Exchange traded versus OTC derivatives

Exchange-Traded Derivatives

This includes the contracts that are managed and regulated by the market. Such contracts are standardized futures or options contracts, thus trading on a recognized exchange. These contracts have less risk (default) for the investor. The parties need to deposit an initial payment at the time of entering the contract.

The prices of securities such as shares, debentures, notes, corporate bonds, etc. are decided by the market demand and supply forces. It can be a physical trading location such as premises, etc. or it can be an electronic platform, i.e. website.

It has an association of persons (registered or unregistered) commonly referred to as member brokers. It is established with the aim of governing the trade of securities by the general public and companies, as a whole. There is a set of rules imposed by the Exchange on the firms and brokers, which participate in the trading of securities.

Features of an Exchange

Ascertainment of price: An Exchange-traded market is one of the best examples of perfect competition, because of the presence of many buyers and sellers in the market. As the market is transparent, all the necessary information is available and so active bidding takes place and in this way, the price is decided.

Trading of Securities: The first and foremost function of a stock exchange is to provide a formal platform for trading of securities and liquidating them whenever an investor needs to encash them, at the prevailing market price. Moreover, it provides the flexibility to the investor to change their portfolio whenever required.

Mobilization of savings: People invest their savings in the share market, to earn good returns and make money out of their investments. In this way, the savings of the public is mobilized and channelised by the stock exchanges, by investing their money in different sectors, which generate high returns.

Raising funds: Stock exchange is commonplace for the companies and governments to generate funds from the market by offering securities for sale to the general public.

Trades in second-hand securities: In an exchange, only those securities are traded which are previously issued by the companies through a public offering in the primary market.

Over the Counter (OTC)

There are private agreements between investors. The provisions of the agreement remain private. Such contracts do not trade on any exchange, nor do they have any intermediaries. These are not standardized contracts. And therefore, parties can easily modify and customize the terms of the contract.

Trading Over the counter is also called off-exchange trading, because of the absence of a formal exchange.

In general, those companies which do not fulfil the prerequisites of the stock exchange for listing their stocks, trade them over the counter. The trade takes place between two companies or financial institutions. Financial products such as bonds, derivatives, currencies, etc. are mainly traded OTC.

It is a dealer’s market, where they buy and sell the financial products for their account and the investors can directly contact the dealers, who are interested in selling their stocks or bonds they have or they can talk to the brokers, who will find out the dealers offering the stocks with the best price.

The dealers making the market for a certain securities quote the price at which they are going to pay for the stock called as the bid price and the rate at which they are going to sell the stock is called ask price. Here, the bid-ask spread implies the amount left in-between the bid and asked prices indicating the markup of the dealer.