Over-the-counter (finance)
Encyclopedia
Within the derivatives
markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk
concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading. Non-standard products are traded in the so-called over-the-counter (OTC) derivatives markets. OTC derivatives have less standard structure and are traded bilaterally (between two parties). In such bilateral contract, each party should have credit risk concerns with respect to the other party. OTC derivatives are significant in the asset classes such as interest rate, foreign exchange, equities and commodities
Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments
such as stock
s, bonds
, commodities
or derivatives
directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchange
s or stock exchange
s.
(OTCBB). The OTCBB licenses the services of OTC Link for their OTCBB securities. OTC stocks are not usually listed nor traded on any stock exchanges, though exchange listed stocks can be traded OTC on the third market
. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through OTC Market Group Inc.
and swaps
are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives
, these agreements are usually governed by an International Swaps and Derivatives Association
agreement. This segment of the OTC market is occasionally referred to as the "Fourth Market
."
The International Swaps and Derivatives Association
suggested five main ways to address the credit risk arising from a derivatives transaction, as follows:
In the past two decades, the major internationally active financial institutions have significantly increased the share of their earnings from derivatives activities. These institutions manage portfolios of derivatives involving tens of thousand of positions and aggregate global turnover over $1trillion. The OTC market is an informal network of billateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets. The internationally financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefit from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance.
The advantages of OTC derivatives over Exchange traded ones are mainly the lower costs (in terms of government taxes and fees payable) and the ability for sellers and buyers of these products to bilaterally negotiate and customize the transactions themselves.
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading. Non-standard products are traded in the so-called over-the-counter (OTC) derivatives markets. OTC derivatives have less standard structure and are traded bilaterally (between two parties). In such bilateral contract, each party should have credit risk concerns with respect to the other party. OTC derivatives are significant in the asset classes such as interest rate, foreign exchange, equities and commodities
Over-the-counter (OTC) or off-exchange trading is to trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
such as stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, commodities
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
or derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchange
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
s or stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
s.
OTC-traded stocks
In the U.S., over-the-counter trading in stock is carried out by market makers that make markets in over-the-counter securities using inter-dealer quotation services such as OTC Link (a service offered by OTC Markets Group) and the FINRA operated OTC Bulletin BoardOTC Bulletin Board
The OTC Bulletin Board or OTCBB is an interdealer electronic quotation system in the United States that displays real-time quotes, last-sale prices, and volume information for many over-the-counter equity securities that are not listed on the NASDAQ stock exchange or a national securities exchange...
(OTCBB). The OTCBB licenses the services of OTC Link for their OTCBB securities. OTC stocks are not usually listed nor traded on any stock exchanges, though exchange listed stocks can be traded OTC on the third market
Third market trading
Third market in finance, refers to the trading of exchange-listed securities in the over-the-counter market. These trades allow institutional investors to trade blocks of securities directly, rather than through an exchange, providing liquidity and anonymity to buyersThird market trading was...
. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through OTC Market Group Inc.
OTC contracts
An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. ForwardsForward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
and swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, these agreements are usually governed by an International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
agreement. This segment of the OTC market is occasionally referred to as the "Fourth Market
Fourth market
Fourth market trading is direct institution-to-institution trading without using the service of broker-dealers. It is impossible to estimate the volume of fourth market activity because trades are not subject to reporting requirements. Studies have suggested that several million shares are traded...
."
Counterparty risk
OTC derivatives can lead to significant risks. Especially counterparty risk has gained particular emphasis due to the credit crisis in 2007. Counterparty risk is the risk that a counterparty in a derivatives transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract. There are many ways to limit counterparty risk. One of them focuses on controlling credit exposure with diversification, netting, collateralisation and hedging.The International Swaps and Derivatives Association
International Swaps and Derivatives Association
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives....
suggested five main ways to address the credit risk arising from a derivatives transaction, as follows:
- avoiding the risk by not entering into transactions in the first place;
- being financially strong enough and having enough capital set aside to accept the risk of non-payment;
- making the risk as small as possible through the use of close-out netting
- having another entity reimburse losses, similar to the insurance, financial guarantee and credit derivatives markets
- obtaining the right of recourse to some asset of value that can be sold or the value of which can be applied in the event of default on the transaction
Importance of OTC derivatives in modern banking
OTC derivatives are significant part of the world of global finance. The OTC derivatives markets are large and have grown exponentially over the last two decades. The expansion has been driven by interest rate products, foreign exchange instruments and credit default swaps. The notional outstanding of OTC derivatives markets rose throughout the period and totaled approximately US$601 trillion at December 31, 2010.In the past two decades, the major internationally active financial institutions have significantly increased the share of their earnings from derivatives activities. These institutions manage portfolios of derivatives involving tens of thousand of positions and aggregate global turnover over $1trillion. The OTC market is an informal network of billateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets. The internationally financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefit from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance.
The advantages of OTC derivatives over Exchange traded ones are mainly the lower costs (in terms of government taxes and fees payable) and the ability for sellers and buyers of these products to bilaterally negotiate and customize the transactions themselves.
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.