Over-the-counter derivatives (OTC derivatives) are securities that are normally traded through a dealer network rather than a centralized exchange, such as the New York Stock Exchange.
These securities are referred to as “over-the-counter” as they are traded directly between two parties rather than being listed on a central exchange.
Each trade is an individual contract between the two counterparties making the trade.
This lack of a central exchange means that the parties to an OTC transaction are exposed to higher counterparty risk.
If you default, the counterparty will not get paid.
The value of an OTC derivative is determined by the value of its underlying asset, which can include bonds, stocks, commodities, or currencies (foreign exchange).
Prior to the 2007-09 global financial crisis, the OTC derivatives market was unregulated.
The risks of default in the derivatives market led global policymakers to increase regulation, leading to 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.
This legislation is designed to limit the threat of default in the OTC derivatives market and therefore reduce the risk of another financial crisis.