Over-the-counter (finance)

Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading. Non-standard products are traded in the so-called over-the-counter (OTC) derivatives markets. OTC derivatives have less standard structure and are traded bilaterally (between two parties). In such bilateral contract, each party should have credit risk concerns with respect to the other party. OTC derivatives are significant in the asset classes such as interest rate, foreign exchange, equities and commodities

Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges or stock exchanges.

OTC-traded stocks

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 Inc.) and the FINRA operated OTC Bulletin Board (OTCBB). The OTCBB licenses the services of OTC Link for their OTCBB securities. OTC stocks are not usually listed nor traded on any stock exchanges, though exchange listed stocks can be traded OTC on the third market. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through OTC Market Group Inc.

OTC contracts

An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement. This segment of the OTC market is occasionally referred to as the "Fourth Market."

Counterparty risk

OTC derivatives can lead to significant risks. Especially counterparty risk has gained particular emphasis due to the credit crisis in 2007. Counterparty risk is the risk that a counterparty in a derivatives transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract. There are many ways to limit counterparty risk. One of them focuses on controlling credit exposure with diversification, netting, collateralisation and hedging.

ISDA suggested five main ways to address the credit risk arising from a derivatives transaction, as follows:

• avoiding the risk by not entering into transactions in the first place;
• being financially strong enough and having enough capital set aside to accept the risk of non-payment;
• making the risk as small as possible through the use of close-out netting
• having another entity reimburse losses, similar to the insurance, financial guarantee and credit derivatives markets
• 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 significant part of the world of global finance. The OTC derivatives markets are large and have grown exponentially over the last two decades. The expansion has been driven by interest rate products, foreign exchange instruments and credit default swaps. The notional outstanding of OTC derivatives markets rose throughout the period and totaled approximately US$601 trillion at December 31, 2010. The global OTC derivatives market will continue to develop strongly. In the past two decades, the major internationally active financial institutions have significantly increased the share of their earnings from derivatives activities. These institutions manage portfolios of derivatives involving tens of thousand of positions and aggregate global turnover over $1trillion. The OTC market is an informal network of billateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets. The internationally financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefit from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance.

The advantages of OTC derivatives over Exchange traded ones are mainly the lower costs (in terms of government taxes and fees payable) and the ability for sellers and buyers of these products to bilaterally negotiate and customize the transactions themselves.

The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange’s clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.