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The world’s financial system is at a critical juncture. The regulatory controls put in place during the financial meltdown in the 1930s are inadequate for today’s world. The leaders of 20 nations meeting in the United States this week have an opportunity to restore critically needed investor confidence in the system.

A leading cause in the chain reaction of failures that triggered the current global crisis can be examined by a view into the opaque world of credit default swaps (CDS). A swap is a “premium” paid by insurance companies, hedge funds and banks to buy protection against defaults on bonds, collaterized debt obligations and other assets. CDS are derivatives – financial contracts that don’t contain any actual assets. Their value is based on the worth of underlying loans and bonds.

Swaps are similar to insurance policies with two key differences. They are unlike traditional insurance in that no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. Additionally, swap buyers don’t need to own the asset they want to protect. It’s as if many investors could buy insurance on the same home they didn’t own and then collect on its full value if the house burned down.

American International Group Inc., the world’s largest insurance company, has lost billions of dollars due to speculating in these financial derivatives. The market for these contracts had mushroomed to $62 trillion during the past decade and was largely hidden from the public’s view. Warren Buffett has referred to them as “financial weapons of mass destruction.”

Computer technology has evolved over the past decade, creating a worldwide flow of money that has surpassed the ability of the Federal Reserve to regulate these contracts.

I believe kudos go to Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson for engineering a response large enough to forestall a collapse in the world’s financial system. Confidence in the system needs to be restored to avoid a possible deflation. A deflationary economic cycle can occur when falling prices for goods and services encourage consumers to wait for even lower prices. It’s worse than runaway inflation. That’s a path we don’t want to go down.

The meeting this week offers the opportunity for real leadership going forward. Regulatory reform proposals include calls for a single worldwide regulator, pricing transparency for the derivatives markets and the establishment of margin requirements to reduce the dangerous levels of leverage and debt currently at play in the markets. Those goals are possible to accomplish in 2009.

I believe that as citizens of a rapidly changing world, we need this unprecedented and coordinated global regulatory action to restore our faith in the world’s financial system.

Bill Taber is the president of Des Moines-based Taber Asset Management.