Diverse in nature and widely misunderstood, derivative securities seem to be everywhere these days. They nabbed a starring role in the current economic crisis. They're even being used to offer hedges against bad weather for seasonal mom-and-pop businesses.

Derivative securities, which are based on some underlying asset, typically fall into two broad categories: Exchange-traded derivatives (ETDs) and over-the-counter (OTC) derivatives. ETDs are sold via large exchange marketplaces like CME Group, Korea Exchange and Eurex, while OTC derivatives are private transactions between two parties. Their value may be based on stocks, bonds, mortgages, funds, indices or even market factors and weather.

David Friedberg is a former Google executive who founded San Francisco-based weather derivative firm WeatherBill, which trades OTC derivatives to help small to mid-sized businesses hedge against losses due to weather fluctuations. He is concerned about the talk of moving OTC derivative trades to an exchange or central clearing center to remove some of the risk.

Friedberg says his company relies on regulatory exemptions, and a change to them would be a threat to his business. His products are so customized it would be nearly impossible to sell them that way.

"If I'm a ski resort and I want to hedge against the winter being too warm and I need to collect $100,000 for every degree in temperature above normal to stay in business, that's a much different situation than if I'm an energy company and I need to protect my entire base against a too warm winter," Friedberg explains.

Experts generally agree that derivatives have been painted with an overly broad brush and that their demonization could be a danger. There is a risk of over-regulation, says Antony Page, an associate law professor at Indiana University who specializes in securities regulation and corporate governance. He says that the fast growth of unregulated derivatives, such as credit default swaps from less than $1 trillion to more than $60 trillion shows a huge market demand for these instruments. "Too much regulation would increase costs, reduce flexibility and reduce demand. Frequently after a corporate crisis, government over-regulates in response," he says.

Effective regulation will serve to make derivatives more transparent and will yield information that is actually used, rather than just creating more paperwork and cost, says Viva Hammer, a partner in the tax and financial services groups in the New York City office of law firm Crowell & Moring. Hammer says that regulation should be approached with an eye toward using information to mitigate risk. "I think the key about derivatives is that the underlying [asset] is not necessarily transparent. You need to make the thing that you're betting on very, very clear," she says.

Friedberg points out that the Commodity Futures Modernization Act of 2000, which repealed the ban on single-stock futures and relaxed regulation on OTC derivatives, has some provision for the regulation of derivatives. "Clean up the language and there is a good body of work that we could look to and expand the jurisdiction of what it covers," he says.

Page agrees. However, he also supports a clearinghouse, and believes in stronger disclosure requirements for unregulated derivatives, such as credit default swaps.