The European Debt Crisis seems to have found resolution. Those holding Greek securities will have to tolerate a one-half reduction in the value of their securities, essentially allowing Greece to halve its current debt overnight. Questions linger about Greece’s ability to pay, and some are suggesting that the change might not produce immediate benefits; a write down will just encourage investors to demand greater returns when new securities come on the market.

In at least one market, however, Greece’s debt problem seems to have manifested internationally. Often described as the sovereign debt derivatives market, buyers and sellers agree to insure one another on the possibility of default for sovereign debt. In buying and selling this insurance, investors can essentially hedge risky bets with private insurance.

However, there seems to be a bit of a problem; the market for credit default swaps wasn’t designed to handle half-defaults. The market provides for buyers of insurance to be paid when a nation defaults by failing to make interest payments on a debt obligation. Credit default swaps are a binary obligation in which a CDS contract pays out (in the case of default) or simply pays nothing (the borrower makes payments as expected.)

A Ticking Time Bomb

The derivatives market has found plenty of criticism before, mostly due to bets placed on mortgage-backed securities, as well as other financial products. However, never has the derivatives market been truly tested on sovereign debt defaults, nor has the market ever lived through a time when a country was allowed to, without going bankrupt, simply devalue its securities by one-half.

Naturally, investors are losing confidence that the massive derivatives market really provides as much security to investors as it purports to provide. If one were to purchase a credit default swap for Greek debt, then he or she should be paid out in the case of default. The problem is that the solution as decided by the European Union wasn’t a default, but it didn’t exactly follow normal operating procedure, either.

Investors are left to wonder how many nations might agree unilaterally or with others to simply write off their debt as if it never existed, or write down the future value of cash flows to make payments. Greece is, by all measures, insolvent, and a default was the next step in the process of market clearing. Now, Greek debt threatens the largest market on earth.

Warren Buffett rightly called derivatives financial “weapons of mass destruction,” implying that the unregulated market could eventually create problems large enough to wipe out an entire global financial system. While such a possibility is remote, there have been more than a few scares since the derivatives market became a normal function of for-profit banks. The Asian Financial Crisis had ties to derivatives, as did the housing market. Bailouts in each case were the temporary solution to stem complete failure of the largest insurance market on earth.

Going forward, the market for credit default swaps could eventually sour to a degree that a meltdown occurs. If a single contract fails to trigger, thousands of others made for the purposes of hedging another contract could as well, sending a ripple effect through the derivatives market, and later into the retail financial markets as institutions raise cash to settle obligations.

Investors may agree that Greece was a one-time event that wasn’t necessarily worth throwing out credit default swaps. If we are to project, quite reasonably, that Greece is only the first of many European countries to claim insolvency, you can be sure that markets of all shapes and sizes will ultimately be sucked into the black hole of derivative deflation.