OTC vs exchange-traded derivatives and central clearing
Over-the-counter (OTC) derivatives are customized contracts agreed directly with a dealer. Exchange-traded derivatives (ETDs) are standardized contracts whose performance the exchange guarantees using margin. Since 2008, most OTC trades between dealers are centrally cleared, which cuts bilateral credit risk but concentrates it in one place.
Before this: What a derivative is, Market Organization and Structure
On the exam
- Describe the basic features of derivative markets, and contrast over-the-counter and exchange-traded derivative markets
Describe derivative markets and contrast OTC and exchange-traded markets. Expect: which feature belongs to ETDs, which market suits a customized hedge, what a central counterparty does, the order of the clearing steps, and the main risk of central clearing.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How does the OTC market work?
An over-the-counter (OTC) derivative is a contract made directly between an end user, such as a company or fund, and a dealer, usually a bank. The dealers act as market makers : they quote prices and then trade offsetting contracts with each other to pass the risk on.
The strength is that terms can be tailored to the exact exposure: the amount, dates and underlying. The weaknesses are lower transparency (though more privacy), more counterparty credit risk , the chance that the other side fails to pay, and sometimes lower liquidity. Contracts usually sit under an International Swaps and Derivatives Association (ISDA) master agreement with negotiated credit terms.
How does the exchange-traded market work?
An exchange-traded derivative (ETD) is a futures, option or other contract listed on an exchange. The exchange sets the terms, so every contract is the same. A made-up specification shows the idea:
| Cocoa futures (example) | |
|---|---|
| Contract size | 10 tonnes |
| Maturities | March, May, July, September, December |
| Settlement | cash, against a published index |
| Daily settlement | yes, by the exchange |
Market makers quote a bid and an offer and can often buy and sell at the same time, earning the spread. When no hedger is on the other side, risk takers (speculators) take it. Clearing is the process of verifying the trade, the exchange of payments and the participants. Settlement is the final payment or delivery.
Each side posts collateral (margin) when the trade starts and keeps it topped up. The exchange then guarantees against default, and it sees all transactions, so the market is transparent to regulators.
OTC and exchange-traded side by side
Memorize
| OTC | Exchange-traded | |
|---|---|---|
| Terms | customized | standardized |
| Counterparty risk | higher (bilateral, unless centrally cleared) | low (exchange or CCP guarantees; margin) |
| Transparency | lower; more privacy | high |
| Transaction costs | higher | lower |
| Liquidity | can be lower | often higher |
| Flexibility | high | low |
| Typical user | company hedging a specific loan or trade | investor taking a standard index or commodity position |
- Over-the-counter (OTC) Memorize end users deal with dealers; customized, bilateral
- Bilateral Memorize each dealer bears the other's credit risk
- Centrally cleared Memorize dealer-to-dealer trades novated to a CCP; end user still faces its dealer
-
- Exchange-traded (ETD) Memorize standardized; exchange or CCP guarantees performance with margin
What does central clearing change?
After the 2008 crisis, regulators introduced a central clearing mandate for most standardized OTC derivatives. A central counterparty (CCP) takes on the credit risk between the counterparties, one of which is typically a dealer, and provides clearing and settlement.
The path of a swap between two dealers has three steps.
- 1. Execute on a SEF Memorize a trading platform used by many dealers
- 2. Submit to the CCP Memorize SEF trade details are shared
- 3. Novation Memorize CCP replaces the trade with two identical trades, each facing the CCP
The trade is first executed on a swap execution facility (SEF) , a trading platform used by many dealers. The details go to the CCP, and then novation replaces the original contract with two identical contracts, each facing the CCP. The CCP is now the buyer to every seller and the seller to every buyer.
End users keep OTC customization when dealing with their dealer, while between dealers credit risk, clearing and settlement work like an exchange. The catch is systemic risk : risk becomes centralized and concentrated in the CCP, so the CCP needs strong margin and loss-absorbing funds and proper oversight.
Exam tip After central clearing the worry shifts from “will my dealer pay?” to “can the CCP pay everyone?”.
Go deeper Why customization and standardization trade off
Liquidity needs many traders to hold identical contracts. The more a contract is tailored, the fewer other parties want exactly that contract, so it is harder to trade or close out.
Go deeper How margin calls work day by day
Each day the exchange compares each position with the settlement price. The loser pays the winner’s gain through the clearing house, and a balance that falls too low must be topped up. The futures pricing module covers this.
