Explained: OTC derivatives vs exchange-traded derivatives

A derivative is a contract whose value is derived from an underlying asset.

A derivative is a contract whose value is derived from an underlying asset. The underlying assets can be financial assets such as shares, bonds, indices, metals such as gold, silver, copper, or commodities such as food grains, coffee, cotton, etc. 

There are 4 types of derivatives: 

• Forwards 
• Futures 
• Options 
• Swaps 

Derivatives can be classified into 2 categories - Over The Counter (OTC) derivatives and Exchange-Traded derivatives.  

OTC derivatives 

These are financial contracts whose terms and conditions are negotiated privately between the two or more parties involved. These contracts are more customized to suit the needs of the parties involved, making them a flexible and convenient arrangement. OTC contracts are less regulated than Exchange-Traded contracts, which makes them a risky arrangement. For example, one of the parties may decide to go back on the agreement and not honour the commitment, resulting in trouble for the other party. An example of OTC derivatives is forward contracts. 

Exchange-Traded derivatives 

Exchange-traded derivatives are OTC contracts that are traded on an exchange. They are more liquid, structured and regulated than the OTC contracts. The settlement of contracts is guaranteed by the clearinghouses, thus mitigating the default risk involved in the latter. Default risk is mitigated by taking measures such as capital adequacy requirements of members, monitoring of member performance and track record, stringent margin requirements, position limits based on capital, online monitoring of member positions and automatic disablement from trading when limits are breached, etc. Futures and options are examples of exchange-traded derivatives.