Over-the-Counter Derivatives (OTC) are securities that are typically traded through a network of dealers rather than on a centralized exchange such as the New York Stock Exchange.
These securities are called “over-the-counter” because they are traded directly between two parties rather than being listed on a central exchange.
Each transaction is a separate contract between the two counterparties making the transaction.
The lack of a central exchange means OTC parties face higher counterparty risk.
If you default, the counterparty will not get paid.
The value of an OTC derivative is determined by the value of its underlying asset, which can include bonds, stocks, commodities or currencies (foreign exchange).
Prior to the global financial crisis of 2007-09, the OTC derivatives market was unregulated.
Default risks in derivatives markets have led global policymakers to increase regulation, leading to the U.S.’s Dodd-Frank Wall Street Reforms and Consumer Protection Acts and the EU’s European Markets Infrastructure Regulation (EMIR).
The legislation is intended to limit the threat of default in the over-the-counter derivatives market, thereby reducing the risk of another financial crisis.
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