Over-the-Counter (OTC) Derivatives

Over-the-counter derivatives (OTC derivatives) are financial instruments that are typically traded through a network of dealers instead of on a centralized exchange like the New York Stock Exchange. They are termed “over-the-counter” because transactions occur directly between two parties rather than being conducted on a central exchange.

Each transaction represents a unique contract between the two counterparties involved. The absence of a central exchange results in increased counterparty risk for those engaged in an OTC transaction. If one party defaults, the other party may not receive payment.

The value of an OTC derivative is based on the value of its underlying asset, which can encompass bonds, stocks, commodities, or currencies (foreign exchange). Before the global financial crisis of 2007-09, the OTC derivatives market operated without regulation.

The risks associated with defaults in the derivatives market prompted global policymakers to enhance regulatory measures, culminating in the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States and the European Market Infrastructure Regulation (EMIR) in the European Union. These regulations aim to mitigate the risk of default in the OTC derivatives market, thereby reducing the likelihood of another financial crisis.