Grigg

Neil Grigg

Plan II Physics

Book Review: A Demon of Our Own Design by Richard Bookstaber

Richard Bookstaber directed risk management at Ziff Brothers Investments and

was the firm-director of Risk Management at Salomon Brother’s. In his recent book A

Demon of Our Own Design, he describes the risks present in the markets of today,

specifically in markets with innovative, synthetic financial products. Most of all, he

discusses the important role of liquidity in markets and the effects of herding behavior

in markets for derivative products.

Aside from studying Plan II, I’m also studying quantitative finance. In my

finance classes, I learn that complex financial products like exotic derivatives, swaps

on synthetic financial products, and asset backed securities all essentially serve to limit

and manage risk. They are. And, repeatedly I hear that the diversity of players in

financial markets - hedgers, arbitrageurs, speculators, market makers, hedge fund

managers, prop desk traders, and investment banks – bring greater stability to markets

through their diversity in approaches to markets. They are. And finally, I hear that the

legality surrounding markets – new rules to selling assets short, to leverage, and others

– have brought unprecedented transparency that removes unfair advantages in the

market. They certainly should be.

Yet, the truth is that: they are not. Markets are becoming more volatile. There

are more manias and more structurally inefficient products being traded. How is it that

the last two decades of financial innovation has not led us to be safer? The theme of

Bookstaber’s book is that recent financial innovations have left our system more brittle

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and vulnerable. Most of all, he emphasizes the role of liquidity in markets and the

limits of the efficient market hypothesis. Because financial innovations often stem from

physics analogies – the Black-Scholes options pricing theorem was, after all, based on

gas diffusion equations – we often see that problems are often arranged such that we

solve for a “min” or “max” value. As we learned in class, optimization problems like

these are used in physics because they ensure that we can have a single number as our

answer. However, markets cannot be efficient if all players overspecialize to the same

parameters. Bookstaber explains attacks the hypothesis that quantitative finance makes

markets more efficient using biological and evolutionary analogies. He suggests that

overspecialization to an environment leads one vulnerable to change. Intricate risk-

management structures may actually make markets brittle because they tune their

optimizations to quickly changing market conditions. Moreover, when multiple players

all are using the same products to hedge risks, it often leads to crises of liquidity when

all players need to use the hedge. Products in these cases cease to be insurance-like

because there’s no method to exercise them when push comes to shove.

In my view, Bookstaber has a sophisticated and practical set of ideas about the

recent shift towards physics-inspired financial innovation. For my article review, I read a

book review of Weatherall’s, The Physics of Wall Street, which carries the opposite

opinion of Bookstaber and believes that financial markets need more and not less

inspiration from physics. I agree with Bookstaber over Weatherall because I do not feel

that advocates like Weatherall acknowledge how seeing finance as an optimization

problem leads to overspecialization, causing the brittleness and liquidity crises.

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