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FD/U1 Topic 11 Difference between Exchange Traded and OTC Derivatives

OTC vs Exchange

Many financial markets around the world, such as stock markets, do their trading through exchange. However, forex trading does not operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC). We’ll examine some differences between exchange trading and over-the counter markets in this article.

Differences
In a market that operates with exchange trading, transactions are completed through a centralized source. In other words, one party acts as the mediator connecting buyers and sellers. There is a specified number of traders that will trade on that single centralized system. This situation places great power on the mediator, and this is a key disadvantage to this type of trading. The positive aspect to this is that it allows for better transaction enforcement, and stricter security. The NYSE is a typical example of an exchange traded market. In such a market, products could be standardized, and it could also be guaranteed that goods and products are in compliance with the terms of trade.

On the other hand, over-the counter markets are generally decentralized. Here, there are many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that costs for intermediary services are as low as possible. The obvious downside is that these markets are usually not regulated, and more prone to untrustworthy and fraudulent mediators. Examples of OTC markets include forex trading markets, as well as markets for buying and selling debt. Over-the-counter markets have overtaken exchange markets in terms of volumes traded daily, mainly due to the increase in electronic trading and the rise in alternative investing.

The differences also demonstrate that there is more counter party risk in over-the-counter traded markets than in exchange traded ones, because the ‘exchange’ acts as the regulatory, and is a counter-part to each transaction thus ensuring the delivery of funds or securities.

Also, exchange traded markets have less chances of price manipulation by mediators, since trading is on a centralized system. However, in OTC markets, it will largely be determined by how many dealers are trading in a particular security at a given time.

And since there are fewer clients willing to trade in OTC markets, the result will be less liquidity, whereas exchange traded markets tend to have many participants and clients, thus, there’s a generally higher level of liquidity.

An exchange traded product is a standardized financial instrument that is traded on an organized exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an exchange, the price of which is directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities or any agreed upon pricing index or arrangement.

The most common types of derivative products are interest rate swaps, caps and their offshoots. Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb and flow of their corporate finance and hedging activity.

The reason derivative products exist is that users often need customized products as the standardization of exchange products can lead to hedging mismatches and gap exposures.

The main differences between exchange and OTC products can be viewed as follows:

  Exchange Traded OTC Traded
Pricing Standardized Customized
Maturity Standardized Customized
Quantity Standardized Customized
Frequency Standardized Customized
Quality Standardized Customized
Documentation Standardized Customized
Regulatory Body One entity Various

The primary difference is standardization versus customization. This leads to a crucial distinction. When dealing in exchange traded products terms are standardized and the clearinghouse guarantees that the other side of any transaction performs to its obligations. That is, it assumes all contingent default risk so both sides do not need to know about each other’s credit quality. This differs from customized OTC products where there is no clearinghouse to guarantee performance.

The need to know the counterparty’s credit standing is an essential distinction. The exposure difference is quite significant. In summary:

Exchange Traded = Standardizes = Market Risk

OTC Traded = Customized = Market Risk + Counterparty Risk

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