A Demon of our Own Design

Richard Bookstaber
Ch.1 The Paradox of Market Risk
Virtually all mishaps over the past decades had their roots in the complex strucvture of the financial
markets themselves.
Ch. 2 The Demons of 87
The problem is you cannot always predict ahead of time if the correlation will be positive or negative. A
particular asset might end up hedging one another, or it might end up doubling your exposure.
Ch. 8 Complexity, Tight Coupling, and Normal Accidents
Just as loose coupling can diminish the effects of complexity, the effects of tight coupling can be
diminished by simple, linear systems. If a system is linear in the sense that actions move in just one
direction without any feedback, magnification, or potential propagation of effects, failures can be
addressed without blossoming into crises.
The problem with adding safety features to systems that are complex and tightly coupled-the very
systems that by nature have the greatest risk of catastrophic failure-is that they can actually increase the
likelihood of these failures because they contribute to the source of the problem: interactive
complexity. By adding that many more wires, switches, meters, and items for human oversight, safety
systems make the operation more opaque. The wires, switches, and sensors also interact with the
system; for every step in improving safety or monitoring failure, they introduce their own sources of
failure. If the safety mechanism are automatic-as they almost have to be in a tightly coupled systemthey serve as one more variable that can add to an unexpected result and a nonlinearity in effect.
Layer one safety system on top of another and you will finally doze off into a world on unjustified
complacency. You never end up as safe as you think because there are inevitably point of interaction
that can hide failures. More layers equal more obscurity.
Ch. 10 The Brave New World of Hedge Funds
The most immediate effect of a small float is to focus demand on the subset of investors who are the
most optimistic. If a company has a hundred million shares and puts all of them on the market, the
company has cast a pretty wide net to find investors willing to buy the stock. The marginal investor is
likely to be more reserved about the companys potential than the most optimistic investors who were
first in line to snap up shares. However, if only five million shares are put into the market, then they will
be bid up by the most optimistic fringe. The stock obviously will be priced higher than if more of the
outstanding shares were available in the market. And it will not take much investor interest to create an
explosive change in price.
So the principal reason for intraday price movement is the demand for liquidity. This view of the marketa liquidity view rather than an informational view-replaces the conventional academic perspective of the
role of the market, in which the market is efficient and exists solely for conveying information.
Ch. 11 Cockroaches and hedge funds

The principal reason that prices vary, especially in the short term, is liquidity demand. That is, far more
that acting as a conveyor of information, the objective of markets is to provide liquidity. Market liquidity
is essential to allow assets to be bought and sold quickly and with low transactions costs. And, most
importantly, it is in the froth of liquidity that profits are made and that the market demons are spawned.
Liquidity suppliers are providing an economic benefit and as such should expect to be compensated for
their services. Liquidity supplier rightly should be paid not just because of the risk entailed in
accommodating the seller, but also because fo the opportunity cost involved in making cahs available
for speculative positions, and in taking time to monitor the market and make trading decisions. The
compensation should also be a function of the volatility of the market. The more volatile, the higher the
probability in any time period that prices will run away from the liquidity suppliers. In addition,
compensation should be a function of the liquidity in the market, the less liquid, the longer the position
must be held, and the greater risk.
Because we cannot measure without some error, for many dynamic systems our forecast errors will
grow to the point that even an approximation will be out of our hands.
Simple systems can give rise to complex, even unpredictable dynamics, an interesting converse to the
point that much of the complexity or our world can-with suitable assumptions-be made to appear
simple, summarized with concise physical laws and equations.
The best measure of adaptation to unanticipated risks in the biological setting is the length of time a
species has survived. One that has survived for many years can be considered, de facto, to have a better
strategy for dealing with unanticipated risks than one that has survived for a very short time. A species
that is prolific and successful during a short time period but then dies out after an unanticipated event
may be thought of as having a good mechanism for coping with the known risks of one environment but
not for dealing with unforeseeable changes.
Animals placed in an unforeseeable setting show a less than fine-tuned response to stimuli and follow
less discriminating diet that they do in the wild. Dogs placed in an unfamiliar experimental setting would
curl up and ignore all stimuli, a condition call experimental neurosis.
If the CEO follows the lessons from the biological world, he will transfer resources away from managing
the known risks and reconfigure the risk management structure to better respond to the risks that
remain unknown. Knowing that the structure cannot address all the risks, he will streamline and simplify
formal processes and procedures because some of those procedures will obscure the unseen risks. The
CEO will decide that it is better to spend less time focusing on detailed investigation of the known risks
and more time thinking and reacting to the unknown risks. Similarly, he will simply the risk management
models and analyses. Specialized analysis, although important in providing perspective for what is
known, can only coincidentally do the same for the unknown.
Coarse measures will be more likely to indicate, although perhaps nut fully elucidate, areas of
unanticipated risk. And being more concise , these measures will be easier to discuss and analyze
intuitively than specialized measures. Our omniscient CEO will reduce the organizational complexity and
hierarchy of responsibility. This complexity, although perhaps effective in a specific environment, will
obscure unidentified risks that fall across organizational lines and slow the companys ability to respond.
The root of the problem is not the complexity of the unseen risks; it is the complexity of the
organization. Yet we continue to turn up the dial-witness the spate of mergers among financial
institutions.

