It's the Derivatives, Stupid

If you wonder why every morning it seems as if you wake up to a new potential market crisis, look no further than the derivatives market. Amazing as it seems, the world of the "shadow banking system," which brought down Lehman Brothers in 2008 and where massively leveraged bets lurk with absolutely no transparency, still exists. In fact, it's potentially worse than it was three years ago.

The notional amount of derivatives contracts recently stood at $601 trillion dollars, according to the Bank of International Settlements. Yes, $601 trillion! That's up slightly from $598 trillion in December 2008, the year of the global banking crisis.

What are these things? Well, here's how they work. Let's say you are a big bank or a hedge fund playing the stock market, like some high roller in the casino. You make your bets, and you win or lose money based on those bets. The casino is watching you and keeping track of your winning and losing. This is analogous to what happens on exchange-traded markets every day.

Now imagine that there are some shady people in the parking lot outside of the casino, making side bets. This is the world of over-the-counter derivatives. Because they are highly leveraged, unregulated, and trade off of the exchange, they are "invisible." But Party A may bet Party B that you're going to lose all of your money in the casino (Lehman Brothers scenario) and draw up a contract to that effect. If you do, in fact, go bankrupt, Party B will have to pay Party A $1 million dollars, according to the contract.

Now consider what happens if Party B can't pay Party A when you go bankrupt. It means Party B will also go bankrupt. But then add in even more bets. Maybe Party C, who is in a high-rise building above the parking lot, has a contract on Party B that allows him to collect $2 million if Party B goes bankrupt. And so on. This is how the systemic crisis of derivatives works.

Washington and global banking regulators are moving to introduce new rules on derivatives, but these rules are being implemented very slowly, and there are huge questions about whether they'll even be effective. The main goal of any sensible legislation would be to bring these contracts to a regulated exchange, so that they could be monitored and measured more transparently.

For example, credit-default swaps and other types of derivatives would have to move through clearinghouses, which could act as safety valves in case one party defaults.

But guess what! These new steps are being slowed, blocked, and, in some cases, rewritten by banking industry lobbyists who don't want this business to move to regulated clearinghouses and exchanges. Why? Because they think they will make less money. The Financial Times reported last week that derivatives implementation is slowing down. Progress on derivatives in the Euro-area is even slower.

Why is progress so difficult? Wall Street perceives this as an area of profit and wants to protect it. What it doesn't realize is that these nuclear derivatives are the things that blow up the world. This is why the Euro crisis -- or any sovereign debt crisis -- is so dangerous. One default would result in billions of dollars for Euro-area banks, but it could also trigger a chain-reaction in derivatives contracts.

The global financial system will continue to be volatile and unpredictable until this is addressed.