Over the Counter (OTC) Meaning
Over the counter contracts, popularly known as OTC contracts, are financial contracts that are not traded via exchange or through a standardized agreement but are traded bilaterally between the participants with terms of contract mutually negotiated.
Types of Over the Counter (OTC) Contracts
Over the counter contracts can be classified into 2 broad categories:
#1 – Based on Type of Market Participants
- Client Market Participants: These are the contracts in which the dealers and the client get into a bilateral contract and the prices for the same are obtained through exchanges. Most of these contracts are executed electronically.
- Inter-Dealer Participants: These are the derivative contracts between two big dealers on behalf of their clients. Most often than not these contracts are priced based on viewpoints on the underlying commodity and are passed to other dealers in a short span of time.
#2 – Based on Type of Derivative Contracts
OTC contracts can be further classified based on the underlying commodity or financial instrument as follows:
- Interest Rate Derivatives: Interest Rate Derivative contracts are mainly interest rate derivatives based on the viewpoints on current and forecasted interest rates and price corresponding to benchmarks like LIBOR, treasury bills etc
- Currency Derivatives: Often terms as currency swaps these are the biggest chunk of the OTC derivatives and are negotiated between big institutional players to offset their currency risk. Most popular of these are USD/GBP currency swaps and mostly involves participants from 2 major financial centres – New York and London. These are also known as forex derivatives in financial markets.
- Commodity Derivatives: These OTC contracts are traded for commodities like Gold, Oil copper, natural gas, electricity. These are the most difficult to price owing to complexities like storage cost, delivery cost etc. They can be further categorized into Agri OTC contracts (based on Agri commodities) and non-agri contracts ( mostly involving Base metals).
- Credit Derivatives: These contracts are based on the credit risk of a third party, basically a view n whether the third party will default or not for a particular time horizon. They constitute two major categories – Credit default swaps (CDS) and Credit Linked Notes (CLN).
- Equity OTC: Most simple of these OTC contracts are equity OTC contracts involving options, futures, and swaps.
Example of Over the Counter (OTC)
Let’s take an example of over the contract (OTC).
Consider an airline that wants to hedge its risk by taking positions on oil derivative contracts. The airline can buy oil futures from the market but the exchange would only provide them with a standardized contract for 1 month, 1 year, 5 years or 10 years. However, the firm needs to hedge only for 120 days. in that case, they can either purchase a 1-month contract and roll over for the next four months leading to transaction costs or can buy an OTC contract with another party and add further customizations and also saving on the transaction costs.
Advantages of Over the Counter (OTC)
Some of the advantages of over the counter (OTC) are as follows:
- Customization: OTC contracts are customized contracts between two parties. They can be tailored and negotiated between two market participants to suit their individual needs and discarding out the unwanted noise. Such customization cannot be provided by exchange-traded funds or contracts through central counterparties.
- Better Hedging: This advantage is linked to the above-mentioned point as better customization helps financial institutions in managing their risk better as they are focussed on their individual needs, thereby making them the perfect instrument for hedging risk.
- Safety from Operational Risk: As OTC contracts only involve two financial institutions, they are not affected by any operational risk which might arise in case there is their part mediator like the exchange. History has shown that unexpected catastrophic events in the market lead to operational risk which might lead to a huge loss for investors. This can be completely avoided in OTC contracts.
- Less Administrative Cost: for smaller companies, OTC contracts are very useful as these firms might be small and cannot qualify the criteria for listing as prescribed by exchanges. Hence these small scale firms can focus on the core financial terms of the contract without worrying much about the administrative and other overhead costs.
Disadvantages of Over the Counter (OTC)
Some of the disadvantages of over the counter (OTC) are as follows:
- Credit Risk: The biggest disadvantage of over the counter contracts is the credit risk involved. Since it is a bilateral contract, there is no legal binding to honor the terms of the contract and both the parties are bound only by their reputation. Unlike exchange-traded contracts, the collateral and margin are calculated based on the mutual negotiation and is most often not the core contract term that parties are worried about when they initiate the OTC. Hence in such a case when the margin is low and collateral value goes down, the party who is in the money faces credit risk, specifically counterparty credit risk as the other party might default on the whole payment or a particular installment.
- Lack of Transparency: Since the OTC contracts are bilateral contracts, the contract terms are not disclosed to the market and even if they are disclosed, they are so complex and relative that it is difficult to estimate the valuation. Hence regulators are always following these contracts with a keen eye.
- Risk: OTC derivatives are very risky, not only for the parties involved in the contract but also for the overall financial market. It may sound funny but the uncollateralized or under collateralized otc contracts were responsible for the great depression of 2008 which was considered to be the greatest economic recession in the last 70 years.
- Speculation: OTC derivative contracts because of lack of transparency and mutually negotiated terms are very prone to speculations which in turn lead to serious market integrity issues – again a cause of worry for the regulators.
Important Points About Over the Counter (OTC)
Some of the important points of over the counter (OTC) are as follows:
- The mechanism of how OTC contracts are traded is quite different. They are negotiated directly by the dealers over the phone or through pink sheets and OTC bulletin board.
- OTC contracts help to trade in the instruments which would otherwise be unavailable to investors, hence opening new avenues for the investors.
- Over the counter contracts are highly liquid because of the absence of standardization. Hence in scenarios where the underlying contract has to be renegotiated or resold to the third party, it becomes highly difficult leading to a huge risk for the counterparty.
Conclusion
OTC derivatives market is huge and an integral part of today’s financial markets. They grew rapidly on account of increased financial awareness and improvements in technology from the 1980s to the early 2000s. They can be effective in hedging risk but need precision as they can lead to catastrophic events if not managed properly.
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