There are two basic structures to financial markets. Exchanges are centralized, formal, locations where securities are traded, whereas OTC is less formal and decentralized. There are reasons to navigate either one, but first it is essential to know the basic differences.
When you hear the term New York Stock Exchange (or the acronym NYSE), you may wonder where the word “exchange” came from. Naturally, it makes sense that it’s called this since it is a place, of sorts, where people buy and sell things.
Originally, the NYSE, and other exchanges like it were physical locations where financial products were “exchanged”.
The idea of an exchange today is the same. It is a centralized and regulated place where Stocks (or Futures) are listed for both buyers to place bids and offers, to purchase and sell shares of Stock (or Futures Contracts). The centralized source serves as a mediator between all transactions.
Trading With Just A Click of a Button
While it once was the case that you had to physically be at the exchange to trade, by way of being a market-maker or a broker, these days you can simply click a button on your computer and make all of your trades remotely. You just need a brokerage account, and an internet connection.
The advantage of the exchange being a mediated market is tighter security and transaction enforcement. It also allows for a more standardized format, so that Stocks and Futures are more efficiently transacted and ensures compliance with terms of trade.
It’s important to keep in mind that the exchange itself does not partake in trades. It merely lists Stocks and Futures for buyers and sellers to place their bids and offers. When talking about counterparties, the buyer is always the counterparty to the seller and vice versa.
Central Counterparty (CCP)
However, once a trade gets “executed” on the exchange, a 3rd party comes into the picture that ensures that both the buyer and the seller are “good” on the trade. This 3rd party is known as the Central Counterparty (CCP). The Central Counterparty then acts as the counterparty to both the buyer and the seller. Another way to think about it is that the initial counterparty to the buyer is the seller. Once the trade is made, the Central Counterparty steps in between the buyer and seller, and becomes the counterparty to both the buyer and the seller (rather than the buyer remaining the counterparty to the seller).
The Central Counterparty exists for regulatory reasons and limits the credit risk, especially when dealing with leveraged assets (i.e. when people are trading on margin).
For those concerned about counterparty risk and defaulting on your obligation, these risks are typically only found in the derivatives market. You’ll almost never hear of someone “defaulting” on a Stock trade. The reason behind this is that derivatives (such as Futures and Options) are usually levered products. If one party defaults on their obligation, it is the broker (of the person who defaulted) who has the responsibility to make good on the trade.
However, in the event that either the buyer or the seller defaults (i.e. can’t fulfill their obligation to cover their losses) the Central Counterparty becomes responsible for the losses. By that token, the CCP must be well-managed and well-capitalized in order to cover such losses.
Over-the-counter (OTC) markets are competitive and often crowded. This means that there are lots of people eager for the opportunity to connect buyers and sellers. Prices and services are negotiated privately between the two parties directly, and usually over the phone.
Because of this, these markets typically have lower intermediary service costs. This is a great option for some people who know what they are doing and would like fewer expenses cutting into their margins.
Since the contracts are negotiated privately, there is more flexibility for customizing the agreements to suit the needs of both parties involved.
OTC is the method for many types of markets such as bonds, currencies, derivatives, and structured products. They can operate in any way they like (since it is a competitive, deregulated market), such as over telephones, online, or email.
The price of these products is directly dependent upon the value of the underlying.
Credit-Worthiness Of Your Counterparty
One of the downsides is more risk. These unregulated markets are susceptible to untrustworthy services. There is a lack of transparency involved as well since transactions are not visible to other market players such as they are on exchanges. This makes it challenging to determine the “market price” of a derivative.
Other risk factor that comes with OTC is the greater possibility for the party with which you made the agreement to default or go bust. Your agreement is only worth as much as the creditworthiness of the counter-party (and even so, there are no guarantees). Because of this, more due diligence is required to make transactions. This lowers the value of these types of trades (except for the most experienced traders), since time is money.
This lack of transparency causes issues when the markets are under stress. When things such as market-backed securities and other derivatives such as CDOs and CMOs are slow to adjust prices when there is a shortage of buyers. In fact, the prices are not likely to be reliable.
What this did in the 2007-08 global financial crisis is cause mediators (who serve as market-makers) to withdraw from the market and trigger a credit crunch with global ramifications.
Which Matters Most To You?
If you’re a retail trader, you will be trading through the exchange 99.9999% of the time. Banks, institutions and large funds are going to be the ones trading via over-the-counter. For most people, knowing how the over-the-counter market works is a “nice-to-know”, but not completely relevant towards their profitability as a retail trader. Should a retail trader ever crossover into the institutional realm, they’ll gain a deep understanding of over-the-counter.
That about wraps up this article. We hope this was useful to you in more ways than one. Please be sure to check out our free course on trading Options, and leave us a comment below if this was helpful. Thanks for reading.