A Demon of Our Own Design

Bookstaber ran risk management at Salomon Brothers and Morgan Stanley and worked at hedge funds, and this book argues that financial innovation has made markets more crisis-prone rather than safer, and that the mechanism is structural rather than behavioural.

His framework comes from Charles Perrow's normal accident theory. Systems that are both complex, meaning their components interact in unexpected ways, and tightly coupled, meaning there is no slack between processes and no time to intervene, will produce catastrophic failures as a matter of course rather than as a result of error. Bookstaber argues that derivatives, leverage, algorithmic trading and the interconnection of institutions have made markets both more complex and more tightly coupled, and that each innovation introduced to manage risk has added complexity that created new failure modes.

He supports this with first-hand accounts. He was involved in portfolio insurance, which he shows converted a hedging technique into a mechanism that generated the 1987 crash. He covers the 1998 Long-Term Capital Management collapse and the way liquidation of one fund's positions moved prices against every other fund holding similar trades, which is the mechanism by which a single failure propagates.

His prescription is counterintuitive and unpopular: reduce complexity, reduce leverage, and accept coarser instruments that do not fit needs exactly but that fail predictably. The book was published in 2007, months before the crisis it describes in general terms, which gives it standing. Its analysis of liquidity-driven contagion between apparently unrelated positions is the most useful part.