“A Demon of Our Own Design” by Richard Bookstaber

Bookstaber’s book is appropriately subtitled Markets, Hedge Funds, and perils of Financial Innovation. He systematically looks at what precipitated the ‘Crash of 1987’ and LTCM, and Value Jet and Chernobyl.

The catastrophic failures are usually the result of complexity mixed with tight coupling giving rise to what he calls ‘normal accidents’ (i.e. unavoidable accidents resulting from structure of the process). Then adding regulation on top of complexity and tight coupling, to prevent the recurrence of a previous/predictable event, usually results in aggravating the situation rather than ameliorating it. Numerous examples from the financial and technological (Three Mile Island, Value Jet, Challenger/Columbia) worlds shows how in the presence of complexity and tight coupling, timing becomes critical and the resulting speed doesn’t allow time for improvisation and creativity.

He discusses emergence of Hedge Funds (explains what they are or rather what they are not, i.e. everything except the standard investment world), bubbles (from tulip bulbs to internet stocks), not-so-‘efficient markets’ due to liquidity seeking market participants, the butterfly effect (where small perturbations can result in massive changes in outcome) and then gets to the really interesting part, the cockroaches!

Why cockroaches? Because they have survived hundreds of millions of years due to “their strategy of dealing with unanticipated risk” using the very ‘coarse’ mechanism of “moving away from slight puffs of air, puffs that may signal an approaching predator”. There are other pieces of potentially useful information that are ignored like visual, smell and auditory, which one might think would be also useful, when in fact more data may actually detract from good risk management.

He shows that the ‘coarse’ response, “although suboptimal for any one environment, is more than satisfactory for a wide range of unforeseeable ones” The omniscient CEO will “eschew pinpoint targeting of the observed risks in favor of lower resolution, 360-degree radar that is more likely to capture the unobserved risks. The unanticipated events that are catastrophic for a species are not difficult to understand in retrospect; we can see that the species was simply not designed to anticipate and react to certain events”. (These are echoes of Taleb’s The Black Swans) The same can be said of recent catastrophic risks in the financial world. “The danger to the system is the system”. The greatest risks are those that we don’t see.

Financial innovation has been accelerating in the past couple of decades and while these innovations have positive effects, unfortunately they also increase complexity. On top of complexity, due to globalization we have growing interdependency among markets, i.e. more tight coupling. Then adding regulation to manage consequences, it ends up having the opposite to the desired effect.

What is needed instead is to prevent complexity at the source, reduce tight coupling, and reduce speed of market activity. What are needed are simple financial instruments and less leverage to have more robust and survivable market. Until then, we’ll continue to live with the unknown unknowns.

Bookstaber’s book is well worth reading!