Over-the-counter (or OTC) trading, also known as off-exchange trading, is the act of direct exchange of stocks, derivatives, commodities, bonds, or contractual rights directly between two parties.
It offers a much lower-risk, though still uncertain, medium for asset trading than exchange trading and reduces the risk of credit damage due to default, as well as facilitating liquidity for all parties involved. Its emerging prominence has led many financial institutions to pursue trading in OTC.
Modern finance counts OTC derivatives as a notable slice of global resource trading. Already large, OTC derivatives markets have experienced exponential growth over the course of the last two decades. Favorable interest rates, exchange of credit defaults, and lucrative foreign exchange instruments have helped to fuel the expansion. By late 2010 the OTC derivative market’s notional outstanding had risen to close to $600 trillion USD.
Derivative activities have grown since the early 90’s to comprise a significant portion of the revenues of many major international fiscal institutions. Such institutions administrate portfolios of derivatives comprising thousands and thousands of transactions and positions, with turnover around the globe surpassing one $1 trillion USD.
Bringing OTC derivatives to fiscal maturity and profitability has been the pet project of financial institutions all around the world, and today OTC trade occupies a pivotal and still-emerging role in modern financial proceedings.
Their lower cost, on account of transaction customization and low government taxes and fees, account for the success of OCT derivatives in diverse markets.
In periods of instability OTC trading suffers, generally, in tandem with the exchange market, but although the volume of OTC trading decreases its nature makes it a more attractive avenue for trade. With liquidity a major concern in the throes of the GFC, many major companies like Australia’s MAKO Energy are moving toward OTC trading.
The unreliability of global exchange finance has resulted in a shift in thinking, and as a smaller, more manageable data network OTC is a natural choice for streamlining. In addition its rapid growth has left many fiscal institutions dependent upon its continued unfettered success.
The risks associated with OTC, especially in derivative trading, can still be significant. Counterparty risk in particular has been focused on as a subject strongly influenced by the (ongoing) credit crisis of 2007. Counterparty risk is defined as the risk both parties in a derivatives transaction take that the other might default, eschewing current or pending payments that their mutual contract stipulates.
Counterparty risk can be limited in a variety of ways, primarily through regulation and market strategy. Credit exposure can be mitigated and controlled through tactics like diversification, hedging, and netting.
Recent initiatives in market regulation, both at home and abroad, have focused on strengthening safeguards on OTC trading, like 2010’s movement to safeguard European investing opportunities. Given the continued explosion of OTC trading, even during the current global financial difficulties, risk mitigation is a keystone of advances in OTC regulation. The increasing size of the OTC market makes it an emergent sector of finance, already vital to the health of the world economy.