Go deeper CCP default waterfalls
A CCP covers a member’s default in layers: first that member’s own margin, then a shared default fund, then the CCP’s own capital. The details are not examinable.
Memorize this
MemorizeOTC vs exchange-traded
| OTC | Exchange-traded | |
|---|---|---|
| Terms | customized | standardized |
| Counterparty risk | higher (bilateral) | low: guaranteed, margin posted |
| Transparency | lower, more privacy | high |
| Transaction costs | higher | lower |
| Liquidity | can be lower | often higher |
| Flexibility | high | low |
Memory hook Standard = busy = cheap = guaranteed. Custom = quiet = pricey = your counterparty's credit.
Know it cold Central clearing: SEF, then CCP, then novation. Credit risk moves to the CCP, so the main concern becomes systemic (concentration) risk.
MemorizeClearing vs settlement
Memory hook Clearing checks and records; settlement pays and delivers.
Know it cold Clearing = verify the trade, the payments and the participants. Settlement = final payment or delivery.
- Over-the-counter (OTC) Memorize end users deal with dealers; customized, bilateral
- Bilateral Memorize each dealer bears the other's credit risk
- Centrally cleared Memorize dealer-to-dealer trades novated to a CCP; end user still faces its dealer
-
- Exchange-traded (ETD) Memorize standardized; exchange or CCP guarantees performance with margin
- 1. Execute on a SEF Memorize a trading platform used by many dealers
- 2. Submit to the CCP Memorize SEF trade details are shared
- 3. Novation Memorize CCP replaces the trade with two identical trades, each facing the CCP
How it is asked
-
Which is an ETD feature?
Compared with OTC, exchange-traded derivatives are most likely to have what?
Lower transaction costs (and standard terms, margin). Trap: more counterparty risk.
-
Customized hedge
A loan has unique payment dates and amortization. Which instrument?
An OTC swap: only OTC matches bespoke dates and amounts.
-
Clearing sequence and counterparty
Order the steps; who is the counterparty after novation?
SEF, CCP, novation. Each dealer now faces the CCP.
-
Main remaining risk
After central clearing, what worries participants most?
Concentration (systemic) risk in the CCP. Trap: the dealer's credit risk.
Exam traps
- Saying ETDs carry more counterparty risk than OTC. It is the reverse: the exchange guarantees performance.
- Saying central clearing removes the dealer from the end user's trade. The end user still faces its dealer.
- Forgetting the downside of central clearing: risk concentrates in the CCP (systemic risk).
- Thinking OTC means unregulated or undocumented. OTC contracts sit under a negotiated legal agreement.
- Confusing clearing with settlement.
Checkpoint
4 exam-style questions. About 90 seconds each.
1Compared with OTC derivatives, exchange-traded derivatives are most likely to have:
2A company wants to hedge a floating-rate loan with payment dates and an amortization schedule unique to that loan. It will most likely use:
3Once swaps between dealers are routinely novated to a central counterparty, the main concern for the market as a whole is:
4In the central clearing of a swap between two dealers, the correct order is:
Key takeaways
- OTC: customized, bilateral, less transparent, more counterparty risk.
- ETD: standardized, margined and guaranteed, transparent, cheaper to trade.
- Central clearing: execute on a SEF, submit to a CCP, then novation; less bilateral risk, more concentration risk.
- Both markets use market makers.
All Derivatives formulas, every lesson
Practice exam-style questions on Derivatives and Derivative Markets
Questions about this lesson?
Where this comes back
- Forwards, Futures, Swaps, Options and Credit Derivatives Derivatives
- Pricing and Valuing Futures Contracts Derivatives
- Derivative Benefits, Risks and Uses Derivatives
Questions candidates ask
What is the difference between OTC and exchange-traded derivatives?
OTC derivatives are customized contracts between an end user and a dealer, with more counterparty risk and less transparency. Exchange-traded derivatives are standardized, margined and guaranteed by the exchange, transparent and usually cheaper to trade.
What does a central counterparty do?
A central counterparty (CCP) steps in as buyer to every seller and seller to every buyer. It takes on the credit risk between the original counterparties and provides clearing and settlement services.
What is novation in derivatives clearing?
Novation is the CCP replacing the original trade, executed on a swap execution facility, with two identical trades, each facing the CCP. Bilateral credit risk between the dealers disappears.
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