What’s the future for much-maligned derivatives?

The global derivatives market has exploded to a notional value estimated at $680 trillion. While that number is a bit otherworldly, remember that the amount of money exchanging hands in a derivatives transaction is often just a fraction of the notional value.

For example, say a business buys a derivative that gains in value. It will generally sell that derivative for an amount that is just a fraction of the value that would be received if the derivative was exercised.

The strongest growth of the derivatives market has come during the past 25 years. It has mirrored the growth of the financial system as a whole, with massive deregulation, greater risk-taking for higher returns, and increased leverage playing key roles.

Of course, what goes up dramatically must come down dramatically. Perhaps the U.S. economy's biggest advantage over competitors-innovation-came back to haunt the entire world as it was applied to the derivatives market. David Jones, a veteran Wall Street executive who is now an economic adviser to Japan's Mizuho Securities, puts it simply: "We innovated and securitized too fast over this golden age of finance."

A case in point is the credit-default-swap market. These swaps were the derivatives that brought down AIG, the world's largest insurance company. They work like this: Say an investor holds a mortgage-backed bond and wants some insurance in case the bond defaults.

For a fee, a company like AIG would sell the bondholder a swap that guarantees the investor the face value on the bond if it defaults. AIG would receive the bond in exchange if it indeed defaults.