Author Richard Bookstaber, a hedge fund “rocket scientist”, presents a scary scenario in Demon of Our Own Design. Today’s financial markets are so complex and tightly coupled that a tremor in one area can have massive, unexpected fallout in another. The current subprime crisis which has triggered hedge fund implosions and cratered the housing market is a timely example of this.
Worse, attempts to add safeguards to prevent such problems can instead make things worse. “The catalyst for the ValuJet crash was a regulated safguard. The problems at Chernobyl started with a safety test.”
Added to this is current financial theory that posits that markets are rational and behave in mathematically precise ways. Not hardly, says Bookstaber. Worse, the theory does not allow for feedback loops. If a hedge fund gets a margin call and it forced to sell stock fast, this very action may drive the price down (aided by other big players who see a wounded animal that needs killing) and this in turn may force more margin calls. Because of the tight coupling of the markets, players who don’t even own that stock may find their holdings have dropped in value.
To solve these problems, Bookstaber says, we need to reduce market complexity, slow the speed of order execution, and cut down on the amount of leverage possible. This may make markets less efficient but will also create a market that is like a cockroach, it can survive and adapt to any circumstance. Because, as s now obvious, turmoil in seemingly arcane financial markets can have real-life consequences for millions.
The book is easy to read, non-technical and highly recommended.