It's a helpful diagram! What it doesn't say is each of those AAA tranches actually [erfpr,ed. When you look back at how the AAA tranches of CDO-squareds circa 2005 to 2008 paid out, they pretty much all behaved like AAA securities.
Those tranches were solvent. In many cases, their junior tranches were solvent. What none of those tranches were was liquid. I can hold a security that will pay me $1,000 indefinitely, but if nobody will buy it for more than a penny, it isn't useful if my trading group is busy diving into a liquidity crisis. (Granted, ratings don't say anything about the liquidity of a thing. Just its solvency.)
I don't know the answer. A quick Google search suggests bucket shops were made illegal in the US, but I don't know the details, or why this doesn't make derivatives illegal.
One rationale for regulation I could imagine is to protect 'investors' from counterparty risk in case the bucket shop is inadequately hedged. Presumably synthetic CDOs were manufactured from derivatives whose counterparties were big banks, which are subject to capital adequacy requirements which in theory provide some protection.
https://en.wikipedia.org/wiki/Collateralized_debt_obligation...
EDIT: and what that diagram misses is that, because the originators couldn't manufacture mortgages fast enough to satisfy the demands of investors/speculators, banks started manufacturing CDOs directly (synthetic CDOs), meaning investors' total notional exposure to mortgage performance could exceed the total value of outstanding mortgages.