10.2.2 Derivative Markets

Overview

As discussed in previous chapters, most bonds trade in the over-the-counter (OTC) market, while stocks and derivatives trade on both the OTC market and organized exchanges. The primary difference between exchange-traded and OTC stocks and bonds lies in trading mechanics. However, the differences between exchange-traded and OTC derivatives are even more pronounced.

Over-The-Counter (OTC) Derivatives

The OTC derivatives market is an active and vibrant market consisting of a loosely connected and lightly regulated network of dealers who negotiate transactions directly with one another. Negotiations typically occur via telephone or through computer terminals.

Key Characteristics

• Dominated by Financial Institutions: Banks and investment dealers primarily dominate this market, trading with large corporate clients and other financial entities.
• No Central Trading Floor: There is no physical trading floor, and no regular trading hours. Trading can occur at any time, with some staff working nights, weekends, and holidays.
• Custom Contracts: OTC derivatives are attractive because contracts can be custom-designed to meet specific needs, leading to more complex instruments than those traded on exchanges.

Exchange-Traded Derivatives

A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. It provides facilities either through a physical trading floor, an electronic system, or both. The exchange also enforces rules and regulations to maintain market fairness, order, and transparency.

Key Functions

• Addresses OTC Issues: Designed to address problems such as lack of standardization, liquidity concerns, and default risk associated with OTC markets.
• Standardization: Exchange-traded derivatives are standardized contracts, which makes them less flexible but easier to trade and understand.

Example: Montréal Exchange

Canada has one derivative exchange: The Montréal Exchange (or Bourse de Montréal), which lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes.

Key Takeaways

• OTC Market: More flexible but less regulated, targeted towards institutional investors requiring customized derivatives.
• Exchange-Traded: More standardized and regulated, aimed at addressing issues like liquidity and default risk.
• No Centralization vs. Organized Structure: OTC lacks a central trading venue, whereas exchanges like the Montréal Exchange offer organized trading facilities.

FAQs

Q1: What is the primary difference between OTC and exchange-traded derivatives?

A1: The primary difference is that OTC derivatives are negotiated directly between parties, making them less standardized and more flexible. Exchange-traded derivatives are standardized contracts traded on regulated exchanges.

Q2: Why are OTC derivatives appealing to corporate clients?

A2: OTC derivatives are appealing because they can be custom-designed to meet the specific needs of corporate clients.

Q3: What role does the Montréal Exchange play in Canada’s derivative market?

A3: The Montréal Exchange is Canada’s sole derivative exchange, listing various options and futures on financial instruments.

Glossary

• Derivative: A financial instrument whose value is derived from the value of an underlying asset, such as stocks, bonds, or currencies.
• OTC Market: Over-the-counter market where trades are negotiated directly between parties.
• Exchange-Traded: Trading of standardized contracts on a regulated exchange.
• Montréal Exchange: Canada’s only derivative exchange, listing options and futures on various assets.

    graph TD;
	    A[OTC Market] -->|Flexible Contracts| B[Corporate Clients];
	    A -->|Direct Negotiations| C[Banks & Institutions];
	    D[Exchange-Traded Derivatives] -->|Standardized Contracts| E[Investors];
	    D -->|Regulated Market| F[Transparency & Fairness];
	    D --> G[Montréal Exchange];