OVER THE next few weeks and probably months, all eyes in the financial markets will be on something called the Vix. It is a sign of the turmoil over the last 10 days that this hitherto little-known measurement has suddenly popped into prominence. Screen jockeys, sweating over the prospect of further mayhem, know the Vix as the "fear gauge".

A tool launched in 1993 by the Chicago Board Options Exchange (CBOE), it is regarded as one of the most reliable barometers of market volatility and investors' appetite for risk. When the Vix is rising, it means the market is running scared.

And lately, the Vix has just about jumped off the charts. Just over a week ago, it broke the 29-point barrier before retreating to 26.57 by midweek, still frighteningly high by the standards of most of this century.

Dealers were so desperate to unwind their positions that the CBOE posted a record 5.5 million trades a day. At 25-plus, the Vix tells a story of sweaty palms and stifled panic.

At a time like this, the significance of this seemingly arcane measurement is that it serves as a window into the highly opaque world of the financial markets, on which so much of commercial life depends but which we know so little about. The Vix is a reflection of the sum of the knowledge - and emotions - of those operating in the very heart of the markets where tens of billions of pound slosh around on a daily basis.

It also serves as a reminder of how incestuous - or interlinked, as central bankers prefer to say - the financial markets have become over the last five years. Until the last few weeks, few business people would have believed their access to capital, and even the rate at which it is loaned, might be affected by a few million dodgy home loans written on the other side of the world.

Yet the American sub-prime market is where it all started. Many of these loans did not require a deposit, repayments of principal, or even proof of income.

A big percentage of the mortgages were provided to unemployed workers against their social security checks. Nothing wrong with that, except that an elementary principle of mortgage-lending is that the borrower should be in a position to pay it back.

Six months ago, as the defaults first began to throw seeds of doubt into the markets, there were over £650 billion of these loans. And now there is the prospect of several years of possibly accelerating defaults on them, solely because of the effects of what has been known as "financial innovation", but possibly not for much longer.

As Chicago economist David Hale pointed out last week: "In the 1980s, those defaults would have led to a run on the local bank. In the current decade the loans have been securitised, repackaged in a collateralised debt obligation bond CDOs and sold to a hedge fund that bought it on leverage."

So many of these CDO-like debt packages have been devised and then aggressively sold to hedge funds and other buyers of debt that they have become embedded in the global financial markets, not just in the US mortgage market as would have been the case in the old days.

The serious problem right now, the one that has spooked the markets, is the precise ownership of this monumental amount of bad debt. As the Cassandras were warning as early as last year, the CDOs and their offspring have been flicked on so rapidly that it has become difficult and even impossible to trace the original lender.

The hedge funds and others that merrily bounced the debt around the world strenuously denied the risks of doing so, insisting that the effect was entirely beneficial for the markets. The debt was being "spread", like a bookie laying off a big wager.

Far better to diversify debt, it was argued, than hold it on the book of the original lender.

So far, so right. However something was lost in the translation, as has abruptly become evident. Not only were the "boy geniuses", as the mathematicians and scientists who devised the hedgies' trading programmes have been described, handing on the debt in a global game of pass the parcel, they were also greatly magnifying it. Some hedgies leveraged their loans - that is loans, not capital - by up to 10 times.

The overall result is that what would once have been an entirely local problem has contaminated the world financial markets, like a fast-moving, virulent strain of flu.

The opaque nature of the debt packages themselves has not helped. Like so many layer cakes, they are generally composed of several tranches of debt of varying worth. By mixing and matching the tranches, it became possible to bake a bigger cake. The bigger the cake, the bigger the potential profit on what are low-margin products. However, the quality of "sliced and diced" debt, backed as it is by dubious assets such as sub-prime mortgage bonds, is much harder to assess in investment terms than, say, the staid old medium-term notes, gilts and other raw material of the money markets.

The big issue now is how far and how violently the markets will unravel. To date, the effects of the explosion in financial innovation have emerged in ones and twos, starting in July on Wall Street when two funds managed by Bear Sterns lost nearly all their investors' money.

Next, massive private-equity deals like the £10bn-plus takeover of Boots Alliance went back on the table because the big commercial banks, which have largely bankrolled the buy-out boom, found they could not unload the debt, as they have been able to do with relative ease over the last few years. At the same time, say sources, the "cov-lite" deals - the relatively non-onerous loans that fuelled the buyout boom - have been quietly withdrawn.

But it was the sudden loss of liquidity in the inter-bank markets just 10 panic-filled days ago that genuinely shocked the world's central banks.

By the end of last week, the normally passive European Central Bank had been forced to pump an historically stupendous 96.5bn over three working days into the money markets, all the while pretending nothing serious was amiss.

It took EBC governor Jean-Claude Trichet until last Tuesday, the day after a second massive intervention, to acknowledge that "a normalisation of the pricing of risk" might be going on and to make a plea for everybody "to keep their composure".

