write a memoir to rival "Liar's Poker" (from a more famous Salomon Brothers alumnus Michael Lewis), and the book starts out well. But after the first third of the book, the narrative loses steam and then meanders listlessly, and then finishes with barely a whimper. You'd be much better off reading "Liar's Poker" and "Remarkable History of Risk" for entertainment and educational value.
  
  
• A well written -- and, it turns out , prescient -- look at the markets
  By A15H8ETI46CPK0 on 2007-08-19
  This book has become a must-read for people I know in investments, so I decided to read it. And I thought it was great.
  Bookstaber ran Morgan Stanley's portfolio insurance, the market "innovation" that ushered in the Crash of '87, oversaw risk at Salomon when "Salomon North" (aka LTCM) failed, and up until recently ran a quantitative hedge fund. It looks like he's seen it all and has been in the middle of most of it. He has taken that experience to create an argument for why we see the sorts of market crises that we are embroiled in now. And what to do about it.
  To top it off, it is readable by a non-professional and entertaining with a peppering of personal experiences.
  
  
• A MUST READ for all financial markets professionals
  By A3QH7WR9AY2LIY on 2007-09-13
  This is an excellent book. I cannot say enough good things about it. Unquestionably one of the best books on financial markets of the hundreds that I have read. This book provides a ringside view of how the major banks and hedge funds work and why financial risks have become more magnified than before.
  
  Derivatives, trading and hedge funds are here to stay. They perform a valuable service to the financial markets, though Warren Buffet will disagree with me. Nevertheless, it is the mis-use of derivatives and the excessive use of leverage that leads to financial disasters. This book provides an excellent insight into why we witness financial turmoil in some of the most liquid markets.
  
  I strongly recommend it to all MBA finance students as well as to financial markets professionals at hedge funds, prop trading desks, risk managers, quants, bankers, pension fund managers.
  
  
• Not much new but well written with some ideas.
  By ABKK8267EVFF on 2007-11-21
  The book by Bookstaber won't provide much additional information if you are already familiar with most of the major leverage-driven derivative trading events in recent history. However Bookstaber provides a very readable overview as someone who was there but one step removed from the inner circles.
  
  Towards the end of the book he makes an interesting point. Starting with Godel, Heisenberg and Lorenz (bravo!) he moves into a discussion of biological methods for dealing with risks that are unknowable. What comes out is a powerful reminder that the right designs for dealing with *known* risks often come at the direct expense of being able to deal with *unknown* risk. This helps to explain why one set of regulations often leads to another different crisis, followed by a new set of regulations and so on.
  
  Lastly there's a good quote about research we have to include here for future use. "There is no reason to think this exercise of tearing apart the accountants' aggregation (10Q's and the like) and then trying to re-aggregate it into a meaningful form can be successful. And it certainly is not the ideal. The ideal is not to take something that is pieced together incorrectly and then redesign it; the ideal is to start with the raw materials, the actual transactions themselves, and build from there. For example, beyond the standard accounting numbers, statistics that might be helpful for companies with non-tangible assets are the cost of acquiring new customers and the retention rate for those customers - think of the insight these would have provided into America Online (AOL) in its years of burgeoning growth - sales backlog, contracts received versus proposals made, training expenditure per employee, revenue from new products compared with revenue from old productions, the proportion of business that is done with existing customers, and the time it takes for a new product to recover its development cost." A Demon of our own Design, Richard Bookstaber, p139.
  
  Bookstaber may not realize that most fundamental equity research looks at precisely these sorts of things but it's still not the rule and sometimes people who know better forget.
  
  
• Overestimates the reliability of probability distributions
  By A1UI9T8WKJPZN5 on 2007-06-15
  This is a very good book overall.The author is certainly correct that the proliferation of many new categories of assets, specifically designed to deal with one,special kind of risky event,has created additional instability and volatility in asset prices overall because these new kinds of assets are susceptible to other kinds of risks that were not contemplated by the designers of the new asset.
  There is a major problem,however,in the extensive discussion of the risk versus uncertainty categorization made by the author in footnote number 12 in chapter 10.It simply is not the case that Knightian uncertainty(the author appears to be completely unaware of the much more detailed and technically advanced work done in this area by J M Keynes,in 1921 in his A Treatise on Probability,on the problem of the weight of the evidence,w,where w is defined on the unit interval between 0 and 1, (this appears in Keynes's 1936 General Theory under the name "uncertainty") and measures the reliability of the probability estimate ,and the work of Daniel Ellsberg in 2001 in his Risk,, Ambiguity,and Decision,with his rho index,also defined on the unit interval between 0 and 1, which measures the degree of confidence a decision maker has in the information and data base on which his estimate of what the relevant probability distribution to use is.Neither w nor rho can be dealt with by the assumption of a unique probability function)can be dealt with by tail probabilities .It certainly could not be dealt with by using the normal distribution's unsupported a priori specification that 99.7 % of all observations will lie within + or - 3 standard deviations of the mean.The tail probabilities relate to the Cauchy distribution's infinite variance,infinite expectation,and fat tails extending out as far as 20 standard deviations in applied work.The fact that Benoit Mandelbrot does not appearto have been referenced in this book means that it will be necessary for the author to include his work in a future,revised second edition.
  
