Global Securities Markets: Navigating the World's Exchanges and OTC Markets

THE OTC DERIVATIVE MARKETS

Derivatives are traded on formal exchanges or in a person-to-person or over-the-counter (OTC) basis that does not involve a formal exchange. Instead, participants trade directly with each other. Traditionally, OTC trades, just as with most bond trading, have been concluded over the phone (voice brokerage) but are increasingly taking place on electronic networks (e.g., between dealers or between dealers and their clients).

OTC derivatives are simply derivatives traded on OTC markets. Their main difference from the derivatives traded on exchanges lies in their highly individualized nature; whereas on-exchange derivatives are traded on standard terms (e.g., there is a limited choice of strike prices or maturities that can be traded), OTC derivatives are nonstandardized, offering full flexibility in deciding those terms.1 They are accordingly tailor-made to fit the specific risk management and other specific needs of investors.

Formerly, there were many derivatives that were traded in the OTC markets and were subject to less regulation than was true for exchange-traded derivatives. In the United States, the Dodd-Frank financial reforms have made significant changes in this area. Now, many more derivatives will need to be cleared through central clearing systems and traded on recognized exchanges.

Why Are OTC Derivatives Markets Regarded as More Risky than Exchange-Traded Derivatives Markets?

OTC markets are characterized by bilateral contracting between counterparties, ...