OTC securities markets operate in much the same manner, with similar rules, regulations, and organizational structures. At one time, the major difference between OTC and exchange markets for securities was that the latter brought buyers and sellers together in a physical location, whereas the former facilitated trading strictly in an electronic manner. Today, these distinctions are blurred because many organized securities exchanges have gone completely to electronic systems. Moreover, OTC securities markets can be formally organized structures, such as NASDAQ, or can merely refer to informal networks of parties who buy and sell with each other, such as the corporate and government bond markets in the United States.
The derivatives world also comprises organized exchanges and OTC markets. Although the derivatives world is also moving toward less distinction between these markets, there are clear differences that are important to understand.
3.1. Exchange-Traded Derivatives Markets
Derivative instruments are created and traded either on an exchange or on the OTC market. Exchange-traded derivatives are standardized, whereas OTC derivatives are customized. To standardize a derivative contract means that its terms and conditions are precisely specified by the exchange and there is very limited ability to alter those terms. For example, an exchange might offer trading in certain types of derivatives that expire only on the third Friday of March, June, September, and December. If a party wanted the derivative to expire on any other day, it would not be able to trade such a derivative on that exchange, nor would it be able to persuade the exchange to create it, at least not in the short run. If a party wanted a derivative on a particular entity, such as a specific stock, that party could trade it on that exchange only if the exchange had specified that such a derivative could trade. Even the magnitudes of the contracts are specified. If a party wanted a derivative to cover €150,000 and the exchange specified that contracts could trade only in increments of €100,000, the party could do nothing about it if it wanted to trade that derivative on that exchange.
This standardization of contract terms facilitates the creation of a more liquid market for derivatives. If all market participants know that derivatives on the euro trade in 100,000-unit lots and that they all expire only on certain days, the market functions more effectively than it would if there were derivatives with many different unit sizes and expiration days competing in the same market at the same time. This standardization makes it easier to provide liquidity. Through designated market makers, derivatives exchanges guarantee that derivatives can be bought and sold.3
The cornerstones of the exchange-traded derivatives market are the market makers (or dealers) and the speculators, both of whom typically own memberships on the exchange.4 The market makers stand ready to buy at one price and sell at a higher price. With standardization of terms and an active market, market makers are often able to buy and sell almost simultaneously at different prices, locking in small, short-term profits – a process commonly known as scalping. In some cases, however, they are unable to do so, thereby forcing them to either hold exposed positions or find other parties with whom they can trade and thus lay off (get rid of) the risk. This is when speculators come in. Although speculators are market participants who are willing to take risks, it is important to understand that being a speculator does not mean the reckless assumption of risk. Although speculators will take large losses at times, good speculators manage those risks by watching their exposures, absorbing market information, and observing the flow of orders in such a manner that they are able to survive and profit. Often, speculators will hedge their risks when they become uncomfortable.
Standardization also facilitates the creation of a clearing and settlement operation. Clearing refers to the process by which the exchange verifies the execution of a transaction and records the participants’ identities. Settlement refers to the related process in which the exchange transfers money from one participant to the other or from a participant to the exchange or vice versa. This flow of money is a critical element of derivatives trading. Clearly, there would be no confidence in markets in which money is not efficiently collected and disbursed. Derivatives exchanges have done an excellent job of clearing and settlement, especially in comparison to securities exchanges. Derivatives exchanges clear and settle all contracts overnight, whereas most securities exchanges require two business days.
The clearing and settlement process of derivative transactions also provides a credit guarantee. If two parties engage in a derivative contract on an exchange, one party will ultimately make money and the other will lose money. Derivatives exchanges use their clearinghouses to provide a guarantee to the winning party that if the loser does not pay, the clearinghouse will pay the winning party. The clearinghouse is able to provide this credit guarantee by requiring a cash deposit, usually called the margin bond or performance bond, from the participants to the contract. Derivatives clearinghouses manage these deposits, occasionally requiring additional deposits, so effectively that they have never failed to pay in the nearly 100 years they have existed. We will say more about this process later and illustrate how it works.
Exchange markets are said to have transparency, which means that full information on all transactions is disclosed to exchanges and regulatory bodies. All transactions are centrally reported within the exchanges and their clearinghouses, and specific laws require that these markets be overseen by national regulators. Although this would seem a strong feature of exchange markets, there is a definite cost. Transparency means a loss of privacy: National regulators can see what transactions have been done. Standardization means a loss of flexibility: A participant can do only the transactions that are permitted on the exchange. Regulation means a loss of both privacy and flexibility. It is not that transparency or regulation is good and the other is bad. It is simply a trade-off.
Derivatives exchanges exist in virtually all developed (and some emerging market) countries around the world. Some exchanges specialize in derivatives and others are integrated with securities exchanges.
Although there have been attempts to create somewhat non-standardized derivatives for trading on an exchange, such attempts have not been particularly successful. Standardization is a critical element by which derivatives exchanges are able to provide their services. We will look at this point again when discussing the alternative to standardization: customized OTC derivatives.
3.2. Over-the-Counter Derivatives Markets
The OTC derivatives markets comprise an informal network of market participants that are willing to create and trade virtually any type of derivative that can legally exist. The backbone of these markets is the set of dealers, which are typically banks. Most of these banks are members of a group called the International Swaps and Derivatives Association (ISDA), a worldwide organization of financial institutions that engage in derivative transactions, primarily as dealers. As such, these markets are sometimes called dealer markets. Acting as principals, these dealers informally agree to buy and sell various derivatives. It is informal because the dealers are not obligated to do so. Their participation is based on a desire to profit, which they do by purchasing at one price and selling at a higher price. Although it might seem that a dealer who can “buy low, sell high” could make money easily, the process in practice is not that simple. Because OTC instruments are not standardized, a dealer cannot expect to buy a derivative at one price and simultaneously sell it to a different party who happens to want to buy the same derivative at the same time and at a higher price.
To manage the risk they assume by buying and selling customized derivatives, OTC derivatives dealers typically hedge their risks by engaging in alternative but similar transactions that pass the risk on to other parties. For example, if a company comes to a dealer to buy a derivative on the euro, the company would effectively be transferring the risk of the euro to the dealer. The dealer would then attempt to lay off (get rid of) that risk by engaging in an alternative but similar transaction that would transfer the risk to another party. This hedge might involve another derivative on the euro or it might simply be a transaction