Exchange traded and over-the-counter (OTC) markets are two primary types of markets in the derivatives industry.
Exchange traded derivatives:
Exchange traded derivatives are standardized contracts that are traded on a regulated exchange. The terms of the contract are determined by the exchange and cannot be modified by the parties involved in the trade. The exchanges act as a central counterparty (CCP), which means they guarantee the trade, thereby reducing counterparty risk. Examples of exchange traded derivatives include futures contracts, options, and exchange traded funds (ETFs).
Advantages of exchange traded derivatives include:
- Standardization: All contracts are standardized, which means they have the same terms and conditions for all participants, making it easier to trade.
- Liquidity: Exchange traded derivatives are highly liquid as they are traded on a regulated exchange. This makes it easier to buy and sell contracts at any time.
- Transparency: The prices of exchange traded derivatives are publicly available, which increases transparency and reduces the possibility of market manipulation.
Over-the-counter derivatives:
OTC derivatives are privately negotiated contracts between two parties. The terms of the contract are tailored to the specific needs of the parties involved in the trade. OTC derivatives are not traded on a regulated exchange and there is no central clearinghouse. Instead, the counterparties are responsible for managing the risks associated with the trade.
Examples of OTC derivatives include interest rate swaps, credit default swaps, and foreign exchange options.
Advantages of OTC derivatives include:
- Customization: OTC derivatives can be tailored to the specific needs of the parties involved in the trade, allowing for greater flexibility.
- Privacy: OTC derivatives are private contracts, and information about the trade is not publicly available, providing greater privacy for the parties involved.
- Innovation: OTC derivatives are not subject to the same regulatory constraints as exchange traded derivatives, which allows for greater innovation in product design.
Disadvantages of OTC derivatives include:
- Counterparty risk: There is no central clearinghouse for OTC derivatives, which means that the counterparties are exposed to each other’s credit risk.
- Lack of transparency: OTC derivatives are not traded on a regulated exchange, which means that prices and market activity are not publicly available.
- Liquidity risk: OTC derivatives are less liquid than exchange traded derivatives, which can make it difficult to sell contracts when needed.