Exchanges vs over-the-counter markets · RiskAtoms Academy

By the end you will be able to

1Compare exchanges and over-the-counter markets on transparency, standardisation and counterparty risk.
2Explain why some trades need tailor-made OTC contracts.
3Explain how a central counterparty changes who loses when a trader fails.
4Give examples of what trades mainly on exchanges and what trades mainly OTC.

Why it matters

In September 2008 Lehman Brothers failed with hundreds of thousands of derivative contracts outstanding, most of them agreed privately with banks, funds and companies around the world. Working out who was owed what took years. That is the hidden risk of trading over the counter.

Core explanation

Two ways to meet a trading partner

Once a security exists, it can trade in two very different kinds of place. Think of a supermarket and a tailor.

An exchange is the supermarket. Everything on the shelves is standardised, the prices are on display, and everyone pays the same price at the same moment. The New York Stock Exchange, the London Stock Exchange, Japan Exchange Group, Eurex and CME are exchanges. Buyers and sellers send orders to one central book, and the exchange matches them.

An over-the-counter (OTC) market is the tailor. There is no single shop. A client calls or messages a dealer, usually a large bank, and the two agree a price and terms between themselves. The contract can be cut to fit. Most bonds, almost all currency trading and most interest rate swaps happen this way.

The two differ on three things above all. Step through them, then on two more that follow from them.

CompareExchange or OTC, side by side

1 / 5

Transparency

Who can see the prices?

Transparency means how much everyone can see of quotes before a trade and prices after it.

Exchange

The best bids and offers are on public screens, and every trade is published within moments.

OTC

Prices are agreed privately. Two clients may get different prices for the same bond. Rules now require many trades to be reported afterwards.

The central counterparty is the key to the third difference. When two members trade on an exchange, the CCP becomes the buyer to the seller and the seller to the buyer. Each member hands it collateral. If one fails, the CCP uses that collateral and its own resources, and the other members' trades carry on. Try it below: fail a firm in each kind of market.

ExploreWho loses when a trader fails?

Then click a firm to make it fail.

Credit relationships per firm

Each firm faces between 2 and 3 trading partners, and must judge whether each one can pay.

The line is blurring

Many OTC trades now happen on electronic platforms, and since the 2008 crisis most standard OTC derivatives must be cleared through a CCP. The differences above describe the two models; real markets often sit somewhere between them. L1.2.07 and L1.7.11 look at CCPs in detail.

Sort itWhere does it mainly trade?

0 of 6 right

Shares in Toyota.
A euro–dollar forward for an exporter, for an exact amount and date.
Brent crude oil futures.
A 7-year interest rate swap with dates matched to a company's loan.
US Treasury bonds.
Options on the S&P 500 index.

Worked example

Futures or a forward?

A German machine maker will receive $10,000,000 from a US customer in five months. It wants to lock in today's rate of 1.10 dollars per euro, so that a fall in the dollar cannot hurt it. It compares exchange futures with an OTC forward from its bank.

Matching the exposure

Step 1 of 5

1
What needs covering, in euros
$10,000,000 ÷ 1.10 = €9,090,909 at today's rate.

Neither choice is wrong. Exchanges trade standard risk cheaply and safely; OTC markets fit unusual needs. That trade-off between fit and safety runs through all of finance.

Regulatory lens

After 2008, the G20 leaders agreed at Pittsburgh in 2009 that standardised OTC derivatives should be traded on exchanges or electronic platforms where appropriate, cleared through CCPs, and reported to trade repositories, with higher capital requirements for contracts that are not centrally cleared. The US put this into law through the Dodd-Frank Act (2010) and the EU through EMIR (2012).

Looking ahead: margin for uncleared derivatives and the capital banks hold against counterparty risk return in later levels on counterparty credit risk.

Sparks

SparkAn exchange that began under a tree

In 1792, 24 brokers signed the Buttonwood Agreement on Wall Street, named after the buttonwood tree they are said to have met under. They agreed to trade only with each other and to charge a common commission. The New York Stock Exchange traces its origins to that agreement.

SparkThe biggest market has no exchange

The foreign exchange market is the largest financial market in the world, with average turnover of about $7.5 trillion a day in April 2022, according to the BIS Triennial Survey. Almost all of it trades over the counter, between banks and their clients.

Key takeaways

Exchanges are central marketplaces for standard contracts, with public prices and common rules.
OTC markets are networks of private deals, usually with dealers, where contracts can be tailored.
Exchanges win on transparency and standardisation; OTC markets win on flexibility.
On an exchange a CCP stands between buyer and seller, so one firm's failure does not spread directly to its trading partners.
Since 2009, regulators have pushed standard OTC derivatives into central clearing and reporting.

Reaction

Check what stuck

Glossary

Exchange: A regulated, central marketplace where standard contracts are traded under common rules, with prices visible to all.
Over the counter (OTC): Over the counter: trades agreed directly between two parties, usually with a dealer, rather than on an exchange.
Dealer: A firm, usually a bank, that buys from and sells to clients using its own money and stock.
Transparency: How much the market can see of prices and trades, before and after they happen.
Standardised contract: Every contract has the same size, terms and dates, so contracts are interchangeable.
Counterparty risk: The risk that the other side of a trade fails to do what it promised.
Central counterparty (CCP): Central counterparty: a firm that becomes the buyer to every seller and the seller to every buyer, so traders face it instead of each other.
Collateral: Cash or securities handed over to cover what a party may owe if it fails.
Futures: A standard exchange-traded contract to buy or sell something at a set price on a set future date.
Forward: A tailor-made OTC contract to buy or sell something at a set price on a chosen future date.

Deep Dives & Origins

Deep Dives

Hull, Options, Futures, and Other Derivatives, Pearson, chapter 1 on exchange-traded and OTC markets. Intermediate.
Harris, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003. Intermediate.

Origins

Hull, J. C., Options, Futures, and Other Derivatives, Pearson.
G20 Leaders' Statement, Pittsburgh Summit, September 2009.
Bank for International Settlements, Triennial Central Bank Survey of foreign exchange and OTC derivatives markets, 2022.
CME Group, Euro FX futures contract specifications.

Watch this lesson

Video version

Prefer to watch? The same lesson as a 10-minute video will sit here, made from this page's script.