Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
Warren Buffett, 2002

Do you remember swaps, those frequently risky and opaque derivatives that nearly brought down the global economy in 2008? They're used for insurance and for gambling, but despite having a notional value estimated at $450 trillion, some of the most dangerous swaps remain totally unregulated, even two years after the financial crisis.

Well, Fools, within just a couple of weeks, we might actually do something about fixing that.

But first, it's important for us to recognize just how crazy and dangerous the swaps market currently is. For example:

No one has any idea what they are worth
Imagine if there were no stock exchanges, and the vast majority of stocks traded over the counter. Five banks -- Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), and Bank of America (NYSE: BAC) -- cornered the market, and only they had access to stock prices. 

So in order to buy shares of Microsoft, instead of just looking up its $26 price, you would have to call up Goldman Sachs and ask how much Microsoft will cost you. Goldman offers to sell you Microsoft at $30 per share, offers to buy shares from another customer at $20 per share, and pockets $10 for every share of Microsoft traded. That's basically how the anti-competitive swaps market works. It's an economically inefficient system that benefits too-big-to-fail banks by allowing them to rip off their customers.

They blow up all the time
Unlike the regulated insurance and gambling markets, there's no law that says you can't sell $400 billion of credit protection if you can't afford to cover eventual losses. Yet that's what AIG (NYSE: AIG) did in the lead-up to the financial crisis. Moreover, the swaps market forms a series of opaque interlocking contracts all across the industry. So when Lehman Brothers blew up, AIG was on the hook for payments it couldn't afford. And instead of letting the world's largest insurer go bankrupt, and economic panic ensue, taxpayers ended up footing a $180 billion bill.

From Orange County and Procter & Gamble in 1994 to Long Term Capital Management in 1998 to AIG in 2008, swaps have a history of causing massive, unexpected losses. They're a huge part of why the banks mentioned above are so risky, so profitable, and "too big to fail."

We are subsidizing them
Currently, banks can fund their swaps trading units with FDIC-insured deposits. Furthermore, each of the five major dealers mentioned above has access to the Federal Reserve's discount window, which allows them to borrow money for gambling in swaps at near-0% interest rates. But the whole point of FDIC insurance and the discount window is to reassure the public that their deposits are safe, and to protect banks from runs on their deposits -- not for the government to help banks finance their own casinos.

For example, it's been estimated that 80% of credit default swaps -- the kind that blew up AIG -- are "naked," meaning they're pure speculation.

So what's the plan for fixing the swaps market?

The derivatives portion of the House bill is a mess; however, because of public outrage at Wall Street, the Senate section on derivatives didn't sell out. It actually addresses those three problems. And now that key House members are lining up in support of real swaps rules, it looks like the Senate version could prevail. Here's what it would do.

1. Require swaps to trade on exchanges
By putting swaps on exchanges, the Senate bill would make market prices for swaps publicly available, and make it harder for banks to rip off their customers. Wall Street justifies the risks its traders impose on the rest of society by citing the "liquidity" and "price discovery" they allegedly provide. Unless Wall Street CEOs and lobbyists are disingenuous people, you'd thus expect banks to be revved up about getting their products out of the over-the-counter derivatives netherworld, and into the light of day; doing so would promote liquidity and allow them to be priced.

2. Require collateral
The Senate bill also requires swaps traders and users to post collateral to a central clearinghouse. That way, we know that banks and insurers can actually afford to make good on their promises. Furthermore, it untangles the confusing web of interlocking counterparties, so that a single failure will be less likely to cause a market panic.

3. Section 716
Here's the part of the Senate reform bill that's been called a "Hiroshima to the era of greed." Section 716 is a straight ban on federal assistance to banks that continue to deal in swaps. If it's included in the final reform bill, the five swaps dealers mentioned above would need to either spin off their swaps trading desks, or create swap-trading subsidiaries with their own capital, instead of relying on FDIC-insured bank deposits, cheap Federal Reserve interest rates, and bailouts.

Wall Street went completely berserk over Section 716, throwing its full weight against the position. Apparently, the big banks think it's the federal government's job to help them fund gambling.

Section 716 is one of the few strong sections of the financial reform bill lobbyists haven't been able to weaken or gut, even after multiple attempts. Every step of the way, Congress proved less afraid of lobbyists' wrath, and more fearful of looking like sellouts over derivatives reform during an election year. Public pressure really worked.

Wall Street has one more chance to kill derivatives reform, and Section 716 is No. 1 or No. 2 on its hit list. Over the next month, a conference committee of key members from the House and Senate will be choosing what will go into the final House-Senate reform bill, and what will get scrapped. This meeting will likely be the endgame for reforming Wall Street -- until we have another financial crisis.  

What do you think? Should the federal government continue to encourage swaps trading with subsidies? Let us know in the comments box below. And if you have a minute and want to make your voice heard, click the petition below to tell your representatives to support Section 716 of the Senate bill that bans government subsidies for swaps trading.

Petitions by|Start a Petition »

Fool editor Ilan Moscovitz doesn’t own shares of any company mentioned. The Motley Fool is investors writing for investors.