More than anything, central banks love liquidity, especially so in the new and unpredictable markets that have sprung up around CDOs and their multiple offspring.

In truth, most central banks had been expecting some sort of tremor. The Bank of England was well aware, for example, that most of these new-fangled financial instruments are highly vulnerable to a liquidity crunch. They require constant massaging by the hedgies using such highly technical - and, as it has proved, failure-prone - techniques like constant proportion portfolio insurance which almost endlessly rebalances the fund according to prevailing circumstances.

However, the trading models clearly do not work when the money dries up, when there is a mad scramble for funding, and when it becomes impossible for the funds to trade their way to safety.

In July, the official Bank of England view was that things were ripe for a "correction" after 10 years of what deputy governor Sir John Gieve describes as the "great stability". Rather prophetically, he noted that "the story of the sub-prime market is not yet over and it certainly does point to some vulnerabilities in modern financial markets "

Thus the boffins at Threadneedle Street, who are after all just as highly qualified as the "quants" who devised the hedgies' trading models, were not too displeased as the spreads for riskier bonds began to widen by up to six times. They rated the narrowness of the spreads as something of a sword of Damocles hanging over the markets and therefore feared a "disorderly" recalibration rather than the duller "re-pricing of risk".

But disorderly is exactly what they got when the next mine in what is turning out to be a danger-packed field blew up, this time in Germany with the £5.4bn rescue of German bank IKB. Its subsidiary Rhineland Funding had rapidly accumulated £13.5bn in so-called asset-backed paper through what should be dull and boring structured investment vehicles or SIVs.

Another arcane corner of the financial markets, SIVs aim to book steady returns on the normally predictable and minuscule differences between short-term borrowing rates and longer-term asset-backed paper.

When the SIVs of IKB's subsidiary went south, the parent bank could not plug the gap. Its usual lenders got gun-shy and it fell to state-owned KFW bank to ride to the rescue.

Suddenly, the sword had become a dagger aimed straight at the main money markets and the IKB rescue sent waves of panic around the world.

The big question now is whether this is the "correction" we had to have or a full-blown, continuing crisis. According to Avinash Persaud, chairman of Intelligence Capital and a professor at Gresham College, London, we are in for a new phase of market volatility "more vicious than before".

He predicts the next few months "will be led by downgraded ratings on credit instruments and followed by further dislocation in the credit markets that will spill over into equity markets". As he ominously adds, it is the credit markets that are the "big brother of the equity markets".

It is a sobering thought that the value of the asset-backed paper under fire is around $1500bn £756bn.

For observers like Satyajit Das, a risk consultant and author of a well-reviewed expose of financial innovation in Traders, Guns, Monday: Knowns And Unknowns In The Dazzling World Of Derivatives, we are "at a very critical inflection point in the markets, a fundamental dislocation in credit".

Using an automotive metaphor, he likens the situation to "a sump with a huge crack in it and the oil is leaking out". Needless to say, he does not see a quick solution because it will take months to find out if the markets can absorb the massive amounts of contaminated debt.

So far, though, nobody predicts an economic Armageddon. As the City licks its wounds, the rest of the economy is in good shape.

According to Andrew Sentance, business economist and a member of the Bank of England's monetary policy committee, the state of commerce is buoyant in the wider world beyond the City, largely because of the general robustness of the global economy. As he reassuringly pointed out in late July: "Across manufacturing, services and construction, the picture for the first half of this year is of healthy growth across the UK as a whole."

Interestingly, Sentance also mentioned at the time that the volatility of the financial services industries "could be an issue for the London economy and other financial centres such as Edinburgh and Leeds in the future". He probably did not mean in the next few days.

However, other observers told the Sunday Herald they feared the troubles in the credit markets, as the leverage slowly and painfully unwinds, might work through into the economy at large.

For evidence, they cite the falling returns already showing through in the commercial property sector. The knock-on effects, they say, could work through into commodities (oil prices are already off by the high single figures) and then into the consumer markets, which are already fuelled by debt.

For instance Ted Scott, manager of the F&C UK Growth & Income Fund, warned that problems in the financial markets will now spill over into the real economy.

"The focus of this drama has been on credit derivatives, hedge funds and excessive leverage which seem remote to the man on the street. However, I believe that some contagion to the real economy is now inevitable," he explained. With consumption accounting for around 70% of UK GDP, a reining-in of debt would inevitably impact company profits and earnings.

As the week closed, the markets were still patently nervous. The benchmark BBA Libor overnight sterling rate, which is another barometer of risk, was retreating to safer levels but still stood above the Bank of England's base rate of 5.75. And the FTSE 100 was down as investors worried about the knock-on effects on the share prices of banking and commodities sectors.

As for CBOE's Vix "fear gauge", it had taken off again, racing past the 30-point barrier for the first time. Maybe it knows something we do not.