Exchange-traded versus Over-the-counter (OTC) Derivatives

An exchange traded product is a standardized financial instrument that is traded on an organized exchange.

An over the counter (OTC) product or derivative product is a financial instrument traded off an exchange, the price of which is directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities or any agreed upon pricing index or arrangement.

The most common types of derivative products are interest rate swaps, caps and their offshoots. Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb and flow of their corporate finance and hedging activity.

The reason derivative products exist is that users often need customized products as the standardization of exchange products can lead to hedging mismatches and gap exposures.

The main differences between exchange and OTC products can be viewed as follows:

	Exchange Traded	OTC Traded
Pricing	Standardized	Customized
Maturity	Standardized	Customized
Quantity	Standardized	Customized
Frequency	Standardized	Customized
Quality	Standardized	Customized
Documentation	Standardized	Customized
Regulatory Body	One entity	Various

The primary difference is standardization versus customization. This leads to a crucial distinction. When dealing in exchange traded products terms are standardized and the clearinghouse guarantees that the other side of any transaction performs to its obligations. That is, it assumes all contingent default risk so both sides do not need to know about each other’s credit quality. This differs from customized OTC products where there is no clearinghouse to guarantee performance.

The need to know the counterparty’s credit standing is an essential distinction. The exposure difference is quite significant. In summary:

Exchange Traded = Standardizes = Market Risk

OTC Traded = Customized = Market Risk + Counterparty Risk