A Comparison Of Over The Counter And Exchange Trade Derivatives

There are essentially two forms of financial derivatives: the Over the Counter (OTC) and the Exchange Traded Derivative (ETD). Knowing the two forms by which financial derivatives operate would lead to more informed decisions and actions regarding financial derivative use.

Over the Counter (OTC) Derivatives

We often associate the term over the counter with medicines. Over the counter medicines are less potent drugs that do not cause serious or life-threatening effects on the body. Hence, you can purchase such drugs even without a prescription. This makes the regulation of over the counter medicines less strict than the prescription types.

In the same way, over the counter forms of financial derivatives are less regulated. These transactions may even happen in private. In over the counter types of contracts, the parties involved enter into an agreement without other intervening parties. The people or companies involved set the terms and conditions of their contract without having to consult such conditions to a central governing body. These deals can happen even through phone calls or internet assisted interactions. A large bulk of financial derivative operations belongs to this category.

The privacy, anonymity and lack of records and transparency have been pointed out by many. There are many risks involved in over the counter transactions. The agreement only happens between the parties involved so if anything happens, there will be no central body to interfere. When one party fails to live up to the expectations of the other, the whole contract may be compromised. Both parties could lose a lot with business deals of this type.

Exchange Traded Derivatives (ETD)

The controversies surrounding Over the Counter derivatives made many people to choose Exchange Traded Derivatives. Unlike the Over the counter type, ETD has a central body who regulates the contracts. The central body that comes in on ETD is often called an exchange derivative. Examples of exchange mediums are Eurex and CME.

Through ETDs, the risks of both parties in the contract are reduced. The inclusion of a central body to manage the transaction makes it more formal and bounding. Both parties are also insured by a safety or in initial margin set by these exchange bodies. Thus, even when the other party fails to live up to the conditions of the contract, the other party will not be on the losing end. Transparency of such transactions makes it easier to track down, monitor and locate these deals. The issue of anonymity and lack of a way to record OTC transactions are then solved.

There are advantages and disadvantages to these financial derivative types. You should weigh the advantages and disadvantages of each to be able to get the most out of this. Both the OTC and ETD are not essentially good or bad. Nobody is advocating one type over the other. It is still your choice on which type to get involved with. Wise and intelligent use of such derivatives will spell the difference.