Derivatives play a vital role in financial markets, offering investors opportunities to manage risk, speculate, and hedge their positions. Understanding the differences between Exchange Traded Derivatives (ETD) and Over The Counter (OTC) derivatives is essential for investors and market participants.
In this article, we will explore the key differences between these two types of derivatives.
What are Exchange Trade Derivatives (ETD) and Over The Counter (OTC) Derivatives?
Exchange Traded Derivatives are standardized contracts that are traded on centralized exchanges. These contracts, such as futures and options, have predefined contract terms, including contract size, expiry date, and settlement methods.
On the other hand, Over The Counter derivatives are privately negotiated contracts between two parties. OTC derivatives offer greater flexibility in terms of contract customization, allowing counterparties to tailor the terms to their specific needs.
Difference between Over The Counter and Exchange Traded Derivatives
1. Market Accessibility
Exchange Traded Derivatives contracts are accessible to both retail and institutional investors. They can be traded on regulated brokerage such as Orient Futures Singapore. This makes them easily available to a wide range of market participants.
Over The Counter derivatives are primarily only accessible to sophisticated market participants, such as large financial institutions and corporations. The OTC market often requires higher levels of expertise and capital commitment, limiting access for retail investors.
2. Standardization vs. Customization
Standardization is a key feature of Exchange Traded Derivatives. The contract terms are pre-established and well-defined, ensuring uniformity and ease of trading. This standardization enhances market liquidity and facilitates price discovery.
Conversely, OTC derivatives offer greater customization. Parties involved can negotiate and agree upon specific terms, making these contracts more tailored to individual risk management needs. However, the lack of standardization in OTC derivatives can lead to less liquidity, more risks and potentially higher transaction costs.
3. Counterparty Risk
The biggest reason why Investors find Exchange Traded Derivatives (ETDs) more appealing is because it eliminates the possibility of default risk. ETDs use clearinghouses as intermediaries, guaranteeing that contracts are honoured.
This means investors can trust that their trades will be successful. Furthermore, all involved parties, such as traders, exchanges, and brokerages, follow standardized rules and undergo regular audits. This creates a secure and reliable investment environment for investors.
In contrast, OTC derivatives rely on bilateral agreements between counterparties, making them subject to counterparty risk. It is crucial for market participants to carefully assess the creditworthiness and reliability of their OTC derivatives counterparties.
4. Transparency and Liquidity
Exchange Traded Derivatives also offer high levels of transparency, as price and volume information is publicly available. This transparency promotes market efficiency, allowing investors to make informed decisions.
In contrast, the OTC derivatives market is decentralized and less transparent. OTC trades occur privately between parties, making it challenging to obtain comprehensive market-wide pricing information. Additionally, the OTC market may experience lower liquidity and transparency due to the absence of a centralized trading platform.
5. Regulatory Oversight
Exchange Traded Derivatives operate within a regulated framework, overseen by regulatory authorities. These regulations aim to promote fair and orderly markets, protect investors, and ensure market integrity. The regulatory oversight provides market participants with confidence and transparency.
In contrast, OTC derivatives face varying degrees of regulatory oversight, depending on the jurisdiction and specific contract terms. The lack of uniform regulation can lead to inconsistencies and potential risks.
Exchange Traded Derivatives From China (ETD China)
There are 5 exchanges in China that trades Exchange Traded Derivatives Contracts. They are overseen by the China Securities Regulatory Commission (CSRC) to ensure fair operation for the different types of exchange traded.
Of these 5 exchanges, Orient Futures International Singapore is an overseas intermediary of 3 of them. They are Dalian Commodity Exchange (DCE), Zhengzhou Commodity Exchange (ZCE), and Shanghai International Energy Exchange (INE).
Dalian Commodity Exchange is known for its commodity futures products, most notably, iron ore futures and palm olein. The exchange also further released Soybean No 1, Soybean No 2, Soybean Meal, and Soybean Oil as internationalized products.
These exchange-traded derivatives by Dalian allow traders to gain exposure to commodities products from China. It can also be used for complex hedging and cross-arbitrage strategies. To learn more about how to calculate crushing arbitrage or soybean costs, refer to the article on soybean internationalized products here.
Zhengzhou Commodity Exchange has been the sole exchange that has offered Purified Terephthalic Acid (PTA) as an internationalized futures product. The exchange also further released peanut kernel futures 及 rapeseed meal futures as internationalized products.
Shanghai International Energy Exchange provides energy futures such as crude oil futures 及 Low Sulfur Fuel Oil (LSFO). Additionally, the exchange has offered TSR 20 rubber as one of its products traded by the QFI scheme. This ETD product can be cross arbitraged with INE TSR20 Rubber. (a list of products that can be cross-arbitrage from these exchanges is also compiled here.)
Apart from these 3 exchanges, the other two exchanges are Shanghai Futures Exchange 及 Guangzhou Futures Exchange.
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