We have so far seen many products and realized that many are exchange traded and many are over-the-counter (OTC).
Any derivative contract which is traded on the exchange is “exchange traded’ product and a Derivative contract which can be bought or sold directly with a counterparty (without the involvement of an exchange is called OTC product.
And clearly with the product being OTC or exchange traded, it brings with it some advantages and disadvantages;
The OTC derivatives markets have witnessed a sharp growth mainly due to developments in information technology
While both exchange-traded and OTC derivative contracts offer many benefits, there are significant differences between the two.
The key difference being that exchange traded derivatives are standardized, more transparent, the counterparty risk is borne by a centralized corporation with stringent margining systems while OTC contracts are customized, opaque in pricing, risk management is decentralized and individual institutions / clients take counterparty risk of each other.
The exchange traded market can offer hedging solution to even small size requirements whereas in OTC market, hedging a very small size requirement may not be possible or the transaction cost may be prohibitive.
The clearing, settlement and risk management part of OTC contracts, if not managed well could lead to unsustainable counter party credit risk exposure leading to rapid unwinding of positions during periods of sharp volatility and movement is asset prices. A default by one or two large counterparties may leads to domino effect of default by other counterparties also and thereby making financial market unstable.
We had observed this phenomenon during financial crisis of 2008. World over regulators and governments are now trying to move more and more derivative contracts to be exchange traded with centralized clearing and settlement.