What are Over the Counter (OTC) Derivatives

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  • 03 Oct 2023

Key Highlights

  • OTC Derivatives are financial contracts between two counterparties with minimal intermediation.
  • Derivatives traded over the counter are often referred to as unlisted stocks since they are traded through dealer networks.
  • Interest Rate, Commodity, Equity, Currency, and Credit derivatives are the types of OTC derivatives.
  • OTC derivative offers flexibility but also poses a credit risk since there is no clearing agency.

OTC Derivatives definition refers to financial contracts between two counterparties with minimal intermediation or regulation. OTCs are private financial agreements. There is no exchange or formal intermediary involved in this negotiation.

The risk and return of over-the-counter derivatives can be negotiated and customised to suit each party's needs. While this type of derivative offers flexibility, it also carries credit risk. There is no clearing agency with this type of derivative, so it carries credit risk.

Interest Rate, Commodity, Equity, Currency, and credit derivatives are the main types of OTC derivatives. Let’s understand each one in detail.

  • Interest Rate Derivatives

Interest Rate Derivatives are financial derivatives that are based on interest rates, the price of interest rate instruments, or interest rate indices. In OTC derivatives, swaps are the most common derivatives that are based on interest rates.

  • Commodity Derivatives

Derivative contracts based on commodities are known as commodity derivative contracts. Agricultural and non-agricultural commodities are traded under this derivative contract.

  • Equity Derivatives

Derivatives are based on underlying equity securities. Options are the most popular OTC equity derivative.

  • Crrency Derivatives

A currency derivative is a futures or options contract that requires you to trade a specific quantity of a particular currency pair at a future date. The trading of currency derivatives is similar to the trading of stocks and futures options. Currency pairings such as USD/INR or EUR/INR serve as the underlying resources.

  • Cedit Derivatives

It is a transfer of credit risk without any exchange of underlying assets. Credit Default Swaps and Credit Linked Notes are two types of credit derivatives traded over the counter.

Derivatives traded over the counter are often referred to as unlisted stocks since they are traded through dealer networks. Through direct negotiation, broker/dealer networks conduct OTC trading. In the OTC derivatives market, there are two types:

1. Inter-dealer Markets

Over-the-counter trading is conducted between different dealers. Their goal is to minimise risks by negotiating prices.

2. Comer Market

An over-the-counter trade is conducted between a dealer and a customer. For buying and selling derivatives, dealers provide prices to customers, which they agree upon.

The following are the advantages of OTC:

  • It allows small companies to trade without being listed on a stock exchange.
  • As OTCs are private agreements, the contract can be customised and much more flexible for the parties.
  • Trading risks can be transferred, hedging can be done, and business operations can be leveraged.
  • Credit risk can be hedged with OTC contracts.
  • Unlisted companies can trade with fewer costs and regulations using this mechanism.

A few OTC downsides are as follows:

  • As OTC contracts are inherently speculative, they can pose a threat to market integrity.
  • As there is no central clearing and settlement mechanism for OTC Contracts, they are vulnerable to credit risk or default.
  • The OTC market poses risks to the stability of the financial markets
  • This type of contract is not regulated.
  • Market integrity and stability, as well as the protection of all market player's interests, are not guaranteed by explicit rules or systems.

By hedging, a financial asset's risk is reduced. Hedge means taking an opposite position in a security or investment to balance out the price risk of an existing trade. Stocks, bonds, interest rates, currencies, commodities, and many other investments can be protected against unfavourable price changes.

1. Currency Risk

A trader can hedge or protect against currency rate fluctuations by using derivatives. Companies that deal with foreign currencies frequently benefit from OTC. They ensure that fluctuations don't increase their obligations or decrease their income.

2. Interest Rate Risk

Interest rate swaps protect traders against rising or falling interest rates.

3. Commodity Risk

Similar to currency risk, traders are exposed to fluctuations in commodity prices such as gold, oil, agricultural products, etc. In a commodity derivative, a trader buys or sells a commodity at a specific price. Therefore, the trader is unaffected by any price fluctuations above or below the agreed price.

Conclusion

OTC derivatives refer to trading securities over a broker-dealer network rather than on a centralised exchange. Also, it is common to refer to these derivatives as unlisted stocks. In OTC derivatives trades, the broker/dealer network negotiates the terms directly with the buyer and seller. Derivatives may be modified to meet the risk and return criteria of each participant over the counter. This type of derivative offers flexibility but also poses a credit risk since there is no clearing agency. In case you are new to trading, Kotak Securities can provide financial guidance. Their expertise and valuable tools will help you make informed trading decisions.

FAQs on OTC Derivatives

The main difference between OTC derivatives and exchange-traded futures is that exchange-traded futures are traded on organised exchange, while OTC derivatives are traded directly between counterparties.

A futures contract isn't an OTC derivative. Contrary to OTC derivatives, futures contracts are traded on exchanges with standardised terms. OTCs are traded directly between counterparties, so they're more customisable and flexible.

Yes, it is risky to trade OTC due to its complexity and counterparty risk. Counterparty risk is caused by the parties' potential default or financial instability. In addition, OTC requires a deep understanding of the underlying assets and market dynamics.

Over-the-counter securities markets are secondary markets where buyers and sellers (or their agents or brokers) trade securities.

Trading on the OTC market gives traders more flexibility than exchange-based trading.

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