Due to the opacity of the market, which is one of the most complex, least
regulated and least understood in the global financial system, it is still
not clear how many contracts have to be settled or which institutions will
take the ultimate hits once the billions of dollars worth of contracts have
been unravelled.

The collapse of Lehman Brothers, is expected to trigger
credit default swap (CDS) protection pay-outs of about $400bn but because
the contracts were sold many times through different counterparties it is
not yet known who will be liable.

One commentator said: “This will be the greatest illustration of the follies
of Wall Street and how unnecessarily complicated the wild off-track betting
became in the past few years.”

Five years ago Warren Buffett, the iconic American investor, warned that the
chaotic profusion of derivatives used by companies and hedge funds to fund
financial growth were “financial weapons of mass destruction.’’

Bankers in the City and on Wall Street are bracing for yet another round of
turbulence as the contracts are unwound.

The Bank of England and the Federal Reserve in America have said they will
keep their special liquidity windows open late on Tuesday night to allow the
contracts to settle.

“We’re in unchartered waters here and it may all prove an anti-climax,” said a
senior City banker on Friday, “but everyone will be watching the situation
and wondering what’s going to happen.”

An earlier auction of Lehman-related derivatives on October 10 prompted early
fears that banks and investors could lose $400 billion. In the event, the
discounts on the Lehman-related paper that day realised losses of only $6
billion.

At the core of Tuesday’s cash exchange between banks stands a quasi-insurance
product, the credit default swaps. Investors buy CDS’s to protect themselves
against the possibility of default on securities issues by firms such as
Lehman. During the boom years, banks’ insurers and hedge funds created and
sold CDS’s to raise what appeared to be risk-free cash in the form of
premium payments.

On September 16, Lehman filed for bankruptcy, leaving them obliged to payout
on CDS’s written to protect investors against the possibility of a default
on Lehman paper.

City bankers say that Lehman also holds a portfolio of CDS’s written to
protect against other institutions defaulting and these, too, could get
caught up in Tuesday’s action.

“This will arguably be the biggest cash-exchange day and somebody will fail,”
one analyst warned last week.