The finely tuned approach to risk-the approach that would seem optimal in any one world-may in the
long run prove suboptimal. Given the complexity and fundamental unpredictability of nature, an
approach that is coarse and less complex may be the best long term risk management strategy. Unlike
the biological world, in the business world the more intricate risk management structures may actually
make the situation worse, leading to greater complexity rather than simply less robust response.
Organizations are inefficient, and larger organizations tend to be less nimble in response to the
unexpected and more prone to failure. Perhaps the problem rests in the very structure and nature of
organizations and institutions. The conflicting goals and mounting inefficiency of operating a large,
multilayered environment are part of this institutional structure, and will exist whether the individual
members of the organization are rational or not.
Once a normal accident occurs, controls can address recurrences. But if a system is already at a level of
complexity where normal accidents are common, adding one control after another will exacerbate
complexity and obscurity. Indeed, the conventional response to the unanticipable events will produce a
cycle where better and better controls of the identified risks will cause an upward spiral of surprise
events. If risk management can fail in unanticipated ways, then adding more controls cant address the
issue. This should lead to a more coarse, not a more detailed response. If we build finely tuned
structures of rules and systems that only address the risks we can embrace and understand, we will
continue to wander down the path of complexity, and pay its exorbitant toll.
We can manage market risk because we know the prices are uncertain; credit risk because we know
companies can default; operational risk because we know missteps are possible. But despite all those
risks we can control, the greatest ones remain beyond our control. These are the risks we do not see,
things beyond the veil. The challenge in risk management lies in our ability to deal with these
unidentified risks.
Conclusion
Financial risk is also higher because the markets increasingly assume a mathematical precise rationality,
as opposed to the way we actually do, or indeed really should, behave. People do crazy things all the
time, yet the efficient market paradigm assumes that investors take all information into account and
react quickly and rationally. The world is not well described by this paradigm; we tend to be coarse in
our reponses and we leave information by the wayside. We do this because we conduct our lives with a
sense of unanticipatable, primal risk that remains unconsidered in the markets design.
Coarse behavior leads to a paradoxical corollary: greater uncertainty leads to more predictable behavior.
Within the limited world of finance, this predictability is a decided negative.
Market crises are not born from nature. They are not transmitted by economic or natural catastrophe.
The machinery of the market itself can take small event and distort it. The more closely we try to follow
the ideal, thereby adding complexity and more tightly coupling the actions of the market, the more
frequently crises will occur. Attempts at that point to add safety features, to layer on safeguards and
regulations, will only add to the complexity of the system and make accidents more frequent.
Linked to the need to reduce market complexity is the need to relax tight coupling. The easiest course
for reducing tight coupling is to reduce the speed of market activity.