As the world economy struggles to recover from the worst financial crisis since the Great Depression, we are reminded of the fundamental truth that every financial system depends on trust.

Market participants need to believe that the counterparties they deal with will fulfill their obligations. That trust has been severely damaged as our financial institutions have suffered life-threatening, self- inflicted wounds by purchasing over a trillion dollars of complex mortgage-backed securities, secured by dicey loans and financed on the thinnest of margins with short-term debt.

There is widespread understanding that the long-run solution must involve substantial deleveraging and recapitalization of our financial institutions. But there is also a popular view that the government should effectively regulate complex derivatives out of existence and impose stringent limitations on executive compensation to curb what critics have described as "the pervasive greed on Wall Street."

I believe that such actions would be short-sighted and counterproductive. They would fundamentally weaken private capital markets that have brought unparalleled long-run prosperity to the United States. Moreover, private institutions are already planning to reorient arrangements in the derivative markets, such as the credit-default swap market; and boards of directors can easily reform compensation systems that have created perverse incentives for the executives of our financial institutions.

While the proliferation of mortgage-backed securities is often identified as the principal culprit in the current financial mess, credit default swaps had an equally important role in the crisis. The credit default swap (CDS) was developed during the 1990s as a useful insurance product to help investors protect themselves against the possibility that the loans they had made or bonds they owned might go sour. Just as individuals buy fire insurance to protect themselves in case of fire, a bond holder could buy insurance to protect against a default of the bond issuer.

The buyer would pay periodic premiums for the protection, and the seller (such as an insurance company like AIG, or a hedge fund) would agree to make the buyer whole in the event of a default. Unfortunately, the benign instrument designed to reduce risk turned into a monster that came close to destroying the entire financial system.

One problem was that the market mushroomed out of control. One could buy a CDS not only on bonds you owned but even on bonds you didn't own. Speculators might bet that some risky company might default on its bonds even if they did not own the bonds. Hence the volume of CDS instruments became a multiple of the total value of the actual bonds that were being insured. In fact, the CDS market at its peak totaled over $60 trillion, far larger than the total bond market and almost four times larger than the total capitalisation of all the stocks traded on the New York Stock Exchange.

Another difficulty was that the normal methods that providers of insurance could use to contain risk were not applicable. An insurance company that sells me fire insurance on my home in New Jersey is not likely to face a claim at the same time from a homeowner in New York. But when one US financial corporation gets in trouble, it is highly likely that another institution is weakened as well. Traditional insurance principles do not work in the CDS market. The CDS market linked financial institutions in such a way that systemic risks to the whole financial system were magnified. Lehman made billions of dollars of swap contracts with AIG. Inability of the counterparties to make good on their bilateral obligations starts a chain reaction that increases the risk of the counterparty going broke. No wonder Warren Buffet called those instruments "weapons of mass destruction."

As can be expected, calls for more regulation (if not an outright ban on CDS contracts) from insurance commissioners and from Congress are frequent. But the CDS instrument can play a very important role in risk reduction and good risk management. Moreover, the market itself can provide the institutional arrangements that preserve the advantages of CDSs, while avoiding the counterparty and systemic risks that we have experienced during the current crisis.

What we need is a shift from the current over-the-counter bilateral CDS market to an exchange-traded market. Contracts should be more "plain vanilla" and standardised. They should be fully collateralised and traded on a central exchange. A central clearing house, backed by capital contributions from the clearing members, should guarantee all contracts. The counterparty for each contract would be the clearing house. Contracts should be marked to the market at least daily and probably even more often. The transparent pricing and volume information provided by exchange trading should eliminate the opacity in the current system. While the new market may well reduce the profitability of current market participants, the advantages of greater liquidity, transparency, and safety should help make the entire financial system stronger, less opaque, and more trustworthy. Already the CME and ICE exchanges have been preparing plans for a CDS market based on these principles.

The second problem requiring a long-run solution concerns the perverse financial incentives inherent in the current system. It too can be handled without government-mandated compensation limits. Under present arrangements, executives of our financial institutions are often paid extremely large cash bonuses based on their attainment of annual profit goals. It is basically the same system by which hedge fund managers earn incentive payments amounting to a fixed percentage of the funds' profits. Small wonder that many institutions became similar to hedge funds, employing more and more leverage in an attempt to increase profits and return on equity. The problem is that such incentives tend to encourage excessive risk-taking and short-term behavior. If the risks succeed, managers benefit; if the risks are unsuccessful, the enterprise as a whole suffers. In some cases, the unsuccessful executives have received obscene severance payments - what amounts to bonuses for failure.

The "solution" to the problem that is often favored by politicians is to limit executive compensation by fiat. Such policies often fail or are counterproductive. If direct compensation is limited, it is easy to increase indirect compensation through more generous benefits. When Congress limited the tax deductibility of regular executive salaries to $1,000,000 per year, the amount of incentive compensation skyrocketed. It will be more effective to channel compensation so that it provides correct incentives to constrain short-term maximisation and excessive risky behavior in favor of the maximisation of long-term shareholder value.

In my view, the best option is for boards of directors to require that all incentive executive compensation be paid in restricted stock. Moreover, the executives should be required to hold the stock not only throughout their tenure with the company but also for several years thereafter. Small exceptions could be allowed to permit the payment of tax liabilities, for medical emergencies, etc.

Congress could play a role by legislating that only incentive compensation conforming to such arrangements could be deducted from corporate income taxes. Personal income tax penalties could also be imposed on the sale of stock to meet "emergencies." Moreover, "change of control" and "severance" payments could be structured in terms of a certain number of shares of stock. Executives who had run their companies into the ground would then receive the payments that were due, but those payments would be in shares of worthless stock.

Such arrangements are likely to align the managers' incentives to the long-run rather than the short-run success of the enterprise. Executives of financial institutions would receive large payoffs only if long-term share owners were similarly rewarded. When Warren Buffett made his investment in Goldman Sachs, he required a commitment from the top executives that they would continue to hold at least 90 per cent of their current equity stake in the firm. If stockholders in all our financial firms could count on a similar commitment, a helpful step would be taken toward restoring trust in the system.

While there have clearly been market failures involved in the current crisis, let us not lose faith in market mechanisms to provide solutions. The US financial markets are the most flexible and innovative in the world and, for all their current problems, they have helped make America an innovation machine. Weakening those markets to calm short-term disruptions would be a serious mistake.

The writer is Chemical Bank Chairman's Professor of Economics at Princeton University and author of A Random Walk Down Wall Street.