Arthur C. Clarke’s third law reads: “Any sufficiently advanced technology is indistinguishable from magic.” What’s the difference between technology and magic? As this blog post points out, “magic” is the halting of inquiry. With that formulation, it’s possible that science can paradoxically plunge us into a second Dark Ages, when the world around us are controlled by forces beyond our ken.
It has become obvious that, among recent technological advances, no field has moved so far so quickly as the world of high finance, specifically, the world of complex derivatives. George Soros testified in 1994 to the House Committee on Banking, Finance, and Urban Affairs, “We use derivative instruments to a much lesser extent than generally believed, very largely because we don’t really understand how they work.” Both he and Warren Buffett restricted their dabbling in derivatives after being seriously burned.
In his 1994 quote Soros didn’t mean that he didn’t know the role derivatives play in the market. Rather, he was pointing out that — like an iPod, or a jet engine — it’s quite difficult to figure out what is going on under the hood of any particular derivative instrument. In other words, they are magic.
Which is not to say that widespread understanding can’t catch up to complex derivatives to make them safer as bona fide financial instruments. Many derivatives have genuine value: consider weather-based derivatives as a hedge for farmers. A heap of regulation to ensure transparency when useful and block abuse when it’s not would help close the gap between financial technology and magic.
