A low level of financial literacy among households, combined with extensive risk-taking, has become "politically an explosive brew", IMF head of international capital markets Gerd Hauser warned at a press conference on the Global Financial Stability Report last week.

The use of financial derivatives has allowed banks to spread their risks to a much wider range of institutions. In turn, this risk is being passed on to private households unaware of what they are getting into, Hauser cautioned.

In effect, a "Faustian pact" has developed, he suggested. Structural change over the past decade in the modern capital markets system enables financial institutions to bear more risk by passing more of it onward. But the change also means private investors around the world are paying a huge and hidden potential price for the returns they are getting.

He said he doubts very much that households being offered new ways to participate in capital markets through, for example, credit derivatives and structured credit products, are fully aware that they are holding assets whose value could be liable to fall quite dramatically.

Through their exposure to such instruments, private households are buoying up the international financial system by, in effect, reinsuring parts of it. "The household sector is invited to participate in the search for yield, to enhance their returns in whatever way."

But this pact also has a ?dark side', which is "visible only when asset prices start to fall significantly and Mephisto asks for his side of the bargain to be fulfilled".

This development in the financial system could be set to "backfire in an unprecedented way", Hauser warned, if public sector authorities end up facing dissatisfaction and disappointment among private households. The credit derivatives market has yet to be tested in a downturn.

Public sector authorities will need to think through this new challenge "long and hard", he said. In the event of a capital market downturn, they could end up facing a public mood that "may turn into a political liability for the authorities, to prompt them to support markets ?which are too important to fall' as opposed to the old fashioned moral hazard pertaining to ?financial institutions too big to fail'".

Regulation may even need to move from the traditional prudential supervisory approach towards "a new paradigm of creating checks and balances between the various sectors of risk takers", Hauser suggested. "Needless to say, we are talking about a mine field of potential conflicts of interest or worse, systematic cherry-picking by the smart and financial educated, a new definition of ?insider trading' if you will."

On the bright side, he said, active trading in such instruments as credit derivatives and structured credit products has meant that market participants and supervisors get more transparent and timely indicators of credit risk. The availability of this information probably helps dampen the credit cycle.