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The OTC derivatives markets comprise an informal network of market participants that are willing to create and trade virtually any type of derivative that can legally exist. The backbone of these markets is the set of dealers, which are typically banks. Most of these banks are members of a group called the International Swaps and Derivatives Association (ISDA), a worldwide organization of financial institutions that engage in derivative transactions, primarily as dealers. As such, these markets are sometimes called dealer markets. Acting as principals, these dealers informally agree to buy and sell various derivatives. It is informal because the dealers are not obligated to do so. Their participation is based on a desire to profit, which they do by purchasing at one price and selling at a higher price. Although it might seem that a dealer who can “buy low, sell high” could make money easily, the process in practice is not that simple. Because OTC instruments are not standardized, a dealer cannot expect to buy a derivative at one price and simultaneously sell it to a different party who happens to want to buy the same derivative at the same time and at a higher price.

To manage the risk they assume by buying and selling customized derivatives, OTC derivatives dealers typically hedge their risks by engaging in alternative but similar transactions that pass the risk on to other parties. For example, if a company comes to a dealer to buy a derivative on the euro, the company would effectively be transferring the risk of the euro to the dealer. The dealer would then attempt to lay off (get rid of) that risk by engaging in an alternative but similar transaction that would transfer the risk to another party. This hedge might involve another derivative on the euro or it might simply be a transaction in the euro itself. Of course, that begs the question of why the company could not have laid off the risk itself and avoided the dealer. Indeed, some can and do, but laying off risk is not simple. Unable to find identical offsetting transactions, dealers usually have to find similar transactions with which they can lay off the risk. Hedging one derivative with a different kind of derivative on the same underlying is a similar but not identical transaction. It takes specialized knowledge and complex models to be able to do such transactions effectively, and dealers are more capable of doing so than are ordinary companies. Thus, one might think of a dealer as a middleman, a sort of financial wholesaler using its specialized knowledge and resources to facilitate the transfer of risk. In the same manner that one could theoretically purchase a consumer product from a manufacturer, a network of specialized middlemen and retailers is often a more effective method.

Because of the customization of OTC derivatives, there is a tendency to think that the OTC market is less liquid than the exchange market. That is not necessarily true. Many OTC instruments can easily be created and then essentially offset by doing the exact opposite transaction, often with the same party. For example, suppose Corporation A buys an OTC derivative from Dealer B. Before the expiration date, Corporation A wants to terminate the position. It can return to Dealer B and ask to sell a derivative with identical terms. Market conditions will have changed, of course, and the value of the derivative will not be the same, but the transaction can be conducted quite easily with either Corporation A or Dealer B netting a gain at the expense of the other. Alternatively, Corporation A could do this transaction with a different dealer, the result of which would remove exposure to the underlying risk but would leave two transactions open and some risk that one party would default to the other. In contrast to this type of OTC liquidity, some exchange-traded derivatives have very little trading interest and thus relatively low liquidity. Liquidity is always driven by trading interest, which can be strong or weak in both types of markets.

OTC derivative markets operate at a lower degree of regulation and oversight than do exchange-traded derivative markets. In fact, until around 2010, it could largely be said that the OTC market was essentially unregulated. OTC transactions could be executed with only the minimal oversight provided through laws that regulated the parties themselves, not the specific instruments. Following the financial crisis that began in 2007, new regulations began to blur the distinction between OTC and exchange-listed markets. In both the United States (the Wall Street Reform and Consumer Protection Act of 2010, commonly known as the Dodd–Frank Act) and Europe (the Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties, and Trade Repositories), regulations are changing the characteristics of OTC markets.

When the full implementation of these new laws takes place, a number of OTC transactions will have to be cleared through central clearing agencies, information on most OTC transactions will need to be reported to regulators, and entities that operate in the OTC market will be more closely monitored. There are, however, quite a few exemptions that cover a significant percentage of derivative transactions. Clearly, the degree of OTC regulation, although increasing in recent years, is still lighter than that of exchange-listed market regulation. Many transactions in OTC markets will retain a degree of privacy with lower transparency, and most importantly, the OTC markets will remain considerably more flexible than the exchange-listed markets.

EXAMPLE 2 Exchange-Traded versus Over-the-Counter Derivatives

1. Which of the following characteristics is not associated with exchange-traded derivatives?

A. Margin or performance bonds are required.

B. The exchange guarantees all payments in the event of default.

C. All terms except the price are customized to the parties’ individual needs.

2. Which of the following characteristics is associated with over-the-counter derivatives?

A. Trading occurs in a central location.

B. They are more regulated than exchange-listed derivatives.

C. They are less transparent than exchange-listed derivatives.

3. Market makers earn a profit in both exchange and over-the-counter derivatives markets by:

A. charging a commission on each trade.

B. a combination of commissions and markups.

C. buying at one price, selling at a higher price, and hedging any risk.

4. Which of the following statements most accurately describes exchange-traded derivatives relative to over-the-counter derivatives? Exchange-traded derivatives are more likely to have:

A. greater credit risk.

B. standardized contract terms.

C. greater risk management uses.

Solution to 1: C is correct. Exchange-traded contracts are standardized, meaning that the exchange determines the terms of the contract except the price. The exchange guarantees against default and requires margins or performance bonds.

Solution to 2: C is correct. OTC derivatives have a lower degree of transparency than exchange-listed derivatives. Trading does not occur in a central location but, rather, is quite dispersed. Although new national securities laws are tightening the regulation of OTC derivatives, the degree of regulation is less than that of exchange-listed derivatives.

Solution to 3: C is correct. Market makers buy at one price (the bid), sell at a higher price (the ask), and hedge whatever risk they otherwise assume. Market makers do not charge a commission. Hence, A and B are both incorrect.

Solution to 4: B is correct. Standardization of contract terms is a characteristic of exchange-traded derivatives. A is incorrect because credit risk is well-controlled in exchange markets. C is incorrect because the risk management uses are not limited by being traded over the counter.