Exchange-Traded Vs OTC Markets2 min readReading Time: 2 minutes
There are two types of derivatives markets – Exchange-Traded & Over the Counter (OTC).
But first, let’s look at a scenario.
If Mr. X is trying to sell a house, he can either go through a real estate broker which comes with structured rules, regulations and a fee for connecting him with buyers. Or he could simply put up a “For Sale” sign outside the house and look for buyers himself.
The real estate broker here is analogous to exchange-traded markets whereas selling on the house on his own without following any rules would be like an OTC trade.
Here’s a detailed explanation on both markets.
What Are Exchange-traded Markets?
These are markets where traders trade standardized contracts defined by the exchange. Let’s look at a little bit of history, shall we?
The Chicago Board of Trade was established in 1848 to bring farmers and merchants together. Initially, it’s task was to standardize the quantities and qualities that were being traded. Within a few years, a futures contract known as to-arrive was developed.
Speculators soon became interested in the contract. Another futures exchange called the Chicago Mercantile Exchange was developed in 1919.
Today futures exchanges exist all over the world. The CBOE started trading call option contracts on 16 stocks in 1973. Options had traded prior to 1973 but CBOE succeeded in creating an orderly market with well-defined contracts.
Many exchanges all over the world now trade options. The underlying assets could be foreign currencies, futures contracts, stocks, and stock indices. Traditionally, the open outcry system was used. However, mostly all exchanges have now resorted to electronic trading.
What Are Over-the-counter (OTC) Markets?
Not all trading is done using exchanges. The OTC market is an equally important alternative to exchange-traded markets and when measured in terms of volume is much larger than exchange-traded markets.
OTC refers to a computer and telephone-linked network of dealers. Trades are done over the phone between two dealers who are usually two financial institutions or a financial institution and it’s corporate client.
Financial institutions usually act as dealers and they are often ready to quote both bid and ask price for commonly traded financial instruments. Telephone conversations in OTC markets are taped. Trades in OTC markets are much larger than exchange-traded markets. The key advantage of OTC contracts is that the contract can be customized. A disadvantage is that there is some credit risk.
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