I’m beginning to think that Europe’s sovereign debt crisis might kill more than municipal credit default swaps. As the financial system trembles alongside the deliberations of the Greek government, areas of the markets that have quietly lumbered along in the dark are getting more and more attention.

Bloomberg held an excellent state and local finance conference on Wednesday where there was a brilliant session with the state treasurers of North Carolina, Delaware and New Jersey. Bloomberg Editor-in-Chief Matt Winkler grilled the trio on the use of derivatives, mainly interest rate swaps, by public officials. In the most thought-provoking back-and-forth, Winkler asked what the difference was between Alabama’s Jeffereson County and Greece. Both Greece and Jefferson County have extensive ties to financial institutions through the bonds they issued and derivatives they have either entered into or that have been written on them. In the case of Jefferson County this exposure is mainly concentrated with JP Morgan Chase, the lead underwriter for most of the bonds and derivatives written on the county. In the case of Greece it’s fairly well-known who owns its bonds but it’s practically unknown how deep the interconnections are for derivatives. As Bloomberg wrote:

The European nations are linked in a network of debts, as Bill Marsh recently illustrated in the New York Times with a beautiful piece of graphic art. The image is like a complex wiring diagram for a ticking debt bomb. Yet what it shows may be less important than what it leaves out: a largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.

This hidden network has been created by institutions that buy and sell unregulated credit-default swaps. These are essentially insurance contracts on bonds; in the event of a default on the bond, the seller of the swap promises to pay the buyer the bond’s value.

This web of interconnections is amplified many times over because of the intense concentration of derivatives on the trading books of a handful of large, global banks. The graph below from the blog Jesse’s Cafe shows the level of concentration for U.S. commercial banks using data from the Office of the Comptroller of the Currency (OCC). Basically five U.S. banks control the whole U.S. market and embody the concentrated risk. A publication from ISDA, the trade association that represents the large, global banks in the derivatives area, said the OCC reported the notional amount of derivatives outstanding at the five largest U.S.-based dealers was $281 trillion as of June 30, 2010. That is a massive spiderweb of risk given that the U.S. annual GDP is about $14 trillion.