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.
Why would you want to trade OTC?
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
|
Standardization versus customization
Hence the primary difference is standardization versus customization. This leads to a crucial distinction. This standardization is fundamental to risk management and trade plans.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 RiskOTC Traded = Customized = Market Risk + Counterparty Risk
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