Over the Counter (OTC)

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:

Types of Over the Counter (OTC) Contracts

#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:

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.

Over the Counter (OTC)

Advantages of Over the Counter (OTC)

Some of the advantages of over the counter (OTC) are as follows:

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 recessionEconomic RecessionEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit.read more 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:

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.

Recommended Articles

This has been a guide to Over the Counter (OTC) and it’s meaning. Here we discuss examples and categories of OTC contracts along with advantages and disadvantages.  You can learn more from the following articles –

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