Five Differences Between OTC and Exchange Traded Derivatives

Over-the-counter derivatives, also called OTC derivatives, and exchange-traded derivatives have several key differences.  Below are five major distinctions between them:

Trading Venue:

1. OTC derivatives are traded directly between two parties with no centralized exchange or intermediary involved.

2. Exchange-traded derivatives are traded on a formal exchange such as the Chicago Mercantile Exchange where the transaction is facilitated by the exchange.

Standardization:

1. OTC derivatives are customized to meet the specific needs of the parties involved such as notional amount, maturity and other contract terms.

2. Exchange-traded derivatives are standardized in terms of contract size, expiration dates and underlying asset.

Counterparty Risk:

1. The risk of counterparty default is higher with OTC derivatives because these trades are not guaranteed by a clearinghouse.  Each party must assess and manage the credit risk of the other party.

2. With exchange-traded derivatives the exchange acts as an intermediary and clearinghouse which mitigates counterparty risk.  The clearinghouse guarantees the performance of the contract, reducing the risk of default.

Regulation:

1. OTC derivatives are less regulated compared to exchange-traded derivatives.  Regulatory oversight may vary by jurisdiction, but in general, OTC markets are more opaque.

2. Exchange-traded derivatives are subject to strict regulatory oversight by financial regulatory authorities.  Exchanges must comply with specific rules and reporting requirements ensuring greater transparency and protection.

Liquidity and Pricing:

1. OTC derivatives tend to be less liquid because they are customized and traded privately.  Pricing can be less transparent and more difficult to determine.

2. Exchange-traded derivatives are typically more liquid due to their standardization and centralized trading.  Prices are publicly available, and there is often a continuous market for these contracts.

There are pros and cons to both OTC and exchange-traded derivatives that impact which is most suitable for a particular organization.  If you are unsure which one best fits your needs, enlist the help of an advisor to assist in making this determination.

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