Exchange-Traded and Over-the-Counter Derivatives

Exchange-Traded Derivatives:

• Centralized Trading: These derivatives are traded on organized exchanges, providing a central marketplace.
• Standardized Contracts: Contract terms (size, settlement date, etc.) are standardized, ensuring uniformity and liquidity.
• Clearinghouse Guarantee: A central clearinghouse (CCH) acts as the counterparty to every trade, mitigating counterparty risk.
• Margin Requirements: Both buyers and sellers must deposit margin (collateral) to cover potential losses, further reducing counterparty risk.
• Transparency and Regulation: Exchange-traded derivatives are subject to strict regulations and offer high transparency.
• Liquidity: Generally more liquid than OTC derivatives due to standardization and centralized trading.
• Examples: Futures contracts, some options contracts.

Over-the-Counter (OTC) Derivatives:

• Decentralized Trading: OTC derivatives are traded directly between parties, often through a network of dealers.
• Customized Contracts: Contract terms can be tailored to meet the specific needs of the parties involved.
• Counterparty Risk: Without a central clearinghouse (unless subject to the central clearing mandate), each party faces the risk that the other may default on their obligations.
• Less Transparency: OTC markets are generally less transparent than exchanges, making it harder to assess overall market activity and risks.
• Flexibility: OTC derivatives offer greater flexibility in terms of contract design and negotiation.
• Examples: Forward contracts, most swaps, some options.

Post-2008 Reforms for OTC Derivatives:

• Central Clearing Mandate: Many standardized OTC derivatives are now required to be cleared through central counterparties (CCPs) to reduce systemic risk.
• Swap Execution Facilities (SEFs): These platforms aim to increase transparency and standardization in the OTC swaps market.