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As complex, structured deals falter, new systemic risks are emerging and threatening to continue financial instability well into 2008.

Credit default swaps, say Gillian Tett and Saskia Scholtes in Friday’s FT, are a $45,000bn market - bigger than the US government bond and housing markets combined. Until now, that huge market has been regarded with a relatively benign eye - largely because its scope and complexity beggars generalisation.

But as more and more troubled, esoteric, off-balance sheet vehicles creep into the limelight, it’s becoming clear that counterparty risk to these deals - through CDS contracts - should be a cause for concern:

In recent years credit derivatives had been heavily used by the so-called shadow banking system - or the assortment of thinly capitalised, off balance sheet vehicles that have been created by banks this decade. These entities might struggle to meet their obligations if derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid.

To flesh that point out, CDS contracts are used in virtually every structured financial product created - from the lowly securitisation right through to CDO squared. Not only are CDS contracts used to hedge risk, but also to “synthetically” transfer it. Most of the $1,350bn CDO market, for example, uses “synthetic” technology and CDS contracts as a basis for the CDO asset portfolio. And in particular, it’s complex deals like synthetic CDOs, or Leveraged Super Senior Conduits that should have people worried.

Pimco’s Bill Gross tells Tett and Scholtes:

“The conduits that hold CDS contracts are, in effect, non-regulated banks,” says Mr Gross. “[There are] no requirements to hold reserves against a significant ‘black swan’ run that might break them.”

And that’s the rub: the CDS world is opaque - frighteningly so - and fragile.

Mr Gross himself calculates that, if total investment grade and junk bond defaults approach historical norms of 1.25 per cent, $500bn of the total $45,000bn of credit derivative contracts could be triggered, “resulting in losses of $250bn or more to the protection selling party once recoveries are inserted into the equation”.

The point is, that the process of the unwind - due to the shock of it, and the complexity of it - could be very violent: even though trouble in the CDS market should be a zero-sum game, it’s the way that game is played-out that is cause for concern.

Take for example, SCC, a Dublin-based CDS specialist that went bust last month. The FT writes,

SCC’s collapse raises important questions about how a company with no credit ratings and just $200m in capital was able to write default protection on $5bn worth of credit risk for the banks involved.

[SCC] …was designed to be similar to the handful of ventures known as Credit Derivative Product Companies. These exist to be end-of-the-line insurers of credit risk in the derivatives markets. But whereas CDPCs, such as Primus and Athilon, spend years building up their systems and capital bases to win the safest AAA credit ratings, SCC began writing credit protection far more quickly - and without the lower AA-rating it intended to apply for, but never actually achieved.

In the event, SCC was unable to post collateral against its CDS contracts, and that’s why it went bust.

Even though the losses to those tied up with SCC were small - around £250m - counterparties still got their fingers burned. Apart from the direct cost of SCCs collapse, counterparties were suddenly left exposed with unhedged risk.

It’s that sudden, unexpected exposure - and how institutions will react to it, that carries a systemic threat.