"Levels of unsigned confirmations and master agreements remain relatively high and raise serious issues for market efficiency and market confidence," Gay Huey Evans, the FSA's capital markets sector leader said in an open letter to market participants.
The FSA said a recent investigation showed that the back office functions of a number of firms in the market were inadequate to keep pace with the growth in their front office business.
Credit derivatives are instruments used to insure against companies defaulting on or restrutucring their debt. The multitrillion dollar market is centred on London and has experienced dizzying growth in recent years.
The British Bankers Association said last year that the market was worth $5 trillion in 2004 and could be worth $8.2 trillion in 2006. That would mark a 45-fold increase since 1997, when the BBA started surveying the market.
One market participant said the FSA's intervention will not come as a big suprise to many.
"The volumes keep on spiralling up and it is like you are in this rickety old boat and everytime you put a another box in it creaks," he said.
"Eventually it'll sink unless banks come to some sort of a convention to encourage the timely notification," he added.
The biggest players in this market include large investment banks such as J.P. Morgan, Deutsche Bank and Morgan Stanley.
Part of the problem, market participants say, is that trading is now so liquid that the bank who writes the initial contract is losing track of the counterparty who needs to keep up the premium payments on their protection.
Credit derivatives have become an important tool for diversifying risk and bringing liquidity to segments of the credit market, the FSA acknowledges.
"With benefits come risks and if simple operational procedures are unable to keep up with the pace of market development, the risk that misunderstandings and uncertainty will negatively impact market confidence increases," Huey Evans said.
Three years ago Howard Davies, then FSA chairman, expressed concern at the risks embedded in credit derivatives.
He said at the time that one investment banker had described some aspects of the fast-growing credit derivatives sector as "the most toxic element of the financial markets."
Banks, however, may not welcome increased regulation into this lucrative market. In a survey this week banking executives said excessive regulation is the biggest risk facing them. They also admitted though that banks are less equipped to handle risk than before.
The FSA's intervention also puts fresh pressure on the structured credit market, which has suffered from bad publicity in recent months on the back of court rows over collaterilised debt obligations. Barclays Plc agreed to pay an undisclosed amount to German state bank HSH Nordbank to settle a dispute over the management of a CDO.
There are already a number of efforts to get to grips with this market. The new Basel Accord and the EU capital Requirements Directive will detail minimum capital requirements for credit derivatives.