Over The Counter Derivatives (OTC) - Meaning, Types, Advantages & Disadvantages

Last Updated: 9 Dec 2024

To have expertise in investing and making profits, you need to be well-versed with all trading terminologies. Among various investment instruments that can allow you to earn hefty returns, Over-the-Counter or OTC derivatives are one of them. If you are unaware of such an investment, this blog will shed light on What are OTC Derivatives. However, before you move on to learn about OTC derivatives, you need to learn about derivatives trading.

Types of OTC Derivatives Market

Over-the-counter derivatives trading is conducted through dealer networks, and these derivatives are frequently referred to as unlisted stocks. The broker/dealer network conducts OTC derivatives trade through direct negotiation in which the two parties agree upon the terms. There can be two types of OTC derivatives market:

Inter-dealer Markets::

Here, over-the-counter trading is conducted between different dealers. They negotiate prices to hedge against risks.

Customer Market:

Here, over-the-counter trading is conducted between a dealer and a customer. Dealers provide the prices for buying and selling of derivatives to the customers, which are agreed upon by the customers.

Differences Between Exchange Traded Derivatives and OTC derivatives.

Factor	Exchange Traded Derivatives (ETDs)	Over the Counter Derivatives (OTC)
Nature of Transaction	Transactions occur on a formal exchange, acting as an intermediary.	Private agreements between two or more parties without a centralised exchange.
Price Transparency	Prices are transparent and publicly available.	Prices lack transparency and can be difficult to ascertain.
Market Participants	Involves retail and institutional investors, market makers, and authorized participants.	Primarily involves financial institutions, hedge funds, and large investors.
Execution Speed	It may be slower due to price matching and potential network delays.	Generally faster as trades occur directly between parties.
Liquidity	Higher liquidity due to a larger number of participants in the market.	Liquidity depends on the size and frequency of trades between parties.
Regulation	Subject to strict regulatory oversight by agencies like the SEC or CFTC.	Minimal regulation, with no central authority overseeing transactions.
Margin in Trade	The exchange rules set margin requirements.	Collateral is negotiated privately between the parties involved.
Costs	Typically lower due to price competition and volume discounts.	Often higher due to the lack of price competition in private negotiations.

Types of OTC Derivatives

Over-the-counter trading can be of the following types based on the below-listed underlying assets:

1. Credit Derivatives  

Credit derivatives are financial instruments that allow one party to transfer the credit risk of an underlying asset to another party without exchanging the asset itself. Common examples include Credit Default Swaps (CDS) and Credit Linked Notes (CLNs), which help manage exposure to credit risk.

2. Interest Rate Derivatives  

These derivatives derive their value from interest rates, interest rate instruments, or interest rate indices. The most prevalent form of interest rate derivatives in the OTC market is swaps, which facilitate the exchange of cash flows based on different interest rates.

3. Commodity Derivatives  

A commodity derivative contract is based on the price of an underlying commodity, which can include both agricultural and non-agricultural products. These contracts allow investors to hedge against price fluctuations in various commodities.

4. Equity Derivatives  

Equity derivatives are financial contracts whose value is linked to underlying equity securities. The most common OTC equity derivative is options, which provide investors with the right, but not the obligation, to buy or sell shares at a predetermined price.

5. Currency Derivatives  

Currency derivatives include futures and options contracts that involve trading specific quantities of currency pairs at future dates. They are similar to stock options and are often used for hedging against foreign exchange risks.

Types Of Risks That Can Be Managed Using OTC Derivatives:

Over-the-counter market trade in derivatives can allow for hedging against three types of risks:

1. Interest Rate Risk:

Here, an interest rate swap between the trading parties allows the interest rate to be fixed, switching from a floating interest rate.

2. Currency Risk:

The exchange rate is fixed or locked using OTC derivatives, thus allowing the trading parties to hedge against currency rate fluctuations. Import and export companies can benefit from using OTC currency derivatives.

