Difference between OTC and ET derivatives

May 1st, 2008

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No doubt, as you read the financial news media, you will often see the word “derivatives” popping up here and there. For those who are not in the finance industry, you may wonder what derivatives are. Today, we will depart from our usual macroeconomic musings and delve into the world of derivatives.

“Derivatives” is a very broad term, just as the word “animals” is. Basically, a derivative is a financial instrument that derives its value from an underlying instrument, ranging from stocks to commodities. Examples of derivatives include options, futures, forwards, swaps (e.g. credit default swaps), contract-for-difference and so on.

In every derivative transactions, there are always two parties (obvious) and a legal contract. This gives rise to two types of derivatives based on how the contract is negotiated:

  1. Over-The-Counter (OTC)– For OTC derivatives, the contract between the two parties are privately negotiated and traded between the two parties directly. Therefore, the contract can be tailor-made to the two parties’ liking. This arrangement is very flexible, but there are disadvantages:
    • The value of your derivative is as good as the credit-worthiness of your counter-party. If your counter-party goes bust, your derivative becomes worthless.
    • It is very hard to pass on the derivative to a third-party because the contract is already signed between the two original parties.
    • It is very hard to discover the ‘market price’ of a derivative contract because there is no transparency in the pricing and it is very hard to value unique contracts uniformly on a mass scale.
  2. Exchange-Traded (ET)– For ET derivatives, the situation is different. They are traded via an intermediary, the exchange, which is a strong institution with deep pockets. Therefore, technically speaking, even if Tom and Dick trade a derivative between each other, their counter-parties are not each other- rather both of their counter-parties is the same exchange. In other words, if Tom sell an ET derivative to Dick, the exchange acts as a buyer to Tom and a seller to Dick. The advantages of such an arrangement is:
    • Since all market participants’ counter-parties is the exchange, the derivative contracts are standardised.
    • There is no credit risk between market participants. For example, if Tom has no need to fear if Dick defaults on the contract. If that happens, it is the exchange that has to bear the consequences.
    • There is a very visible and transparent market price for the derivatives.

So, since we have mentioned a lot about credit-default-swaps (CDS) in our past articles, we can now tell you that CDS is an OTC derivative.

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