Financial derivatives provide investors with a way to secure investments. They may be traded in an organized exchange or over the counter. Unlike exchange traded derivatives, over the counter, or OTC, derivatives are not carefully monitored or regulated.
Over the counter financial derivatives are private agreements that usually occur between two companies or between a company and an investor. In most cases, the companies involved in issuing OTC derivatives are commercial banks, investment companies, and hedge funds.
There are numerous complications and problems associated with OTC derivatives. While all of the aspects of exchange traded financial derivatives are carefully detailed, many aspects of OTC derivatives are left unaddressed or unspecified. For example, it is common for the duration of over the counter financial derivatives to be flexible. Another potential problem associated with these securities is that companies often require investors to offer collateral in order to obtain OTC derivatives.
Therefore, if the investor defaults on the agreement, the issuing company may seize the personal property that was offered. However, the companies issuing the financial derivatives will not need to offer collateral, and therefore, there is little to stop them from defaulting on an agreement.
Because an exchange does not monitor or regulate OTC derivatives, there is often little that can be done to compensate investors if a company defaults on an agreement. Many within the United States Congress favor the use of exchange traded derivatives, and wish to have OTC derivatives discontinued. If this occurred, an organized exchange would have the ability to better track all derivatives in order to ensure that no party involved in a contract is defaulting on an agreement.
However, banks and corporations do not wish to do away with OTC derivative contracts. In most cases, the business of selling derivatives allows a bank to make a substantial profit. Non-financial institutions also do not want OTC derivatives to be discontinued, as they are much less expensive to obtain because exchange traded derivatives require large quantities of collateral.
There are many different types of derivatives sold over the counter. Options, swaps, and forward contracts are all forms of OTC derivatives. They each work in a similar manner to their exchange traded derivative counterpart. For example, forward contracts function much like futures contracts, allowing both a buyer and an issuer to agree upon a specified price, which an investor will be granted to obtain a designated share of stocks on a certain date in the future. However, instead of being regulated by an exchange, this derivative is sold over the counter. This allows a derivative to be modified so that it suits the needs of the investor.
