Monday, September 10, 2007

Review of `A demon of our own design' by Richard Bookstaber

This book review appeared in Business Standard today. While on this subject, you might like to also read this article which appeared in Wall Street Journal.

A demon of our own design: Markets, hedge funds, and the perils of financial innovation by Richard Bookstaber, 2007.

Modern finance is a relatively new creation. In my reckoning, "modern" finance only got started in the early 1970s, with the launch of currency futures trading at CME in 1972, the invention of the Black/Scholes option pricing formula in 1973 and the launch of stock options trading at CBOE in the same year. In India, the starting point of "modern" finance was the rise of equities trading at NSE in 1995.

Many people who spent their formative years away from these developments, or grew up being used to Indian-style financial repression, have a profound mistrust of finance. By and large, this "fear of finance" is merely a luddite fear of the unknown and a conservative instinct biased against change. Richard Bookstaber is in a unique position of knowing the new finance from the inside. Starting from an economics Ph.D. at MIT, where Robert Merton was on his committee, to a ring side view of the evolution of modern finance, he has a tremendous knowledge of this new world. He was directly involved in the two major crisis events of modern finance - the 1987 crash in the US and the failure of LTCM in 1998. Hence, a provocatively titled book about the difficulties of modern finance by him has credibility.

It is said that great minds discuss ideas, average minds discuss events, and small minds discuss people. The accessibility of a book flows inversely from this - stories of people are highly readable, recounting events is fun, heavy pages of ideas are least read. Bookstaber has done a wonderful blend of personal memoir, where he takes you close to many of the key players of these fascinating decades, accompanied by a treatment of the major events of the period both at the level of personalities as well as a larger picture. And every now and then, he plunges into a mini-essay of big ideas.

I think this is an excellent way to write a book. Particularly in India, where most of us have little firsthand experience with the great global world of modern finance, the book is particularly useful in giving a flavour of how this world works. I would recommend that all senior staff in financial firms and financial regulators read the book. I only have a slight complaint that such an intellectually oriented personal story is not what you expect based on the title of the book.

The main puzzle of the book consists of the question: If we have devoted so much trading technology and financial economics into building modern finance, why do financial markets occasionally seize up? Why does liquidity sometimes abruptly vanish; why do `market crises' happen? Will loading on more trading technology, more financial economics and more financial innovation solve the problem - or make it worse?

There is much merit in Bookstaber's explanations. A key feature of the problem lies in the (mis)behaviour of employees of institutional investors, who suffer from two kinds of problems. First, regulations often prevent them from doing rational things. Second, the difficulties of organisational structure often give them incentives to do the wrong things.

I was disappointed that the book did not link up more explicitly to the `limits of arbitrage' argument of Andrei Shleifer and Robert Vishy, which works out the consequences of inadequate arbitrage capital in the real world, and the analysis of `liquidity black holes' by Avinash Persaud and others. I would encourage the reader to follow through from this book to an examination of those two themes.

This intellectual framework contradicts the Indian public policy bias in favour of `institutional' investors and against arbitrage. The Indian public policy bias against arbitrage is positively harmful, and constitutes one of the biggest intellectual failures of policy making in India, one that doubtless reflects the fear of finance in the minds of many key policy makers. The public policy bias in favour of `institutional' investors needs to be tempered by an understanding of their limitations. The employees of institutional investors are prevented far more often, by regulations, from engaging in rational trades. And, the difficulties of organisational structure that generate incentives for doing wrong things are only a feature of large financial firms.

In my view, the two important ways to make progress - which are not adequately emphasised by Bookstaber - are to emphasise individual market participants and to emphasise hedge funds. Individuals and hedge funds have behaviour that is less distorted by regulations. And in both cases, organisational dynamics intrudes to a lesser extent.

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