In a financial world where yields are relatively low and risks high, it's no surprise that insurers, hedge funds, and commercial banks are keen on credit derivatives. For buyers, such instruments offer a way to manage portfolio risk; for sellers, they promise high-yield returns. And for the global financial system as a whole, they could diversify and diminish risk, at least in theory.

In practice, though, some players—among them insurance companies and commercial banks—are pushing too aggressively into the market, distorting prices and raising the possibility that one company's large, unexpected losses could upset the entire system. Many have entered the market opportunistically, tempted by the attractive yields and trusting that their portfolios can absorb the risk. Too few of the newcomers sufficiently understand the potential dangers of credit derivatives. Some companies have learned the hard way: at the French reinsurer SCOR, for example, credit derivatives contributed to net losses totaling €769 million in 2002 and 2003, prompting it to exit this market.

A credit derivative, in its basic form, is a contract purchased by a bank or other financial institution to protect itself if a borrower can't repay a loan or fulfill a lease obligation. For the buyers, these...