Is Greece bluffing?

FORTUNE — Greek Prime Minister George Papandreou seems to playing an extremely high-stakes game of chicken with the European Union in his call for a national referendum on the euro zone’s latest fix-it plan. The move has destabilized a situation that was already on thin ice. In the end, European leaders may have to sweeten the pot for Greece to make this vote go away.

It is unclear why exactly Papandreou decided to step up now and call for a referendum. Unlike in places like California and Switzerland, referendums are extremely rare in Greece, with the last such vote held in 1974 when the country voted to abolish the monarchy.

Papandreou claims that a vote by the people is necessary given the major impact the latest European fix-it plan would have on Greece. That rational has raised some eyebrows across the continent. A referendum wasn’t used when the Greek government pushed through two rounds of tough austerity measures. Nor was it used when the country decided to take billions of euros in aid from the European Union and International Monetary Fund.

So what is really going on here? While receiving a vote of confidence from the people is justifiable given the seriousness of the situation, the move is being seen by some in the market as a way for Greece to push the EU into giving it a better deal. It probably isn’t a coincidence that the call for the vote came after the country received its latest cash payment from the EU and IMF and a couple days before the G-20 summit in Cannes, where the EU was supposed to show the world that it has finally got its act together.

“There is probably something going on behind the scenes that isn’t being seen in the public eye,” a portfolio manager with close ties to the EU told Fortune. “Papandreou is obviously trying to get the EU to step up with more cash.”

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Germany and France seemed genuinely shocked by Papandreou’s decision to call for a referendum. This morning, officials from both countries telegraphed that there would be no alterations made to the plan and that Greece was going to have to accept it in its entirety or lose the billions of euros in aid it needs to keep paying its bills.

So who holds the advantage here? If Greece goes ahead with the referendum, its citizenry would most probably reject the plan, creating a wave of instability in the region. In response, the EU would probably cut its lifeline to Greece, forcing the nation to default on its debt. That would cause all of the major Greek banks to collapse, as they are the largest holders of Greek debt. But at the same time, it would cause several European banks to take billions of euros in write downs, as they too hold significant amounts of Greek debt.

Snowball effect

It doesn’t end there. Since the Greeks were forced into default, credit default swap contracts on Greek debt would be triggered. That means the banks and hedge funds that were short Greek debt would now be owed billions of euros in insurance payments by those that were long Greek debt. It is widely believed that the large banks, which issue and sometime hold on to all those CDS contracts, have not set aside enough capital to payout claims. This could lead to an AIG-style meltdown of many financial institutions. That explains why bank stocks around the globe fell hard yesterday, especially those that play big in the CDS market like Bank of America (BAC) and JP Morgan Chase (JPM) in the U.S., which were both down around 6%, as well as those in Europe like Societe Generale, which was down over 16%.

This CDS chain reaction is one of the major reasons why the Europeans have kept Greece on life support for so long. The total collapse of the Greek economy would be a sad event, but a confidence crisis in the word banking system, three years after the fall of Lehman Brothers, would be a catastrophe. One of the major planks of the latest fix-it plan was to get the banks and other major holders of Greek debt to agree to take a 50% haircut on their bonds. Since such a cut would be voluntary “soft default,” it would not trigger the CDS contracts, therefore limiting the fallout to those banks that physically held Greek debt.

A hard default would probably see all that Greek debt go to zero. While that would wipe the slate clean for the country, it would be a pyrrhic victory as its economy would be decimated. Papandreou is fully aware of this fact, as are members of Greece’s main opposition party in parliament, which has blasted the prime minister for being reckless. If Papandreou survives a vote of no confidence Friday, the stage will be set for months of further market instability. The referendum would take place probably at the end of December or beginning of January.

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To avoid all of this, the French and the Germans may need to swallow their pride and work out a better deal for the Greeks with the banks. Under the current plan, Greece’s debt-to-GDP ratio is projected to be around 120% by 2020. While that is an improvement from the projected 190% ratio projected by 2013, it’s still very high. The plan assumes further cuts in Greek government spending and a positive economic growth rate. Those assumptions are generous, since the cuts in spending, coupled with a strong euro, would probably lead to much slower economic growth. To dig itself out of this hole, Greece needs to cut its debt by more than 50%. The banks have balked at taking a larger haircut, but the threat of a hard default may scare them into accepting a greater loss.

Warren Buffett once called derivatives financial instruments of mass destruction. The CDS contracts attached to Greek debt are proving to be quite a destructive force indeed. Papandreou is now threatening to push the button. To avoid a nasty surprise, the Europeans will probably need to yield to Greece’s demands.