OTC Derivatives

What are Over the Counter (OTC) Derivatives?

Over the counter (OTC) derivatives are like special financial deals made directly between two parties, without using a regular marketplace or middlemen. The special thing about them is that they do not have fixed rules; instead, the two parties can decide the rules themselves. This flexibility makes OTC derivatives a versatile tool for handling different financial needs.

But here is the catch: while OTC derivatives offer flexibility, they also bring a concern called "credit risk." Unlike regular deals, OTC ones do not have an extra layer of protection, making them riskier.

Types of OTC derivatives

OTC derivatives are classified into four categories: forwards, swaps, options, and credit derivatives:

• Forwards: A forward contract acts like a financial handshake between two parties, outlining an agreement to buy or sell an asset at a set price and date in the future. What sets forwards apart is that the asset's price is fixed when the contract is made, but the actual deal happens later. Businesses often use forwards to shield themselves from unpredictable price changes and, conversely, for individuals to take a calculated bet on future prices.
• Swaps: Think of swaps as a financial trade-off between two parties. It is an agreement where cash flows are exchanged based on a prearranged formula. Swaps are handy tools to manage risks associated with interest rates, currency fluctuations, and commodity prices. This means that, through swaps, businesses, and investors can adjust their financial positions based on changes in interest rates, currencies, or commodity prices.
• Options: Options provide a unique flexibility in the derivative world. These contracts give the holder the choice (but not the obligation) to buy or sell an asset at a predetermined price and date in the future. There are two flavours: call options, giving the right to buy, and put options, granting the right to sell. Options are a dual-purpose tool, allowing investors to protect themselves against price swings and, alternatively, to speculate on potential future price movements.
• Credit derivatives: Credit derivatives are like financial safety nets. They are contracts enabling investors to shift credit risk from one party to another. Businesses and investors use credit derivatives to manage the uncertainties related to credit risk, essentially protecting themselves from the possibility of someone not being able to pay back what they owe. Simultaneously, credit derivatives also offer a way for investors to make bets on the credit quality of various entities.

Advantages and disadvantages of OTC derivatives

Advantages of OTC derivatives:

1. Flexibility: OTC derivatives offer a high level of flexibility as private contracts. Parties involved can customise these contracts to precisely match their risk tolerance and return requirements. This adaptability ensures that financial instruments are tailored to specific needs, enhancing their effectiveness.
2. Lower costs: Trading OTC derivatives typically involves lower costs and fewer regulatory hurdles compared to their exchange-traded counterparts. This cost-effectiveness contributes to making OTC derivatives an attractive option for parties seeking more streamlined and efficient financial transactions.
3. Hedging opportunities: OTC derivatives serve as valuable tools for hedging against credit risk. They enable companies to manage and mitigate their exposure to risks associated with fluctuations in exchange rates and commodity prices. This risk management aspect enhances the stability of businesses in volatile market conditions.
4. Tailored deals: In the OTC environment, companies enjoy greater freedom in structuring deals. Unlike exchange-traded transactions with lengthy and costly protocols, OTC derivatives empower parties to design agreements that precisely meet their financial objectives. This ability to tailor deals adds a strategic dimension to financial decision-making.

Disadvantages of OTC derivatives:

1. Higher credit risk: OTC derivatives, lacking regulatory oversight, introduce an elevated level of credit or default risk. The absence of a supervisory body increases the potential for counterparty default, exposing participants to financial uncertainties and losses.
2. Illiquidity concerns: The liquidity of OTC derivative securities relies heavily on the availability of buyers. If there is a lack of market interest or willing buyers, it may lead to an illiquid situation. This illiquidity poses challenges for participants looking to buy or sell these derivatives promptly.
3. Lack of transparency: Unlike regulated exchange markets where trading prices are mandatorily disclosed to the public, OTC derivatives lack such transparency. The counterparties involved are not obligated to disclose the terms or prices of their transactions. This lack of transparency can hinder market efficiency and make it challenging for participants to assess fair value.

Differences between exchange traded derivatives and OTC derivatives

Exchange-traded derivatives (ETDs):

1. Standardised contracts: ETDs are standardised financial contracts listed and traded on regulated exchanges. These contracts have uniform terms and specifications.
   
2. Listed on regulated exchanges: ETDs are actively listed on regulated exchanges, providing a centralised platform for trading.
   
3. Standardised terms and specifications: Each ETD contract comes with standardised terms and specifications. This standardisation simplifies crucial information for investors, including contract value, the quantity of the underlying asset, and allowable transaction volumes.
   
4. Counterparty risk eliminated: The exchange itself acts as the counterparty for each ETD transaction. This arrangement eliminates the risk of the counterparty defaulting on its obligations, providing a layer of security for investors.
   
5. Clearing corporation present: ETD transactions benefit from the presence of a clearing corporation, which ensures the smooth settlement of trades and mitigates risks associated with default.

OTC derivatives:

1. Customised contracts: OTC derivatives are private contracts arranged directly between two counterparties, allowing for a high degree of customisation. The terms of these contracts are tailored to suit the specific risk and return preferences of each party.
   
2. Not listed on exchanges: Unlike ETDs, OTC derivatives are not listed on regulated exchanges. They operate in a decentralised manner, negotiated directly between counterparties or with the assistance of a broker.
   
3. No standardised terms: OTC derivatives lack standardised terms and specifications. The absence of uniformity means that each contract can vary significantly based on the negotiation between the parties involved.
   
4. Counterparty risks present: OTC derivatives introduce counterparty risk, given the absence of a centralised exchange acting as a counterparty. This risk arises from the potential default of one of the parties involved.
   
5. No clearing corporation: OTC derivatives transactions do not benefit from the presence of a clearing corporation. This lack of centralised clearing exposes parties to credit risk, as there is no intermediary to guarantee the fulfilment of contractual obligations.