Credit default swaps, once the darlings of risk managers, are now dirty words. Eric Dinallo, superintendent of the New York State Insurance Department, calls them a "catastrophic enabler" of the dark forces that laid waste to financial markets. Former Federal Reserve Chairman Alan Greenspan, once an ardent supporter, has disavowed them in "shocked disbelief." Even "Saturday Night Live" has lampooned them for taking down Wall Street.

At their most basic level, CDSs act like insurance, allowing sellers to take on new credit exposure and buyers to assume the cost of insuring against default. But like most derivatives, they trade away from centralized exchanges, which has stoked the ire of regulators in the wake of last year's financial collapse. The question for the CDS market in 2009 isn't whether Washington will intervene, but how. Several exchange operators are waiting for approval to launch their own CDS clearinghouses. And regulators themselves are vying for a piece of the oversight action.

Credit default swaps are just a slice of a larger derivatives market and the new year will see a flurry of activity from the construction of a regulated infrastructure for these complex instruments. In early Jauary, the Nasdaq OMX Group announced the opening of a clearinghouse for interest-rate swaps.

Credit default swaps were a minuscule part of Wall Street's business until the Senate unanimously passed the Commodity Futures Modernization Act of 2000, removing derivatives and CDSs from the purview of federal oversight. To prevent states from regulating CDSs on their own, Congress exempted trading of the instruments from gambling statutes. The notional value of outstanding CDSs exploded from almost nothing a decade ago to $25 trillion in 2005 and up to $62 trillion at the end of 2007 -- though that figure has slipped to $50 trillion and continues to fall.

The trillion-dollar figures reflect not just those who have a material interest in, or are owed money by, the underlying company, but those willing to bet one way or another on the firm's demise. CDSs, unlike stocks and bonds, have no finite availability, so bets could be almost limitless.

Not surprisingly, CDSs became instruments of speculation for hedge and pension funds, insurers, corporations and other investors.

When the housing market tanked, it sent defaults higher and prompted claims from investors who bought credit default insurance. Banks already teetering from bad loans had to pay out and got hammered from losses, which obliged them to pump in additional collateral. When insurance giant American International Group Inc. had its credit rating cut from AAA to A in mid-September, it had to post more than $14 billion in collateral against its CDS positions, prompting a government bailout. Had AIG been allowed to go bust, the swaps market might have been undone.

Earlier in the year, similar fears led the Federal Reserve to examine how extensively Bear Stearns Cos. was connected to other firms through, among other things, its derivatives contracts. The Fed decided it would be too disruptive for Bear to fail. A few months later, it concluded differently about Lehman Brothers Holdings Inc.

But while CDSs are being reviled as an insurance contract's evil twin, the market actually has held up better than expected. The process for settling claims after Lehman's default and the government's seizure of Fannie Mae and Freddie Mac were orderly.

The International Swaps and Derivatives Association Inc. says that although $21 billion had been theoretically at risk, only $6 billion had to change hands in the Lehman auction because most payments had already been made as swap sellers marked their positions to market. The CDS market has also remained liquid even as cash markets have dried up. Some credit gurus still believe they are a good early indicator of troubled banks.

Perhaps a smarter way to view CDSs is like any hedging tool: sensible if used to safeguard against predictable risks; risky if used for speculation; and a systemic threat if the market overhang gets too big. To preserve what is a valuable investment tool, only the most unrelenting advocates of deregulation would oppose creating a system to track and settle CDS positions.

Such a system would have been a valuable early-warning tool had one existed when CDS speculation started rising to dangerous levels. In 2005, the Federal Reserve became concerned about the volume of contracts piling up. The agency asked for and obtained a commitment by 14 major dealers to upgrade their systems and reduce the backlog of "unprocessed" CDS contracts. Dealers, afraid of increased scrutiny, began reducing their backlog. But as the market for mortgages escalated, so did the number of contracts.

The game, however, is about to change. The secrecy that surrounds CDSs, the opaqueness of such an important financial derivative and a 40% loss in value has sent regulators and exchanges searching for solutions for the CDS market. Among the options under study is the creation of a central clearinghouse for credit derivatives.

Engineering one such project is IntercontinentalExchange Inc., an electronic futures exchange. Along with its newly acquired partner, the Clearing Corp., ICE wants to design a clearing model for the CDS market that would be subject to direct oversight by the Federal Reserve Bank of New York. ICE doesn't want to use its facilities because it believes the contract design and risk profile differ too significantly from futures, its main business. Meanwhile, CME Group Inc., the world's largest futures exchange, has teamed with hedge fund Citadel Investment Group LLC to establish a platform that the Commodities Futures Trading Commission regulates.

Both the CME and ICE operations would aim to keep a tighter rein over the CDS market, allowing buyers and sellers to meet in a central place and engage in some negotiating. The Securities and Exchange Commission would prefer a more traditional exchange platform that would suit only the most standardized or plain-vanilla contracts. The answer might be to provide more than one option to the market, with CDSs then migrating to the platform for which they are best suited.

But that would still leave another problem to solve: Which agency, if any, is best equipped to oversee such a huge market? The SEC, CFTC and the New York Fed all want a piece of the action. The jockeying follows a memorandum of understanding signed by all three under which they would share information and cooperate with one another.

The CFTC says it deserves the job because it has oversight of futures exchanges. The New York Fed argues that because IntercontinentalExchange would be organized as a bank holding company, the clearinghouse ICE is developing would come under its purview.

Finally, the SEC says instruments traded on a clearinghouse platform are securities and belong under its wing.

A jurisdictional dispute among regulators would mean uneven or incomplete regulation. But in the confusion of a presidential transition at press time, it remains unclear what agreements can be generated. Joint regulation could be an option but is unlikely to accomplish anything. A single federal regulator like the New York Fed or the Federal Reserve Board would provide uniformity to the complex market and avoid yet another element of confusion in the market. The Fed may have the most experience with this type of contract.

What's clear is that there will be benefits to trading on a central facility, the biggest being less counterparty risk, since each member firm would face only the clearinghouse, not its partners.

The exchange and-or clearinghouse would establish standards for the contracts, provide a centralized marketplace, establish and enforce rules on posting collateral and making payments and act as a guarantor that trades will be made good and that users will not have to rely on individual counterparties to pay what they owe. Standardized collateral arrangements would reduce payment disputes. This type of operation has worked well for trading energy swaps.

While standardized trading would ease one set of problems, it may create others. Buyers and sellers will be forced to disclose more information, and they will probably have to come up with more capital to trade, making the market less attractive. Risk will be concentrated in the clearer, and the mere act of trading centrally will eat into the profits of banks providing the service at a time when revenue is scarce. But while an extreme makeover of the CDS market will make it a lot less lucrative, it will also be safer. Right now that's what matters.