Although derivatives themselves are highly varied — they can be easily sorted into four basic types, but a huge range of sub-types exists within each of those groups — when it comes to trading, derivatives can typically be bought and sold in one of only two ways: on a listed exchange, or over-the-counter. Read on for a further breakdown and comparison of these two types of derivatives markets.
Also known generically as listed derivatives, exchange-traded derivatives are highly standardized derivatives contracts that are traded on a regulated exchange. The central element of this type of derivatives market is the clearinghouse, or the central counterparty (CCP), which fulfills three main functions.
First, the clearinghouse sets all the characteristics of the derivatives being traded, including the size of the contract, dates and manner of settlement, and pricing. No deviation is permitted from these specific rules set by the exchange, which has the effect of facilitating trading and enhancing liquidity. Second, the CCP tracks all outstanding contracts, records the daily details of what is owed by and to whom, and makes available the aggregate information about each different contract type.
Finally, the clearinghouse establishes and enforces margin requirements in order to prevent parties from defaulting on their obligations. To achieve this, the clearinghouse conducts daily pricing of all contracts and oversees settlement of resulting requirements for additional margin.
In this way, having legally replaced bilateral trades between anonymous counterparties with trades between the CCP and clearing participants, the clearinghouse takes on the role of counterparty to all trades conducted on the exchange. In other words, the exchange itself acts as the buyer for every seller and the seller for every buyer. Thus, participants’ risk is with the clearinghouse, and vice versa, rather than with each other. This has the effect of facilitating price discovery and transparency, affording anonymity of trade counterparties, and standardizing the credit risk among all clearing participants.
While exchange-traded derivatives are highly standardized, over-the-counter (OTC) derivatives are the opposite: customized, private contracts that are negotiated and booked directly between counterparties rather than being traded on an exchange. OTC trades can incorporate many of the types of assets also traded on exchanges, including commodities and debt instruments. However, there are several important differences between OTC and exchange-traded derivatives.
The first is the relative lack of standardization. While a certain degree of standardization of terms may be involved, OTC transactions are based on customized negotiations between contracting parties, in which bespoke terms that fit each party’s individual risk preferences are set. Another difference is that, rather than trades being executed on an exchange, contracting parties typically trade with dealers, who then in turn trade with each other.
Finally, unlike their exchange-traded counterparts, OTC derivatives involve direct exposure between contracting parties with no regulated intermediary. As a result, each party is exposed to counterparty credit risk (the risk that one party in an agreement will default on its obligations to the other).
In many ways, then, exchange-traded and OTC derivatives markets are essentially opposites of each other in terms of what they look like and how they operate. Exchange-traded markets feature standardized products, a large number of trading parties, both retail and professional, large numbers of transactions, and a high degree of transparency upheld by detailed trade reporting requirements.
It is also worth noting that fungibility of contracts — or the interchangeability of a good or asset with other individual goods or assets of the same type — is an important feature of exchange-traded markets. This feature allows a position to be initiated by an opening trade and subsequently closed by an offsetting trade.
OTC markets, on the other hand, involve a fairly small number of trading parties, the vast majority of which are institutional rather than retail, and a relatively small number of large transactions. Transparency levels are also much lower compared to exchange-traded markets. This is mainly because of the nature of the risks traded in OTC markets: customized, illiquid, and challenging to trade — even among highly-informed traders.
And while OTC markets do involve a large number of highly customized products, there are limits to how far such customization goes. Any OTC market will also feature a range of generic contracts, known as “vanilla” contracts, which are more liquid than more bespoke products.
A Middle Ground Option?
While exchange-traded and OTC markets remain the main types of derivatives markets, a third category is beginning to emerge and assume an increasingly important role in derivatives trading. Known as “cleared OTC derivatives,” this is a kind of hybrid between exchange-traded and OTC. It involves the bilateral trading of transactions which are privately negotiated, but which are also relatively standardized and booked with a CCP.
The participation of a CCP removes exposure to counterparty risk, as dealers do not have direct counterparty credit exposure to each other, only to the clearinghouse. And while the standardization of contracts need not be as rigorous as in exchange-traded derivatives markets, a fairly high degree of standardization is necessary in order for the CCP to facilitate risk management.