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OTC or Listed, Which is the Best?
by Standard Bank

The acronym OTC is often bandied around financial markers? OTC stands for an “Over-the-Counter“ transaction in a financial market. When one starts looking at financial markets, one quickly realizes that many of the transactions are done either through an exchange or via OTCs.

What is an OTC? An OTC is simply a security traded outside a formal Stock Exchange (NYSE, JSE, BESA...) It can cover a wide range of instruments from a share dealt via a stockbroker, to debt securities and other financial instruments such as derivatives (Equity options, credit default swaps, interest rate swaps and others).

OTC’s usually involve a contract between two parties, which sets out the terms of the transaction and gives every necessary detail on which each party has agreed on as well as all the various recourses. The contract is legally binding.

You may well ask why investors trade on exchanges rather than via OTC’s? The simple fact is that it is often easier quicker to trade in listed instruments, directly on an exchange.

The main reason for using an OTC is that the range of instruments covered is far greater. OTCs are often traded in instruments that are either not listed or not listed in the desired specifications.

OTC’s are the instrument of choice for any start-up or fledgling market. For example when the derivatives markets started booming in the late 80s, market participants naturally used OTCs as they were the only instruments available. Listing requires some form of standardization and liquidity, which does not necessarily exist when markets are in their infancy.

Similarly some stocks are traded OTC because the company is too small to meet listing requirements. They are then traded through brokers, “off-market”.

What are the main hurdles to trade OTC derivatives?

One of the two parties to an OTC trade needs to draw up the contract. This can be a significant cost, which is why OTCs are rarely traded between individuals. Even for large financial companies (Banks, pension funds, life companies), cost can have an impact on the profitability of a transaction. This is especially true when the contract involves complex legal issues.

It is common for an OTC contract to take weeks, even months before the two parties finally agree on the exact wording suiting both of them.

The main reason for market participants preferring listed instruments, in some cases, is the embedded credit exposure of the transaction. Before entering into a transaction, one needs to make sure your counterpart will be able to fulfill their obligations at the term of the contract. Hence you are at risk of a possible default for the length of the contract, should the counterpart default. This credit exposure is scrutinized and managed increasingly closely and the resultant cost tends to be priced in, making the transaction less profitable. If one uses a listed instrument, this risk is mitigated as one is now facing an exchange, which in turn uses clearing houses to mitigate its risk.

Then why would people use OTCs?

Many transactions are still being traded OTC. There are several reasons for this, even in well-matured markets OTC remains the best way to trade, depending on what you want to achieve.

The biggest benefit of OTC trading is flexibility. As you draw up a contract between yourself and your counterpart, you can actually specify whatever you want in it. Should you wish to include fixed conditions for exiting the trade, you can include that in the OTC confirmation. OTC is often the only way of transacting tailored products where specific needs of a customer are being embedded in the transaction itself. Listed products have some degree of flexibility, (such as various strikes and maturities for listed options) but listed instruments will never match OTCs when it comes to flexibility and the ability to provide bespoke terms.

When trading an OTC there is no need to open accounts with an exchange. In theory, all what trading an OTC needs is for the two parties to understand what is being traded and the relevant risks involved in the transaction. Nevertheless, one must not forget the time that can be spent on legal work if a full contract has to be written from scratch.

An added benefit to OTCs is that they are confidential instruments. Large exchange traded transactions usually draw a fair amount of attention. Even if counterparts are not disclosed, traders will see the trade and speculate on the source. For instance, if an institution trades a large number of options with a bank, the whole market will notice the trade and may try and trade against it, making it more difficult for the bank to mitigate its risk. This may impact the level at which the trade gets done. OTCs are a more discreet form of dealing.

There are also costs attached to listed instruments, exchanges will charge a fee on each transaction. In some instances, people prefer trading OTC even if a listed instrument is readily available as they find the OTC is cheaper than the equivalent listed instrument.

So OTC or listed?

Eventually the two ways of trading complement each other well. OTC will be mainly used in illiquid markets or when a fair amount of tailoring is required. Listed instruments will be used as they become more readily available, i.e. when the underlying product has become commoditized enough to justify a listing. When possible, trading a listed product is generally simpler but there can be specific reasons to choose to trade OTC instead.

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