  
• A scattered story-telling
  By A2QDC0KEY1GX87 on 2008-02-08
  I will not recommend this book because the content is not rich. The author based mnay of his comments not on data but on anecdotal evidence. Besides, the story seems to be everywhere. In the beginning, he talks about Wall Street, then physics, etc. Confusion is the word I give to this book.
  
  
• Good read? Yes. Practical? No
  By A1FKFG7NR9A7C0 on 2008-04-19
  This book will be a great read if you want to know someone's way into the Wall Street's biggest companies and his experiences working in those companies, but you will not find anywhere in the book practical recommendations on how to manage risk of a fund. The author says that he was behind the October 1987 crash, because it's him who started the program trading at Morgan Stanley and then other firms started doing the same thing. By accumulating the hedge from the short side in S&P 500 futures they caused a crash. It sounds to me like Dr. Richard Bookstaber is proud that he was the one who was somehow connected to the crash of 1987. The most interesting part of the book was about Bookstaber's career at Salomon Brothers. The chapters about Salomon's arbitrage team in Japan are exciting. Rob Stavis and Andy Fisher brought a lot of dough to the firm and then left it. The money making technique is explained in the book as well, but then again, how did they manage the risk when they got into troubles? The trade of 1993 by Larry Hilibrand at Salomon is an amazing example of the real TRADER, someone who doesn't fear the risk and in the end takes it all. The position was in a loss of 300 millions dollars and ended up with a nice 1 billion $ profit for the company. But again, no strict money management rules were mentioned here. It was the board of directors of Salomon that let Hilibrand stick to the position and even increase it, why Dr. Bookstaber, the company's risk manager, didn't manage the situation remains unclear to me. The chapters of Complexity, Tight Coupling, and Normal Accidents contain too much explanation of the workings of a nuclear plant. Why a trader needs to know that? Why couldn't you simply bring examples instead of going into details like: " The operators resorted to what is termed high pressure injection to force cool water into the core. This raised issues of its own, as the sudden injection of cold water into the superheated core could crack the structure." (Page 150). Why do you think it's important for a reader to know the details of a nuclear plant structure and its functionality? The most boring part would be "Liquidity in Three Easy Lessons". Here you'd read something like:" The implications of primogeniture were most evident in the social organization of the countryside" (Page 216). Why should someone who is reading a book on risk management and trading read about countryside of medieval England? Eventually Bookstaber - Langsam paper "On The Optimality of Coarse Behavior Rules" was interesting and you could learn some surviving principles from this chapter. In the end of the book the author talks about reducing the complexity of the financial instrument and minimizing leverage as a way to prevent the crashes and make the markets robust. I doubt that reducing the leverage will help the markets become more robust, reduced complexity could do that. Is it a good read? Yes. Is it a practical book? No.
  
  
• A view from the inside
  By A11MD2N9YLOJT3 on 2007-05-10
  The book articulates an important perspective from someone who has worked through the major market crises during the last 20 years. The experiences are insightful and the book is tightly written containing both interesting examples and concepts.
  
  
• Only a Matter of Time
  By A10LWBOIZCF2QT on 2008-02-01
  The premise of this book is definitely interesting: the financial products introduced into the market in the past few decades have become too complicated for our own good. But the book seemed more of a history lesson in finance in the past twenty years than a warning that we are setting up our own economic demise. Yet, it's a worthwhile history lesson, especially upon the tail of what we have seen the subprime and collapsing MBS market do to the markets. The book highlights the ups and downs of the financial markets since the 1987 crash, as told by one who witnessed it all occur firsthand. Bookstaber assumes that the reader has a certain level of understanding of finance and complex financial products and provides excellent examples of how increased regulation and safety procedures actually led to more problems and human error once the emergency that was sought to be prevented by the safety measures occurred. The bottom line: we are not better off if we can squeeze every last dollar out of some financial product. The markets and financial engineers should focus on what they know works, is understandable and simple. Otherwise, a crash bigger than one we have ever experienced before is bound to happen.
  