3. Commodity Price Risk :

Here, the trading parties lock the future selling price of a commodity.

Advantages Of OTC Derivatives

The benefits of over-the-counter trading include:

• It allows small companies to engage in trade without being listed on stock exchanges. These companies can also stand to benefit from lesser financial and administrative costs compared to companies listed on stock exchanges.
• It can be used for hedging, transferring trading risks, and as leverage for business operations.
• It can allow for increased flexibility as the companies don’t have to abide by the standardised norms vis-a-vis exchange-traded derivatives.
• It can allow companies to provide stable prices to their customers.

Disadvantages Of OTC Derivatives

Over-the-counter trading has some disadvantages as well. Here’s a look:

• Any OTC contract runs the associated risk of credit or default as there is no central mechanism to clear and settle the transactions.
• Any OTC contract is fraught with inherent and systemic risks in the absence of standardised regulations and norms.
• OTC contracts are inherently speculative, thus having the possibility of creating market integrity issues and forcing traders to make losses.

Over The Counter (OTC) Derivatives Meaning

Over-the-counter (OTC) derivatives are financial contracts negotiated directly between two parties without being traded on a centralized exchange. These contracts can be customized to meet the specific needs and risk profiles of the counterparties involved. Common types of OTC derivatives include interest rate swaps, commodity derivatives, equity options, currency forwards, and credit derivatives.

While OTC derivatives offer flexibility and tailored solutions, they also carry significant risks, particularly credit risk, due to the lack of regulatory oversight and the absence of a clearinghouse. This means that if one party defaults, the other may face substantial financial losses. As such, participants must carefully assess their counterparty’s creditworthiness before entering into such agreements. Overall, over-the-counter derivatives play a crucial role in financial markets by enabling participants to hedge risks and manage exposures effectively.

Conclusion

OTC derivatives are private contracts between counterparties negotiated without stock exchanges. It allows for increased flexibility, as the terms are negotiated and tailored to fit the requirements of the two parties. Now that you know what are OTCs, you can effectively begin your trading journey with confidence and poise. However, choosing a trusted and reliable financial partner is wise to make prudent investment decisions. Look for features such as a free Demat account/trading account, options to invest in multiple options via a single account, cutting-edge technology and the app with the best stock and scheme recommendations .You can learn more about these options by downloading our trading app.

Frequently Asked Questions

Are futures contracts OTC derivatives?

No, futures contracts are not considered over-the-counter derivatives. They are standardized agreements traded on organized exchanges, which provide a regulated environment for transactions. In contrast, OTC derivatives are customized contracts negotiated directly between parties without the involvement of an exchange. This allows for more flexibility but also increases risk due to less regulatory oversight and no central clearinghouse.

What is the most common OTC derivative?

The most common over-the-counter derivatives include interest rate swaps and forwards. Interest rate swaps allow parties to exchange cash flows based on different interest rates, while forwards are customized agreements to buy or sell an asset at a future date. These instruments are widely used for hedging and managing financial risks associated with interest rates and market fluctuations.

Are mark-to-market margins applicable to OTC options?

Mark-to-market margins are generally not applicable to over-the-counter options as they are not traded on exchanges. Instead, the parties involved privately negotiate the terms and collateral for these options. This lack of standardisation means no centralized clearinghouse enforces daily margin requirements, increasing counterparty risk in these transactions.

Are OTC derivatives risky?

Yes, over-the-counter derivatives carry inherent risks due to their lack of regulation and standardisation. Since these contracts are privately negotiated between parties, they expose participants to credit risk if one party defaults. Additionally, the absence of a central clearinghouse means there is no oversight or guarantee of performance, making it crucial for parties to assess their counterparties’ creditworthiness.

What is an example of OTC?

An example of an over-the-counter derivative is a forward contract, a private agreement between two parties to buy or sell an asset at a specified future date and price. Unlike standardized futures contracts traded on exchanges, forwards can be tailored to meet the parties’ specific needs, allowing for flexibility in terms and conditions.