Over the Counter Vs. Exchange Traded
Whether you are trading futures, options, or swaps, they are either exchange-cleared or OTC contracts, so it’s worth familiarizing yourself with the differences between them.
When you execute an exchange-cleared trade, once that trade is matched and cleared, the contract is guaranteed. If the broker you executed with faces bankruptcy, your trade will still be valid, so exchange-cleared trades are deemed far less of a risk than OTC trades. The risk for an OTC trade sits with the counterpart you transacted with. If they go under, chances are your trade goes with them. Exchange trades are matched and settled through a clearing house (we will cover the role of clearing houses in a separate post). While OTC trades can be cleared, depending on the product and jurisdiction, there is no requirement for them to be. Some financing banks may require hedges to be exchange-cleared to finance the physical product.
Exchanges are much more heavily regulated than OTC markets. This can be both a positive and a negative depending on your needs. There are certain conditions and often size requirements for a company to become a broker on an exchange. OTC markets often have much less scrutiny, so the counterparts you may deal with in the OTC market may not be as credit-worthy as executing through exchanges.
The visibility, and often liquidity of exchange-cleared trades is far greater than the OTC market. All bids, offers, and executed trades are visible to market participants in exchange trades, the opposite is usually true in OTC trades. That information stays between the two parties executing the trades.
There are certain advantages to OTC trades. Foreign exchange for example trades largely through a decentralized network of banks, allowing for trading 24 hours a day, rather than on an exchange that would have set trading hours.
You may also be able to access derivatives for certain commodities or types of trades that you would otherwise not be able to execute exchange-cleared. All aspects of exchange trades are standardized, but OTC markets can typically offer a more customized solution. The less stringent trading requirements and lack of visibility may also be appealing to certain traders.
In general OTC markets carry a lower cost of execution compared to exchange trades. Because there is no exchange sitting between the trades, OTC markets can bypass a lot of the fees exchanges charge to access them.
Whether you are trading exchange-cleared or OTC is often dictated by the commodity or market you are trading in, but sometimes you will have the choice. It is wise to be educated in the nuances between the two so you can make the best decision for your company and overall goals.