  
• Great risk insights, and lots of useful reminders on liquidity mechanics
  By AA7N4H0ZV389Y on 2007-09-21
  A finance-related book like this one is always something I open with a fear of "deja vu". To Bookstaber's credit, his numerous insights quickly got me over this. It is a constant reminder to risk practitioners and traders that liquidity supply is a serious matter. It does indeed move mountains. For new comers into risk management and trading, it explains the sources of the LTCM debacle, and its learnings. By all standards, I recommend this book to any finance graduate, experienced trader, or risk manager. A very useful read.
  
  
• Fascinating context, a little weak elsewhere
  By A7XO1DM6W3DOS on 2007-12-16
  Bookstaber has had a fascinating time on Wall Street, and was in a great position to watch various debacles such as the market crash of 1987 and the collapse of LTCM. Because he spent much of his career in risk management, he has a great viewpoint on the failures that let such disasters keep recurring. While he published his book before the subprime mortgage meltdown, reading it will give you a much better handle on how UBS could so mismanage risk as to require a $10 billion write-down.
  
  The book gets weaker when he leaves those topics for which he was in close proximity. He uses the ValuJet crash and the Three Mile Island nuclear accident to illustrate points about how system design makes accidents more likely. While the examples are certainly apropos, they make for dry reading against the more personal accounts. Fortunately, his interesting narrative constitutes the majority of the book.
  
  There are also a couple of surprising errors. For example, he completely misstates the risk profile of principal only (PO) mortgage securities, saying that the holders lose out when prepayments come either faster or slower than expected. (Actually, PO holders make out very well when prepayments accelerate.) Such factual errors, while rare, are so blatant that they somewhat undermine Bookstaber's credibility. If he doesn't understand such a fundamental product, does he really understand the causes of market instability?
  
  But despite such errors, his description for the reasons of increased instability ring very true. And enough of this book is a fascinating, engaging read, that it's worth getting just for that reason.
  
  As a last note, while Bookstaber does usually define his terms, much of this book will be incomprehensible to someone without some background in financial markets. If you don't know what a basis point is, or how a stock option works, then I doubt you'll enjoy or get much out of his writing.
  
  
• GLB
  By ANHDUL6XQJN36 on 2008-08-14
  I have had great difficulty reading this book firstly as I am not a quant nerd. Secondly, the author deems fit to draw comparisons with hedge funds and a host of unrelated topics eg. Chernobyl, Two Mile Island and the military and the Post Office (for heaven's sake)! The less said about the ill fated shuttles the better!! Third, the book is poorly written and/or badly edited as there are many duplications throughout the text an example of which is LTCM which crops up in every other chapter. Nevertheless, I also read the authors' presentation to the oversight committee of Congress where he did a complete about turn and in complete contrast to this book stated that better regulation was the way forward!
  Confused? You better believe it!!
  
  
• Crash of 1987
  By A5WMBIOGE8Q6N on 2007-08-16
  Portfolio insurance created a new form of investment strategy opportunity. Portfolio insurance is design to protect a portfolio from dropping below a prespecified floor value. The strategy works by hedge - selling S&P 500 futures. If the portfolio increases in value and moves above the desired minimum floor value, the hedge is reduced, allowing the portfolio to enjoy a greater fraction of the market gain; the hedger purchase an undervalued stock with good prospects of profit (innovation, market interest, or breakthrough technology) and combines a short sell of a related security, in the case the market goes down. The short sell allows short term gain, offsetting some of the losses. The risk occurs for a catastrophic downturn when the complete market is experience a tidal wave of selling and buyers are reluctant to enter fearing "unknown" news may be known by the other buyers.
  
  The trader hedges the risk by short selling (number of shares x price). "If the trader were able to short sell an asset whose price had a mathematically defined relation, a call option, the trade might be essentially risk less and be called arbitrage." Suppose two stock share a correlation X and Y.
  
  A trader can borrow a security and sell it, a short seller. A short seller is used when the trader believes the stock will decline. A long seller is used if the trader believes the stock will rise in value. The trader owes the broker the monies for the security, who is hold his shares long; the broker seldom actually purchases the share to lend to the short seller. If the trader borrow 1000 shares of X for $10, he assumes a $10,000 loan, if the price of the shares drop to $8. The short seller would buy the 1,000 shares back for $8,000 and return the shares to the original owner, profiting $2,000. If the share price climbed to $12, a $2,000 loss would be realized.
  
  Short 1,000 shares of X at $10
  And Long 500 shares of Y at $20
  
  Arbitrage insures the investor funds. The risk occurs if no market exists to hedge, a selling frenzy.
  
