The basic definition of an over-the-counter (OTC) derivative is a bespoke, private derivatives contract that is negotiated directly between counterparties rather than being traded on an exchange. It sounds simple enough, but the reality is rather more complex. Read on for a closer look at some of the fundamentals of OTC derivatives.

Why trade over-the-counter?

The OTC derivatives market is an extremely large one, with three main drivers: the demand for customized derivatives contracts, the demand for an efficient way to trade large contracts, and the demand for greater liquidity.

  1. Customization

stock marketsThe possibility for customization is the primary reason that most participants use OTC contracts rather than exchange-traded derivatives, which are highly standardized. A customized OTC contract be used to satisfy requirements such as the physical delivery of a commodity at a date or location that may not be available at an exchange.

Additionally, these contracts can also be used to create what is known as a “perfect” hedge, in which the fair value of the underlying is offset by the fair value of the derivative. Such hedges require the minimization of “basis risk,” which arises when the derivatives contract (the hedge) and exposure to the underlying asset, commodity, or liability are imperfect substitutes for one another.

These imperfections are caused by factors such as qualitative differences in the assets, different start or expiration dates of the “legs” of the hedge (the legs are the underlying exposure and the derivatives contract), or differences in the market price movements of the hedge legs. However, in an OTC transaction, it is possible to mitigate this basis risk by precisely tailoring contract terms to meet specific requirements.

  1. Size of contracts

The second factor that accounts for the extent and popularity of OTC derivatives markets is the opportunity they provide for large contracts to be traded efficiently. When market participants — institutions whose business needs require the regular assumption of or exit from large derivatives positions — place multiple, large-quantity orders on a public exchange, they not only risk exposing themselves to a variety of manipulation techniques, there is also the possibility that their actions may significantly affect the market.

As an alternative, such institutions typically prefer to trade in OTC markets, which offer them the certainty that they will be able to negotiate acceptable prices for entering into and out of large positions, and that the quantity of contracts they need will be available. It is important to note that, for the most part, these institutions are not participating in the market in order to speculate; rather, they are insulating their business from the effects of volatile commodity prices, foreign currency exchange rates, or interest rates.

  1. Liquidity

A final reason why market participants choose OTC derivatives markets is to obtain greater access to liquidity: in other words, to have another, possibly more effective channel for finding counterparties willing to engage in specific transactions. Because of unique or otherwise highly specific economic terms — which may include currency types, delivery locations, contract amounts, maturities, and underlying reference rates — some transactions tend to lack liquidity. But for contracts that may have no other trading venue, OTC derivatives markets offer the possibility of liquidity since, as long as at least two parties are willing to negotiate a trade, a transaction can be completed.

Who conducts OTC trades?

There are two discrete segments in the OTC derivatives market: the customer market and the interdealer market.

businessmanCustomers — typically corporations, asset managers, hedge funds, and institutional investors — are end-users of OTC derivatives that are in need of OTC contracts for one of the three reasons outlined above. In order to execute OTC trades, customers almost always go through dealers. There is no prohibition against customers dealing directly with each other, but the practice is quite unusual due to factors such as a lack of risk analysis expertise or associated high transaction and search costs.

Dealers are large financial institutions possessing the necessary capital and expertise to set up complex, large-value trades. Dealers execute such trades for end-users, and hedge their own risk in turn by transacting either in exchange-traded markets or in the interdealer market. It is also possible for dealers to trade on their own account, or to participate in market-making activities for OTC contracts. Financial institutions like Barclays, Credit Suisse, Morgan Stanley, and Wells Fargo are among the largest OTC dealers.

Interdealers, as their name suggests, are brokers that facilitate risk management, price discovery, and trade execution between dealers. Unlike dealers, interdealers do not act as market makers or trade for their own accounts.