A FEW years ago, a group of bankers gathered secretly in the City to discuss the crisis at Marconi, the heavily indebted UK telecommunications supplier. The mood was co-operative, and most of those round the table were getting ready to sign a debt-restructuring deal.

Legend has it that, just then, there was an awkward cough. One financier admitted his bank had lent Marconi £10m but had also built up a £15m “short position” in the debt using credit derivatives, and it was therefore not in its interests to back the proposed agreement.

That particular issue was resolved smoothly, but the incident was a wake-up call to the City and its regulators — a new type of financial derivative had arrived that was starting to have a huge impact.

Credit derivatives are both a great British success story (perhaps the fastest-growing segment of financial-market activity worldwide, with about half of all global transactions in London) and a source of worry for central banks and regulators.

Both the Financial Services Authority (FSA) and the Bank of England are uneasy about this new market. “It’s a question of vigilance and of trying to understand better by talking to the main players,” is how one observer put the official attitude.

Some pessimistic outsiders have gone much further, predicting that problems in the credit markets, magnified by derivatives, could cause a serious upset. A hint of this has come in the past few days. A profit warning by General Motors on March 16 led temporarily to what one trader described as “almost a panic” in credit markets.

The birth of credit derivatives took place at JP Morgan in 1994, when the investment bank decided to try to get a higher return from its loan book. It wanted to hedge some of its existing loans, and so create space on its balance sheet.

The pioneer was Tim Frost, then a 29-year-old JP Morgan bond trader and former Parachute Regiment officer. Frost said the initial trading system was developed to cope with 100 deals a day. “People said that was ridiculous and the market would never be that big. Within five years, we had to take out that system and put in a new one with 10 times the capacity.”

Growth has been astronomical: the British Bankers’ Association estimates the value of this market worldwide increased from $180m (£96m) in 1997 to just under $2 billion in 2001, and just over $5 billion in 2004. It predicts further expansion to $8.2 billion by 2006.

This boom has resulted in a shortage of experienced personnel and, consequently, huge rewards for its City specialists. Lee Thacker at executive-search firm Highland Partners said: “A senior trader in a leading bank would earn $2m-$3m a year including bonuses, and each institution would have eight to ten of those.” Industry estimates put the number of people working in credit derivatives in London at 2,000-4,000.

The BBA said: “London continues to be the dominant centre in the global credit-derivatives market.” For 2004, the BBA put London’s market share at 44%, with New York on 40%, Asia and Australasia on 9% and other European centres at 7%.

How has the City of London managed to grab pole position? Marcus Schüler at Deutsche Bank said: “In Europe, banks have been much more important lenders to corporates than the bond market. In the US, it has been the opposite way round. So when European investors decided to shift more of their assets into credit, credit derivatives became the instrument of choice.”

Frost, now a director of hedge fund Cairn Capital, said traditionally banks took depositors’ money and lent it out to businesses. As a result they took on credit exposure: if the borrower went bust, they’d end up with a hole in their balance sheet.