Contrast exchange-traded derivatives with those traded over the counter
The idea
Exchange-traded derivatives are standardised in size, expiry and underlying, trade on a transparent order book and clear through a central counterparty that requires margin. Over-the-counter derivatives are negotiated bilaterally and can be shaped to an exact exposure, which is their advantage and the source of their drawbacks: less price transparency, thinner liquidity and direct credit exposure to the counterparty, though clearing mandates since the financial crisis have pushed much standardised OTC activity through central counterparties.
A practice question
What is standardised about an exchange-traded derivative?
- Its size, expiry and underlying - correct
- Its priceWhy not: The price is discovered by trading and changes continuously; it is the contract terms that are fixed.
- The identity of the counterpartyWhy not: The clearing house becomes counterparty to both sides, which is a matter of novation rather than standardisation of terms.
An exchange-traded derivative is a contract bought and sold on an organised exchange. The exchange fixes the contract terms in advance: the size, the expiry date and the underlying asset. Only the price changes, set by trading. Because every contract of a type is identical, buyers and sellers can easily trade with each other, which gives a liquid market, meaning one where trades happen easily.
A harder one
What is the principal advantage of an over-the-counter derivative?
- Lower counterparty credit risk through daily settlementWhy not: Daily settlement through a clearing house is a feature of exchange-traded contracts. Bilateral OTC trades carry more credit risk.
- Prices are published continuously for all participantsWhy not: Continuous published prices are an exchange feature. Bilateral markets are opaque by nature.
- Terms can be tailored to the exposure being hedged - correct
Over-the-counter (OTC) means the contract is agreed privately between two parties. The big advantage is that the two sides can choose the exact size, date and underlying they need. A hedge that matches your exposure closely leaves little leftover risk. Example: a company must hedge 1.3 million units on one specific date. An OTC contract can be written for exactly that, whereas exchange contracts come in fixed sizes and dates. The price paid is higher credit risk and less transparency.
The hardest tier
Why have regulators pushed standardised OTC derivatives toward central clearing?
- Because large dealers' bilateral exposures concentrated systemic risk - correct
- To stop dealers tailoring contracts to the needs of clientsWhy not: Customisation remains available for genuinely bespoke trades; only standardised ones are pushed to clearing.
- To raise trading revenue and the volume of contracts tradedWhy not: Regulators had no such aim, and clearing adds margin costs and tends to reduce gross exposure.
Before clearing, big dealers owed each other large sums with no collateral (assets pledged as security). If one dealer failed, the others lost money and could fail too, so trouble spread across the system. That spreading danger is called systemic risk. A central counterparty (a clearing house) takes the other side of each trade and demands margin, a cash deposit that covers losses. This spreads the risk and backs it with collateral. Only standardised trades are pushed this way, and tailor-made ones can stay private.
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