On Wednesday, the White House released its plan for reviving financial regulatory reform. And the plan nicely sums up how credit default swaps--complex financial instruments traded between financial firms to cover possible losses--helped grease the way to the current economic disaster:

One of the most significant changes in the world of finance in recent decades has been the explosive growth and rapid innovation in the market for financial derivatives. Much of this development has occurred in the market for OTC derivatives, which are not executed on regulated exchanges. In 2000, the Commodity Futures Modernization Act (CFMA) explicitly exempted OTC derivatives, to a large extent, from regulation by the Commodity Futures Trading Commission. In addition, the law limited the SEC's authority to regulate certain types of OTC derivatives. As a result, the market for OTC derivatives has largely gone unregulated.

The downside of this lax regulatory regime for OTC derivatives - and, in particular, for credit default swaps (CDS) - became disastrously clear during the recent financial crisis. In the years prior to the crisis, many institutions and investors had substantial positions in CDS - particularly CDS that were tied to asset backed securities (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated of market participants. At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against declines in the value of such ABS, as well as poor counterparty credit risk management by many banks, saddled our financial system with an enormous - and largely unrecognized - level of risk.

When the value of the ABS fell, the danger became clear. Individual institutions believed that these derivatives would protect their investments and provide return, even if the market went down. But, during the crisis, the sheer volume of these contracts overwhelmed some firms that had promised to provide payment on the CDS and left institutions with losses that they believed they had been protected against. Lacking authority to regulate the OTC derivatives market, regulators were unable to identify or mitigate the enormous systemic threat that had developed.

But what's missing from this accurate summary is a list of the culprits--that is, those policymakers and legislators responsible for allowing swaps to go unregulated and turn into a financial Frankenstein's monster. I've written about ex-Senator Phil Gramm's underhanded role in this. But another key player was Larry Summers. In 1998, the Commodities Futures Trading Commission raised the prospect of regulating swaps. But Summers, then the deputy secretary of the Treasury (along with Treasury Secretary Robert Rubin and Fed chair Alan Greenspan) shouted, No!

These wise men each gazed with horror upon [CFTC chair] Born's proposed consideration of regulation for derivatives. Speaking for them, on July 30, 1998, Summers testified in the Senate against the notion of the CFTC even pondering rules governing the trading of derivatives. By releasing its memo, the CFTC, Summers complained, "has cast the shadow of regulatory uncertainty over an otherwise thriving market--raising risks for the stability and competitiveness of American derivative trading."

....Even "small regulatory changes," Summers cautioned, could throw the whole system out of whack. Determined to slap down the CFTC, his Treasury Department, the Fed, and the Securities and Exchange Commission crafted a proposal that would prohibit the CFTC from issuing new rules regulating any swap or "hybrid instrument.

How tables turn. These days, Summers is President Barack Obama's top economic adviser and had a strong hand in Obama reform plan that calls for regulating OTC swaps (but not private swaps between large institutions). If only Summers had been so cautious about swaps a decade ago. He might have saved himself some work--and saved the American taxpayers billions (or is it trillions?) of dollars in bailouts for swaps-enabled firms.

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Okay, now I'm officially scared.

Ever since I did an article reporting how former Senator Phil Gramm slyly prevented the regulation of credit default swaps, I've worried about the shadow economy of financial derivatives--financial instruments bought and sold by large financial institutions off public markets, often to hedge or cover their wild and woolly speculation.

Now, The Motley Fool guys are pointing out that the trillions of dollars being devoted to the various financial bailouts--$13 trillion, by their count--comprise not much more than a drop in the bucket when compared to the total (and shaky) derivatives markets. Writing about Treasury Secretary Timothy Geithner's plan to mop up toxic assets held by big financial firms and other bailout initiatives, one of their site's bloggers notes

Fools may be right to question whether any amount of money will prove sufficient to sate the hunger of this deleveraging beast. According to the Bank for International Settlements, the notional value of over-the-counter derivatives worldwide reached a mind-boggling $684 trillion last summer. That's more than six times the scale they had reached by 2002 when Warren Buffett dubbed derivatives "financial weapons of mass destruction".

Perhaps the trillions pledged can plug the leaks from subprime mortgages and failed auto loans, but can we reasonably expect to keep a derivatives market afloat that is at least eight times the size of a contracting global economy? I don't know, but I sure hope Bernanke and Geithner do....

To be clear, a sizable disconnect remains between the number of casino chips presently in play and the pile from which more chips may be drawn as needed.

Wow. What if this derivatives market needs bolstering? It does seem too large to be propped up. (Imagine holding back a tsunami.) But what if it does collapse? I don't know. So much of derivatives activity is complex and opaque, and apparently few people truly understand it. But my hunch is, an implosion of a $684 trillion dollar market won't be good.

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