The current notional value of outstanding global financial derivative contracts stands at close to $600 trillion. That’s quite a figure; roughly ten times annual global GDP. Only 10% of these derivatives flow through regulated exchanges, with 90% traded “over-the-counter” on a bilateral basis between institutions. At the moment there is little reliable information on what goes on in the “OTC” market. From a risk perspective current proposals to increase transparency and adjust capital requirements make good sense. On the flipside, if properly implemented they may shine a light on a dark place and impose an unmanageable burden on industry participants, who are already under-capitalised.

According to the Office for National Statistics, the value of UK housing stock is a wee bit north of £4 trillion, a hefty portion of overall UK net worth which is £6.7 trillion. The vast majority of that £4trillion worth of property will be insured, in some form, against catastrophe.

I have just gone through the process of renewing our home insurance and it’s clear why so many desperate salesmen tried to call me immediately after entering my details on the gocompare.com website: premiums are expensive, and hopefully I won’t have to make a claim, so the premium is the insurance company’s to play with as they see fit. A “free-float” as Warren Buffett would call it.

Insurance is a great business. People are obliged to buy a policy if they want a mortgage, or if they want to drive a car, and there is a huge captive market to sell into. Houses don’t tend to fall down in bunches (not in the UK at least, touch wood) so payouts are reasonably predictable. If you do have to make a payout, compensate with a higher premium the following year. Market share is key – thus the success of those annoying market comparison websites.

Still, as buyers of insurance, we are collectively glad to have the peace of mind provided by an insurance company. The sellers of home insurance are regulated to ensure that if they are obligated to make a payout that there will be enough funds in reserve at the insurer to meet their obligations. As an insured homeowner, the tendency is not to think too much about that and to take it for granted.

In the wider financial markets, derivatives are traded in billions of dollars on a day-to-day basis. To the layman the concept of a derivative seems highly complex, obtuse even. Often they are not much more complicated than a house insurance policy.

In simple terms a derivative is a financial contract linked to the future value of the underlying to which it refers: a plane manufacturer who has a contract to build 6 planes in the next 6 months, may want to guarantee the price at which he is able to buy steel over that time period, so that he can budget accordingly. To cover the risk of the steel price rising, the plane manufacturer could enter into a derivative contract to insure himself against a significant rise. The contract would allow the manufacturer to buy steel at a fixed price, over the requisite time period.

Elsewhere, farmers might use derivatives to guarantee sale prices for their crops, international companies might use currency derivatives to guarantee exchange rates between countries they operate in, and banks might use interest rate derivatives to switch mortgage interest payments from floating rates to fixed. All valid uses of derivatives for risk mitigation.

On the other side of these trades are the risk takers; banks, hedge funds and insurance companies who assume and distribute these risks, or hold them in speculation.

Unlike the market for house insurance “derivatives”, regulatory oversight in the financial derivatives world is virtually nil. The “over-the-counter” (bilateral) derivatives market currently represents 90% of all derivative contracts (around €450 trillion) – an unbelievably large market and scarily untouched by regulatory oversight, until now.

Consider the very real notion of a New York based hedge fund selling credit insurance to a bank that owns a large portfolio of loans to US companies. Let’s say that the bank owns $1bn worth of loans to these companies and the hedge fund sells an insurance policy (a “credit derivative”) that will cover the first $100mm worth of losses if any/ all of these companies default. For taking on the risk, the bank pays the hedge fund a 10% premium per annum – $10mm. The hedge fund can theoretically use this money as it pleases – to pay the bonuses of its partners for example. If the proverbial hits the fan, and the loan portfolio sees losses of $100mm, the hedge fund needs to find $100mm to compensate the bank.

Under the status quo, in the unregulated world of derivative contracts, and of limited hedge fund regulation, the financial system relies both upon the hedge fund to manage its risks appropriately and for the bank that is buying the insurance to choose which hedge funds are appropriate to deal with. This is theoretically possible but with skewed incentives involved not necessarily likely.

The AIG story offers a perfect illustration of the problem. AIG had billions of dollars of insurance exposure via mortgage derivatives. The banks that were party to the mortgage derivatives (Goldman Sachs and Deutsche Bank for example), retained the right to jump in front of the creditors’ line by demanding immediate collateral under certain circumstances. Other than those banks, however, no one except AIG really knew how much exposure they had. Unsurprisingly, given this lack of information, the market extended far too much cheap credit to AIG.

As Andrew Feldstein points out in the FT: “To add insult to injury, some of AIG’s derivative counterparties, with superior knowledge of this riskiness, insured their credit risk by buying credit protection on AIG from market participants who were in the dark about AIG’s position. The ability to buy this artificially inexpensive protection enabled the banks to sell even more poorly disclosed mortgage derivatives to AIG.”

Even inside the AIG organisation, it was only really within the AIG Financial Products group, where these derivatives were being sold, that the risks were in any way understood. The rest of the group, as it turned out, didn’t think the Financial Products group were running significant risks. The beneficiaries of this heads I win, tails you lose strategy were the employees of AIGFP, who received big bonuses in the previous years for running these positions and essentially got away with it.

Sweeping changes to the world’s derivatives markets have been promised by lawmakers and regulators since the financial crisis began. Specifically, the demise of Lehman Brothers and AIG (in particular) highlighted the dangers of a poorly capitalised and poorly understood derivatives market.

The planned solutions to this lack of insight encompass four main areas:

Firstly, Capital Requirement Directive (CRD) proposals are pushing for as many as possible of these derivative contracts to be traded through regulated exchanges. The theory being that if one dealer or “counterparty” defaults, the knock-on effects can be measured, handled and absorbed by clearing house members.

Secondly, regulators will be nicer in terms of capital requirements to those who trade through exchange as opposed to “over the counter”. For that reason alone we should probably be looking to buy shares in the existing derivative clearing houses as their volumes will increase exponentially if this proposal is implemented. This is the premise upon which the Deutsche Borse-NYSE Euronext is based: if €450 trillion of OTC derivatives need to be processed through exchange, their volumes and profitability might well be heading in a compelling direction.

Thirdly, there will be requirements for all trades to be reported to regulators, with data repositories being set up to track the amount of exposure accumulated in both cleared and uncleared trades.

The fourth big push is that there will be explicit capital requirement for the credit valuation adjustment risk (CVA). Apparently two thirds of the losses stemming from derivatives during the financial crisis were a direct consequence of the deterioration of the credit quality of the counterparty and not necessarily triggered by the default of the counterparty.

To take the AIG example again, they sold credit insurance (credit derivatives) to Goldman Sachs and others on portfolios of mortgage bonds owned by Goldman at various points from 2005-2008. As AIG’s credit quality deteriorated the market value of the insurance policies owned by Goldman would have fallen significantly, even though AIG had not yet defaulted. Under the new CVA proposals Goldman would therefore have had to raise more capital against these mark-to-market losses. Instead, AIG’s demise left a gaping hole in Goldman and other’s balance sheets that could only be filled by a US government bailout, given the prevailing market contagion at that point in time.

Despite how complex and obtuse derivatives may appear to the layman, everyone should care about the outcome of this debate. Failure to address systemic flaws increases the likelihood of another financial crisis. On the other hand, new regulatory requirements will tie up capital that would normally go towards investments in growth and will also create disincentives to otherwise rational risk management decisions. The amount of capital that will ultimately be tied up in already undercapitalised banks remains to be seen, but with a $600 trillion market fractions are incredibly meaningful.