PROJECT M
 
Douglas Eu
Rick Bookstaber

What can we learn from a cockroach?

The cockroach is not the best-designed animal, yet it can teach financial markets important lessons about simplicity, says noted author Rick Bookstaber. And he almost convinces Douglas Eu, CEO of Allianz Global Investors Asia Pacific

What can we learn from a cockroach?

The cockroach is not the best-designed animal, yet it can teach financial markets important lessons about simplicity, says noted author Rick Bookstaber. And he almost convinces Douglas Eu, CEO of Allianz Global Investors Asia Pacific


Douglas Eu

In your book, A Demon of Our Own Design, you call for more simplicity, both in financial markets and regulation. Have your views changed since its publication in 2007?

Rick Bookstaber

Essentially, no. We still need a flight to simplicity; otherwise, the complexity and opaqueness of innovative financial products will remain a potential source of market instability.

Douglas Eu

Yet, new products never come into existence with a sudden big bang, but evolve over time. A limit on complexity would require someone to establish and enforce that limit. How can we improve financial innovation?

Rick Bookstaber

Financial innovation does not necessarily foster economic growth. Sometimes it is simply a tool for allowing market participants to game the system. New products ought to be required to bring additional value to market performance to create real economic value. I do not know the mechanism for limiting these innovations. My hope is that pension fund executives and other institutional investors increasingly demand proof of extra value before agreeing to non-exchange-traded derivatives in their portfolio.

Douglas Eu

When competitors are taking the risk as well as the returns, executives like myself would need a lot of backbone to forgo potentially higher returns for less risk. What actions do you expect from governments outside the United States?

Rick Bookstaber

I believe it is critical for the United States and Great Britain to construct similar regulations, because these two countries are the major trading centers and it is in the interest of all players in financial markets. This would certainly tighten controls. Even though some might argue that companies would then seek other domiciles with less stringent regulatory regimes, I believe most clients are likely to interpret headquarters under US or UK jurisdiction as a commitment to transparency and to the companies’ disposition to be regulated in a reasonable fashion. So even with more stringent regulation, it will turn this into a locational advantage in the long run.

Douglas Eu

Do we need regulations like the US Volcker rule?

Rick Bookstaber

I strongly support the Volcker Rule. Client business and proprietary trading create a conflict of interest, which should be eliminated. Trading should be outsourced to an entirely different entity, with one exception: banks need to be able to take principal risk to facilitate market-making on the behalf of their clients.

Douglas Eu

That is fair enough. Risk managers – and you were one yourself – are in a difficult position. What regulatory changes would you advocate?

The reason people want to so many flavors is because so many flavors are marketed.Rick Bookstaber

Rick Bookstaber

In financial markets, imprudence drives out prudence. If one trader takes risk and makes money doing so, the herd will follow. To break the vicious cycle, risk managers should be required to report major unresolved risk first to their CEO and, if no action is taken to resolve it, to the regulator. In the majority of cases, the issue will be solved without involving regulators. The CEO, knowing where the next call will be going, will likely be cooperative in solving the risk issue. But even if the regulators do get involved, it would be only one more level of verification.

Douglas Eu

I presume you then advocate penalties for risk being consciously ignored.

Rick Bookstaber

Yes, however, I do not know how draconian to make it. Risk is hard to measure and risk managers are in a difficult position because nine times out of 10, the risk is not realized and they have to live with the suspicion of having forced traders to leave money on the table. But the markets are currently leaning towards taking too much risk, and we need to empower risk management.

Douglas Eu

In your book, you propose what you call the cockroach approach towards coarser market behavior. Yet, clients do not want to buy the plain vanilla stuff anymore; they demand increasingly complex products.

Rick Bookstaber

I don’t think this is an argument against simple markets. The reason people want so many flavors is because so many flavors are marketed. The best advertising makes consumers realize a need they did not have before, indeed, a need they do not really have.

Douglas Eu

Do you think diversification is still an efficient hedge against risk?

Rick Bookstaber

Diversification works well except when it really matters. During a crisis, when assets are under pressure, they melt together and correlations increase. This is especially true in globalized markets. However, if an asset manager does take steps to control the potential for loss in a crisis, he is likely to reduce returns ahead of the crisis, when equity markets are rising, volatility is low, credit spreads narrow and investors are searching the economic hinterlands for places to differentiate their returns. Until the crisis appears – if it does appear – his prudence will mean he underperforms.

Douglas Eu

I can see your point, but ultimately, the portfolio is stressed on historical data, isn’t it?

Rick Bookstaber

Yes. But historical data can help guide us in terms of potential risk, although not necessarily the most-recent data. Pre-crisis, data will paint a rosy picture. But look back to past crises and invariably what you will see is a situation where credit spreads widen, equities drop, and correlations and volatility rise. For that matter, less liquid markets such as emerging markets and low-cap equities severely underperform. This is the historical fact, and it is understandable. For example, less liquid markets will underperform because there is a flight to quality and liquidity. Volatility rises because the least bit of information has a multiplied impact in a jittery market. Correlations will rise because during a crisis, all assets are either risk-laden or safe, liquid or illiquid; the subtleties that usually differentiate assets no longer matter. So, while you are right, these risk characteristics have occurred historically, there is more to them than just history.

Douglas Eu

Rick, it was great speaking to you.

Comments