A derivative can either be ‘exchange-traded’, where a contract is bought or sold on a recognised exchange, or it can be over the counter (OTC). An OTC instrument is written or created by a bank (or sometimes other financial institutions) and tailored to suit the exact requirements of the client.
This is an instrument that is bought or sold directly on an exchange such as NYSE LIFFE, ICE (InterContinental Exchange) or the CME (the Chicago Mercantile Exchange Group). There are many regulated exchanges worldwide.
Majority of exchange-traded trading occurs online with increasing technology over the past 5 years. Within this market there is an entity known as the clearing house.
Clearing house – Responsible for the clearing of trades (which will be discussed later)
The clearing house also becomes the ‘buyer’ to everyone who sells and the seller to everyone who buys and are known as a central counterparty. This is incredibly important as no matter who you deal with your ultimate counterparty will be the clearing house. Whether you deal with a small bank, or large bank, European or American fund, if you deal on the NYSELIFFE your eventual counterparty will be LCH.Clearnet Ltd. This is a body formed from the merger of the London Clearing House and Clearnet. In effect this removed the requirement to check individual credit lines before dealing, as the exposure will be to LCH.Clearnet, not to the firm with which you transacted.
This is a financial instrument that is sold by a bank (usually), to a client and tailored to fit a specific set of requirements., Occasionally, banks will purchase these products from companies or other non-banks, but each buyer and seller must take the credit risk of their counterparty. In the even that there is a failure of any kind, each party to the trade is exposed to the risk that the other party will be unwilling or unable to proceed.
An OTC product allows much greater flexibility in terms of expiry date, reference price, amount and underlying commodity, and vast amounts of transaction are executed every day. An OTC instrument can be very simple, in which case it is known as a ‘vanilla’ product, or it can be exceedingly complex. The price of the trade will be agreed upon between the parties, is confidential and involve many factors.