Subject 2. Exchange-Traded versus Over-the-Counter Derivatives

Based on the markets where they are created and traded, derivatives can be classified into two groups:

  • Exchange-traded derivatives are created, authorized, and traded on a derivatives exchange, an organized facility for trading derivatives.

    • They are standardized instruments with respect to certain terms and conditions of contracts.
    • They trade in accordance with rules and specifications prescribed by the derivatives exchange and are usually subject to governmental regulation.
    • They are guaranteed by the exchange against loss resulting from the default of one of the parties.

  • Over-the-counter derivatives are transactions created by any two parties off a derivatives exchange.

    • They don't have standardized terms and features. The parties set all of their own terms and conditions.
    • Each party assumes the credit risk of the other party.

User Contributed Comments 8

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epizi: Exchange traded derivatives are standardised while OTC are customised to the taste of the parties involved.

Exchange traded risk of default is guaranteed by exchange whereas OTC parties gaurantee risk
BunnyBaby: Exchange traded derivatives seem safer because you have the guarantee of the government regulations to appeal to, as well as the back of the exchange for the specific security. What effect does this difference in risk have on the liquidity and price of the securities?
kutta2102: One would think that liquidity is less since there are fewer parties who would be interested in buying/selling contracts where terms are very specific and not standardized. Therefore, if one can find an identical (or similar) instrument trading on an exchange, the difference would be in the bid-ask spread.
kutta2102: To add to my previous comment - the whole credit crisis of 2008 sort of imploded because of the counterparty risk. The repo market for Bear Stearns and Lehman froze once other companies found out that the collateral they were using had all these toxic assets.
akotova1: Exchange traded would be more liquid and prices less volatile
johntan1979: Oh no, akotova1... I can assure you that the OTC is much much much much much more liquid
johntan1979: Whoops, sorry about that comment. Just realized my mistake after reading the next section.
To-be-CFA: Classification on basis of Markets:
I. Exchange-traded
- Standardized instruments.
- Subject to government regulations.
- Guaranteed by the exchange against default risk.

II. Over-the-counter
- No standardized T&C.
- Each party assumes the credit risk of the other party.