Definition – What does Over the Counter mean?
On the derivatives markets, many products are traded through exchanges. Exchange is known to assist liquidity and diminish all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardized to transparent trading. Non-standard products are traded in the over-the-counter (OTC) derivatives markets. OTC derivatives have a less standard structure and are traded between two parties. In such a bilateral contract, each party should have credit risk concerns with regard to the other party. OTC derivatives are important in the assets such as interest rates, foreign exchange, equities and commodities.
Over-the-counter (OTC) or off-exchange trading is the trading of financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is different to exchange trading, which is done through facilities conceived for the purpose of trading, such as futures exchanges or stock exchanges.
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 Board (OTCBB). The OTCBB licenses the services of OTC Link for their OTCBB securities. OTC stocks are not commonly listed nor traded on any stock exchanges, though exchange-listed stocks can be traded OTC on the third market. Even though stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those labeled as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through OTC Market Group Inc.
An over-the-counter contract is a bilateral contract where the two participants will concur on how a trade or agreement will be settled in the future and is usually done through the computer or telephone. Forwards and swaps are the most evident examples of such contracts. For derivatives, these agreements are usually regulated by an International Swaps and Derivatives Association agreement. This segment of the OTC market is sometimes referred to as the “Fourth Market.”
OTC derivatives can lead to significant risks. The 2007 credit crisis has placed particular attention on counterparty risk. This is the risk that in a derivatives transaction a counterparty in will default before the expiration of the trade and will not make the current and future payments required by the contract. One of the ways of reducing this type of risk is to focus on controlling credit exposure with diversification, netting, collateralization and hedging.
The International Swaps and Derivatives Association propose five main ways to address the credit risk arising from a derivatives transaction:
1. Not entering into transactions in the first place;
2. Being financially strong enough and having enough capital set aside to be prepared for possible risk of non-payment;
3. Reducing the risk through the use of close-out netting;
4. Having another entity reimburse the losses, just like insurance, financial guarantee and credit derivatives markets;
5. 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 an important sector of global finance. The OTC derivatives markets are large and have been rapidly growing over the last two decades. This growth has been driven by interest rate products, foreign exchange instruments and credit default swaps.
The notional outstanding of OTC derivatives markets augmented throughout the period and totaled about US$601 trillion on December 31, 2010. In the past two decades, the major internationally active financial institutions have increased the share of their earnings from derivatives activities.
These institutions manage portfolios of derivatives involving tens of thousands of positions and accumulate global turnover to over $1trillion. The OTC market is an informal network of bilateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets.
International financial institutions have increasingly aimed at being able to profit from OTC derivatives activities and financial markets participants have tried to benefit from them. As a result, OTC derivatives activities play a central role in modern finance.
The advantages of OTC derivatives over Exchange-traded derivatives are lower costs and the ability for sellers and buyers of these products to bilaterally negotiate and adjust the transactions themselves.
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which permits counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange’s clearinghouse, eliminating credit and performance risk of the initial OTC transaction counterparts.