Introduction to OTC Derivatives

Financial markets are split into two broad categories: Capital and derivatives. This piece gives you an introduction to everything on OTC derivatives.

OTC derivatives: A basic guide

Financial markets are split into two broad categories: Capital and derivatives.

Capital markets are what people normally associate with the stock market. You gain partial ownership in a company by buying its stock. Your future profit is thereby directly proportional to the success of the company.

The derivatives market lets you buy securities that are tied either positively or negatively to the value of the underlying stock or asset. Essentially, you’re speculating on specific market outcomes. With the right derivatives, even bad news for a company’s stock may be good news for you.

Derivatives markets themselves fall into two categories: Exchange-traded derivatives (ETD) and over-the-counter derivatives (OTC). As the name implies, ETDs are traded through a public exchange with everyone having access to the same information.

OTC derivatives are a different story.

What are OTC derivatives?

In short, OTC derivatives are financial instruments that are traded directly between two parties. They aren’t listed on any central exchange or otherwise made publicly available. Typically, they don’t involve any intermediaries but may rely on a third-party broker to facilitate the trade.

Over-the-counter derivatives let both parties put together a more flexible contract that serves their exact needs. At the same time, they’re somewhat riskier. That’s because there’s no clearing corporation overseeing the transaction. Also, OTC contracts aren’t subject to the same rigorous regulations as financial instruments listed on public markets.

What types of OTC derivatives exist?

OTC derivatives vary based on the kind of underlying assets they’re tied to. These include:

• Interest rates
• Commodities
• Equities
• Foreign exchange rates
• Fixed income securities
• Credit risk

The following are the main types of over-the-counter derivatives:

1. Forwards

A forward contract outlines the exact terms---such as quantity and price---on which one party will buy a certain asset at a specified future date. It’s the more flexible OTC equivalent of publicly traded futures.

2. Swaps

Swaps are a way for one party to introduce predictability into an otherwise uncertain future trade-related to fluctuating rates: commodity prices, currency exchange rates, interest rates, and so on.

In a swap contract, parties agree to undergo an exchange at a fixed rate, regardless of the actual market rate at the time of the exchange. The first party benefits from a predictable exchange price. The second party stands to earn a profit if the floating market rates turn out to be lower than the fixed one stated in the swap contract.

3. Options (and swaptions)

An option gives one party the right to buy or sell an asset at a predetermined price during a specified future period. Unlike other similar contracts, options don’t obligate the party to make the trade. If the price of the asset is unfavorable, they can simply let the option expire without acting on it.

A “swaption” is an OTC-exclusive derivative that combines a swap with an option. Basically, the swaption holder may - but doesn’t have to - execute a swap at a future date on conditions specified in the contract.

Generally speaking, most other derivatives are some variations or combinations of the three main types above.

What is the OTC market?

Unlike the stock market, which relies on a centralized asset exchange, the OTC market is essentially a network of dealer-brokers. These brokers facilitate the listing and over-the-counter sale of derivatives and other securities.

There’s no main governing body overseeing the OTC market. Companies and assets traded over the counter don’t have to fulfill the same listing requirements as their stock market counterparts. This opens up options for companies that would otherwise have difficulty getting listed on regular stock exchanges.

There are a few ways for companies to trade over the counter.

OTC Markets Group

The OTC Markets Group is a publicly traded company that facilitates the majority of all over-the-counter exchanges. It separates listed companies into three tiers:

1. OTCQX® Best Market: These are audited companies that could well be listed on regular exchanges (but may choose not to do so).
2. OTCQB® Venture Market: This tier is for early-stage and growth companies, with a required minimum $0.01 bid price.
3. Pink® Open Market: This lowest tier is for all other cases and is the main destination for companies that do not disclose their financials.

Gray Market

Also known as “Other OTC,” this is an umbrella term for all other over-the-counter transactions that aren’t quoted by any broker-dealers.

How is the OTC market regulated?

Despite being less strictly regulated, the OTC market isn’t exactly the Wild West.

First, every broker-dealer on the OTC Markets Group is registered with the US Securities and Exchange Commission (SEC) and is a member of the Financial Industry Regulatory Authority (FINRA). In late 2020, SEC adopted measures specifically aimed at offering additional protections to investors trading in over-the-counter securities.

Second, the OTC Markets Group imposes certain market disclosure standards on all OTCQX- and OTCQB-listed companies. According to the group itself, the majority of US states consider these standards to be compliant with Blue Sky Laws aimed at protecting investors from fraud.

What are the risks of trading on the OTC derivatives market?

Still, investors must take into account the following risks of trading in OTC derivatives.

1. Limited oversight

Despite a certain degree of regulation, the level of required disclosure and government oversight is lower for over-the-counter derivatives. This is especially true for the Gray Market outside of the main OTC Markets Group.

2. Price volatility

Because the trading volumes for OTC securities are generally lower, individual company stocks are subject to more unpredictable price fluctuations.

3. Lack of transparency

Since OTC deals are private, there’s nothing stopping a seller from potentially charging different prices to different customers for the same type of financial contract.

4. Low liquidity

The volume of trading on the OTC market is lower compared to traditional exchanges. As such, it may be difficult to find an interested party if you’re holding an OTC contract you’d like to sell.

Ways to limit the risks

Being aware of the OTC market’s riskier nature means you can take steps to protect yourself from the worst-case scenarios. To limit your exposure:

1. Rely on reputable trading platforms like the OTC Markets Group.
2. Deal only with licensed and vetted broker-dealers.
3. Do your own due diligence. Review any available information about the seller before trading in OTC derivatives based on its assets.
4. Get legal help with your OTC contracts to make sure your interests are covered.