Exchange versus OTC Derivatives Trading

In the dynamic landscape of financial markets, exchange-traded and over-the-counter (OTC) derivatives both have their part to play with respect to their use by institutional investors, corporations and individual traders. Each has particular merits and limitations, and the choice to use one or the other to support investment or commercial strategies will be determined by individual requirements with respect to customisation, liquidity, risk tolerance and regulatory rigour. Leveraging data solutions significantly enhances efficiency in reference data management, ensuring streamlined operations and informed decision-making across the financial landscape.

The key differences between ETD and OTC are:

Exchange-Traded Derivatives (ETDs):

Exchange-traded derivatives are some of the world’s most actively traded (liquid) instruments. In the year to September 2023, the world’s derivatives exchanges traded some 95 trillion contracts, an increase of over 50% on the previous year.

Exchange-Traded derivatives (ETDs) are standardised financial contracts traded on organised exchanges. ETDs follow predefined contract specifications relating to contract size, expiration date and other terms. ETDs are subject to the rules and regulations of the exchange on which they are listed. Futures and Options on futures are typical examples of exchange-traded derivatives.

ETDs are traded on regulated (organised) exchanges subject to very rigorous oversight by regulatory bodies. Exchanges are required to enforce strict rules governing fair and transparent trading designed expressly to protect the interests of market participants. Examples of well-known regulated derivatives exchanges include the Chicago Mercantile Exchange (CME) and Eurex.

While the standardised nature of ETDs enhances liquidity (access and availability) and makes them easily tradable, there is, however, limited flexibility for customisation.

Over-the-Counter (OTC) Derivatives:

Over-the-Counter derivatives are financial contracts traded directly between two parties, without the involvement of an organised exchange or intermediary. OTC transactions are typically facilitated by dealers, brokers and financial institutions (e.g. banks).

OTC derivatives are entirely customisable; counterparties tailor the precise terms of the contracts to fulfil specific requirements. Common types of OTC derivatives include forward contracts, options and interest rate swaps.

Liquidity in OTC markets can vary depending on the specific derivative and the counterparties involved. Some OTC derivatives may lack the depth of liquidity found in highly traded exchange-traded products.

OTC cleared products are also traded over-the-counter, but they differ in the way they handle counterparty risk. In OTC cleared products, a central clearinghouse acts as an intermediary between the parties involved in the trade. When a trade is executed, the central clearinghouse becomes the counterparty to both the buyer and the seller. This arrangement helps to mitigate counterparty risk by ensuring that both parties fulfil their obligations.

Counterparty risk

Because OTC transactions involve a direct contractual relationship between two parties each counterparty has a credit risk to the other (i.e. the risk that one party will default on its obligation). To mitigate this risk, parties often use collateral agreements or credit derivatives.

However, for ETD transactions, the exchange acts as a central counterparty (CCP) to all transactions; it is in effect the buyer to every seller and seller to every buyer on the exchange. As such, it ‘guarantees’ to settle all contracts and reduces individual participants’ counterparty risk. To offset its own risk as the CCP, it requires the payment of margins (deposits) by all trading counterparties that are adjusted regularly in line with price movements (value) of the contracts.

Regulation

Whereas organised exchanges are subject to very rigid rules and rigorous regulatory oversight, OTC markets are subject to far less regulatory scrutiny. The 2008 financial crisis prompted far greater regulatory interest in OTC derivatives and has resulted in specific and ongoing regulatory reform including the US Dodd-Frank Act, EMIR in Europe and ASIC in Australia.

OTC derivatives offer flexibility and tailored solutions but come with heightened counterparty risk. Exchange-traded derivatives, with standardised contracts and centralised clearing, provide greater liquidity and reduced counterparty risk but offer less customisation. Ultimately, the decision to engage in OTC or exchange-traded derivatives depends on the specific objectives and risk appetite of the market participants involved.

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