What is over the counter derivative

Introduction:

In capital markets, derivatives have no intrinsic value but derive their value through their underlying asset. The first official derivatives took place in 1848, Chicago. It was a forward contract where the derivatives derived their value from wheat. Today this underlying value could come from bonds, stocks, commodities, currencies, etc. In the absence of a supervisory exchange market, there are no limits to the lot size of the securities being traded. That allows the parties to fit their contracts with their requirements after accessing the risk factors. Companies that cannot list themselves on formal stock exchanges sell their stocks through the counter platform. That allows them to gauge market and counterparty risks and proceed with caution.

Advantages of OTC derivatives

In global finance, OTC derivatives (and OTC markets in general) have a special place for ensuring the movement of and access to capital, especially for companies that are yet to enlist and trade on formal centralized exchanges. This means:

• Trading of less liquid companies: OTC derivatives help buy or sell smaller and less liquid assets, thus contributing to the overall flow of capital
• The flexibility of traded items: OTC traders are more flexible in tailoring their contracts according to market risks
• Non-standardized items: OTC markets have no limit on the quantity and quality of the items being traded
• Hedging instruments: OTC derivatives are cost-effective ways to access stocks before investing in them further

Additional read: What are the different instruments available in India under the derivative segment?

Disadvantages of OTC derivatives

While OTC markets afford greater flexibility to traders regarding their contract specifications, their risks are relatively higher than trading through formal stock exchanges. These include:

• Higher credit risk: Being unregulated by a supervisory body, derivatives traded on the OTC platform have increased credit or default risk
• Illiquidity: If there are no buyers to derivative securities, it may lead to a liquidity impasse. On the other hand, a regulated exchange market ensures trading without interruptions
• Lack of transparency: Unlike a regulated exchange market where there is mandatory public disclosure of the price at which the trading occurs, OTC counterparties are not obligated to do so. Hence a buyer may end up buying a stock for more than what it’s worth

An example of OTC derivatives:

A forward contract is a clear example of OTC derivatives. It is a non-regulated, non-standardized, and customized contract between a buyer and a seller. The two parties negotiate the terms of the agreement and settle it only after its expiration date.

Additional read: What is the difference between a Futures contract and a Forward Contract?

Conclusion:

Though they offer more flexibility and customization to the contracts, OTC derivatives are riskier than listed securities traded through formal stock exchanges. However, OTC markets are significant in ensuring access to and flow of capital among the smaller players.