CFA Level 1 - Derivatives - 2 - ETD vs OTC

Continuing from our last article, we will take a look at the two derivatives markets we have, that is, Exchange Traded Derivatives (ETD) and Over the Counter (OTC).

Both have their own set of products that get traded and features that differentiate them.

Let's look at Exchange Traded Derivatives first:

Futures and Options contracts are traded on officially listed exchanges, similar to equity shares.

Some of the major stock markets in the world:

Source : investing.com

Exchange Product Features

Products traded on exchanges have some special features that make them safer and easier to use.

First, these products are standardized. This means the exchange lists the contract details like quantity, expiry date, and the underlying asset. Anyone can buy or sell the contracts that are listed.

For instance, in India, the Nifty futures contract always covers 50 units or shares.

When it comes to credit risk, all trades on an exchange are backed by a clearinghouse. For all the contracts you buy and sell, the counterparty is the clearinghouse that guarantees settlement, that is , whether it's in cash, shares, or whatever is mentioned in the contract.

It acts like a trusted middleman, ensuring both sides keep their promises.

So even if one party fails to pay, the other doesn’t lose money.

To reduce risk, the exchange asks both sides to pay some money at the start of the trade. This is called Initial Margin.

If one side starts losing money, they may need to add more to the margin with the clearinghouse. This is called Variation Margin. It helps to cover the risk of loss.

The prices at which trades are ready to buy and sell are open and visible to everyone.

There is high liquidity in the market, so it's easy to get in and out of a trade. It is also highly regulated by respective financial authorities.

So, in simple words: exchange-traded products are easy to trade, safer because of the clearinghouse and are transparent. That’s why many people and companies prefer to use them.

Over-the-Counter (OTC) Derivatives

These are private contracts between two parties, usually banks or financial institutions. They are not traded on an exchange and are custom made to suit the needs of the buyer and seller.

Common OTC derivatives include forwards, various types of swaps like interest rate swaps or equity swaps, and some customized options. These are private agreements between two parties.

These contracts are customizable, meaning both sides can decide on everything that is contract size, expiry date, settlement method and even the underlying asset.

This is useful when someone needs something specific that an exchange-traded contract doesn’t offer.

There is more credit risk because you're dealing directly with the counterparty and there’s no clearinghouse in between to guarantee settlement. This is known as counterparty risk.

The OTC market is comparatively less regulated, and trades are not visible to the public, reducing transparency around what people are buying or selling and at what prices.

Since these contracts are not standard, it makes them less liquid and harder to enter or exit with the same terms, which also results in higher costs compared to exchange traded products.

Post-2008 Crisis Changes

After the 2008 financial crisis, regulators recognized the risks posed by various derivative products traded in the OTC markets. So, they introduced new regulations.

Hope the above explanation helps. See you around.

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Mustufa Petiwala