Source: BURSA ACADEMY | Published: April 2022
Exchange-traded derivatives are derivatives that are traded with contracts based on derivatives exchanges, and are standardised and defined by the exchange, with the exchange acting as counterparty to all contracts.
OTC derivatives (Over-the-Counter) on the other hand are derivatives which are negotiated and traded directly between two parties, forming the largest market for derivatives.
Bursa Malaysia products are available on the CME Globex electronic trading platform, which allows Bursa Malaysia to increase the distribution of Malaysian derivatives offerings to a global audience.
The Bursa Malaysia Derivatives Berhad (BMD) utilises CME Globex as an electronic trading platform, and the BMD provides the stage where futures and options can be traded and the BMD also offers the most liquid and successful FCPO (Crude Palm Oil Futures) contracts in the world.
Derivatives can be bought and sold OTC, but there are several advantages to trading derivatives over exchanges. The first is that exchanges offer a standardised product. The derivatives contract allows the value to be agreed. The exchange- traded derivative follows a contract that is agreed and traded over the exchange.
The exchange-traded derivative may be more palatable to the new investor, unlike the OTC derivative, which is more complex, because the structure of the derivative is customisable and defined by traders, not by exchanges which provide a more regulatory aspect to derivative trading.
There is greater transparency of pricing information, because the trade happens over a market exchange. OTC derivatives on the other hand, tend to be more private making them less transparent.
The OTC derivative on the other hand faces counterparty risk because trading partners deal with each other through intermediation. This increases credit risk for transacting parties. The derivatives are traded via a dealer network, and are generally unlisted, unless by broker-dealers through direct negotiations.
Each market provides different characteristics to suit different investor needs and aspirations. The OTC market at times provides an incubator role for new financial products to be market tested. OTC derivatives give varying exposure to a variety of markets depending on what the composition of the OTC derivative may be.
OTC derivatives are also sometimes subject to greater speculative risk and rarely, but notably derivative integrity issues.
Trading in derivatives has become a preferred investment method for many small and large investors. Because of this growth in investment in derivatives, global leaders are committed towards safety and use of such financial instruments, calling for greater standardisation, listing process and regulation even of OTC derivative models.
Derivatives are priced based on risk-factor valuation and assessment and clearinghouses use pricing adjustments to evaluate risks such as counterparty risk and credit default risk.
Tags: OTC, DERIVATIVES