  Oct 19, 1987, a severe imbalance of buyers and seller occurred where sellers of futures outpaced the seller of stock on the S&P 500. The price decline which usually would have been like a dinner bell for buyers, but the velocity of the price drop signaled for buyers to stay on the sidelines and await more information. At the end of the day, the S&P had dropped 22 percent and the futures market declined 29 percent.
  
  Portfolio insurance program complicated the matter the downtick rule, which proscibes short-selling a falling stock. "The arbitrageurs wanted to buy the futures and sell the stocks short against them. If the market is in free fall...many short seller are trying to squeeze in their execution. It can take time to execute the trade. In the meantime, the long futures position is being held unhedged. If the market drops, the trader loses."
  
  "When the S&P futures contracts sell for less than the price of the basket of individual stocks in the S&P; then the cash-future arbitrageurs buy the S&P and send in orders to sell the stock. If the price difference is greater than the transaction cost profit is guaranteed."
  
  The arbitraguers caused large and long range effects that crashed the market. "The potential liquidity suppliers and investment buyers were being scared off by the higher volatility and wider spreads" With each drop the portfolio software trigger more selling, and portfolio managers threw more sell orders into the futures market" "By the time equity investors could have reacted to the prices and dones some bargain hunting the specialist had moved prices so precipitously that these potential liquidity suppliers were scared away."
  
  
  
  
• A Warning about market risk.
  By AGP9YEWH8VJCK on 2007-09-12
  This book is mostly devoted to the author's career in risk management of hedge funds and the like. The author warns against the present complexity of our financial system because of leverage, hedge funds and derivatives. He states that the current complexity and increasing complexity makes it a more dangerous place to invest. Unfortunately he provides very few answers for the investor to protect himself .
  
  
• Timely! and well done.
  By A93LQJYN9ETLC on 2007-11-27
  I would have bought this one just for the clever title and jacket design.
  It turns out to be a thoroughly readable survey of the gathering storm of risks being built into modern financial markets. Bookstaber was, in his own words, "in the vicinity" for the fiascos of portfolio insurance, Salomon Bros. and Long Term Capital. This book appeared just before the subprime mess but, when reading it, it feels as though it is being discussed. The arrogant rise of the "quants", the insane use of leverage in the belief that hedges made it all safe, the corrupt system of incentives... it's all there. Moral: on Wall St. the hundred year flood comes every seven years.
  
  
• Essential Reading for Traders, Investors, and Regulators
  By A74RVK5ZVI91X on 2007-11-27
  This is a beautifully written, entertaining and informative exposition on markets and hedge funds, and what can go wrong. Traders and investors will find a tremendous amount of useful information clearly laid out. Much of the content is based on the experience of the author, who was directly involved in the investment banking and hedge fund business for many years.
  
  Besides being factual and very well documented (there is an index and detailed notes on each chapter) this book contains insights and viewpoints supported by sound arguments that you are unlikely to find anywhere else. Personally, I believe that not only should all traders and investors read this book, but all those involved in the regulation of financial markets should read it as well. I believe it is destined to become a genre classic. I could not put it down. It is a fascinating and rewarding read.
  
  
• Insight into the Past 2 Decades of Financial History
  By A23SB6VGGB9E8U on 2007-12-09
  Today's financial derivatives, designed to control risk, have only succeeded in intensifying it.
  
  The author, Richard Bookstaber, a Wall Street quant, makes a simple point. Although economic growth is more stable today than it has in the past 50 years, the markets have grown more volatile. A MIT-educated mathematician was lured out of academia to create complex financial instruments and computer models designed to limit risk. In his own words, he failed.
  
  Yet that does not lessen his insight. The author paints as poignant a picture of the 1987 Crash and Long Term Capital Management (LTCM) failure as I have read. In the latter case, he argues convincingly that LTCM demise began not with the Russian default, but with Sandy Weill's decision to shutter the newly acquired U. S. fixed income arb desk of Solomon Brothers,
  
  As great as his historical analysis is, Bookstaber's book appears to lose focus when stipulating solutions. The author admits it took him more than a decade to complete this book. That comes as no surprise. Complex situations defy Euclidean precision.
  
  His prescription of reduced complexity and coupling with less leverage seems, somehow, unlikely. Neo-classical economics with its efficient markets assumption does not jibe with today's instantaneous distribution of copious amounts of information. Until human beings adapt, volatility promises to increase.
  
  
  
  

• The Black Swan: The Impact of the Highly Improbable
• Capital Ideas Evolving
• The Age of Turbulence: Adventures in a New World
• The Panic of 1907: Lessons Learned from the Market's Perfect Storm
• The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash