The $650 trillion derivatives market is a nightmare scenario waiting to happen.
First problem: the size. It's 36 times the size of the U.S. GDP and over eight times larger than the world GDP, that is, the entire global output of the entire world in a year.
While credit default swaps (the type of derivative that played a huge role in the financial crisis) have shrunk significantly in size since the financial crisis, they remain large enough to constitute a potential time bomb inside the financial system that could blow up any time.
Second problem: the interconnectedness. Every derivative contract involves two parties. In a crisis, one of these counterparties may be unable and/or unwilling to meet his obligations, leaving a volume of broken contracts that will overwhelm these institutions and render them instantly insolvent.
That's why it's crucial we understand the ramifications of these instruments - because while the derivatives monster is ugly, there are things individual investors can do now.