What’s the future for much-maligned derivatives?

Because the swaps weren't truly an insurance product, AIG's use of them wasn't regulated. Everything worked fine for a while: The swaps brought in bountiful fees for AIG, and investors who owned mortgage-backed securities felt safe.

But once the bonds started defaulting as mortgages went bad, investors sought to cash in their swaps. AIG didn't have enough capital to pay off all the swaps, and down it went.

Wall Street created a host of other derivatives like credit default swaps that provided little real protection for users but juicy fees for the issuers. Financial institutions brought in a lot of people with math and physics Ph.D.s to create complicated derivatives. But most of the mathematical trading models used by these rocket scientists didn't take into account the possibility of a market meltdown in which no one wanted to touch these esoteric financial products.

Given the blowout in the derivatives that has sent the financial system into crisis, what does the future hold for this market?

Clearly it's going to shrink. Some derivatives developed in recent years were simply vehicles to let issuers gain revenue and for buyers to use these unsafe vehicles to protect unsafe underlying investments.

Many of the dangerous derivatives will disappear, leaving in place their tried-and-true brethren such as stock options and Treasury bond futures. "Financial innovation will be stifled for a while," Jones says.