"We're staring into the abyss," said one nervous capital markets banker last week before the federal government stepped in to take control of American International Group Inc. and rescue it from bankruptcy with an $85 billion loan from the Federal Reserve. The banker was referring to the systemic threat posed by the huge insurer, a threat that is largely transmitted through AIG's writing of billions of so-called credit default swap contracts.

AIG's near-death experience last week once again highlights the dangers posed to the financial system by the unregulated and opaque world of credit derivatives. The use of these instruments has exploded in recent years, and, despite their arguably secondary role in the functioning of the markets, they now pose a primary threat to the stability of the entire financial system.

To understand why seemingly arcane instruments like CDSs pose such a threat requires some understanding of how they work. These contracts act as insurance policies to protect against the threat of debt default. Holders of debt securities will buy protection from dealers such as AIG, Deutsche Bank AG, Goldman, Sachs & Co., and J.P. Morgan Chase & Co., and, if default occurs, the CDS contract seller agrees to pay the buyer the face value of the debt security in question.

Although bond markets don't necessarily need such insurance to function -- after all, the CDS market itself goes back only a decade or so -- dealers realized there was money, quite a lot in fact, to be made by issuing CDSs. Today the market for such insurance contracts is enormous and has grown, ironically, during a period when default rates on even the riskiest debt fell to historic lows.

According to Richard Zabel, a forensic accountant at Minneapolis-based law firm, Robins, Kaplan, Miller & Ciresi LLP, the CDS market was created in the late '90s by commercial banks that wanted to transfer risk off their books and free up regulatory capital. As Zabel describes it, by buying CDS protection, banks were able to shift default risk to a third party and thus reduce the amount of regulatory capital they had to set aside against debt holdings.

The market grew slowly at first but then began to expand exponentially once market participants realized they did not have to own the bonds to buy insurance against their default. Instead, purchasing a CDS contract allowed a speculator the ability to bet on the possibility of a bond issuer's defaulting, effectively creating a
shorting opportunity.

This movement from practical usage to speculation supercharged growth of the market and influenced the creation of a secondary market in the instruments, which further fueled speculation in the instrument. According to Moody's Investors Service, some $62 trillion of debt was protected by CDS contracts at the end of 2007. That number exploded from $10.2 trillion in June 2005 and represents the face value of the underlying debt. The face value would have to be paid to CDS buyers if all the underlying debt were to slip into default.

Defaults by all debt issuers insured by CDS contracts are, of course, improbable (though less so than a few weeks ago), so Moody's generally estimates the size of the CDS market at $2 trillion, or 3.5% of the notional amount. Moody's defines that figure as the replacement value of the CDS contracts in circulation. Put another way, the figure quantifies how much it would cost to replace existing CDS contracts and provide new protection to buyers.

Adding complexity (and volume) to the market is the fact that sellers of CDS contracts, to hedge against default, will often themselves buy protection for the debt they insure. This allows them, in the case of default, to collect insurance at the same time as paying it out, limiting, if not entirely eliminating, the resulting loss. The insurer thereby also becomes the insured, and a complex web is quickly woven that stretches from one corner of the financial markets to the other.

While the risk of default always hangs over the CDS market, the damage to the system from any isolated default would likely be relatively low. As Moody's describes it, the CDS market is a closed system in which losses by one party are balanced by gains from another, in what, in theory, is as close to a zero-sum game as is possible in
the markets.

More worrisome, however, is the default of a dealer, especially one as large as AIG. Although it's impossible to gauge the relative size of the major dealers, market participants agree that AIG was one of the more aggressive players in the CDS market. As Moody's put it in a May research report, "In the event of a default by a major CDS counterparty, there would likely be considerable systemic damage that would extend beyond credit default swaps."

This would happen because CDSs, like all over-the-counter derivatives, are traded strictly bilaterally between buyers and sellers. With no exchange or centralized clearing platform, it's impossible to gauge any party's total exposure, and dealers who write the contracts take on central importance to the functioning of the market.

Imagine if AIG had collapsed: The default would have exposed other dealers to losses from the sudden evaporation of premium payments to any parties that had sold protection to AIG. It would also have made buying new CDS contracts more expensive as default risk rose generally, raising the cost of insurance at the precise moment that a flood of protection seekers would hit the market, looking to replace now worthless CDS contracts sold to them by AIG.

The resulting escalation in CDS prices would make existing CDS contracts less valuable, and, since CDS contracts are marked to market, the resulting fall in value would hurt not only dealers' balance sheets, but also those of any company with CDS contracts used to hedge their debt holdings, which means nearly everyone. It's easy to see how the numbers would pile up quickly, and alarmingly. And given the size and global nature of the market, almost no corner of the system would escape losses.

That same ugly scenario came to the fore when Bear Stearns Cos. barely skirted bankruptcy in March before being absorbed by J.P. Morgan Chase. After that near miss, regulators and the industry recognized that something had to be done to bring some clarity and organization to the CDS market. At the urging of the Fed, the industry set into motion plans to create a clearinghouse to manage the market. In May, Chicago-based Clearing Corp. announced that it had been chosen by leading banks and brokers to set up the exchange and said it expected to begin operating in the third quarter.

"AIG would not have been as big a problem with a clearinghouse in place," says one debt trader, noting that the clearinghouse would have resulted in greater transparency of each dealers' holdings and volume restrictions on the number of contracts, mitigating the impact of a big dealer bankruptcy. In theory, a centralized exchange would have allowed for an orderly unwinding of CDS trades, helping dampen the fear factor that's roiling the market today.

Those plans, however, have been delayed. According to sources, Clearing Corp. still hasn't submitted its application for a New York state banking license to set up the exchange amid questions about which regulators will oversee the clearinghouse's activities. It's unclear when the CDS clearinghouse will now be launched, but one can only hope that there's still a CDS market to clear when that time comes.