The OTC Market and Counterparty Risk

An over-the-counter, or OTCOver-the-counter (OTC) or off-exchange trading or pink sheet trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.Read on Wikipedia →, derivativeIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia → is agreed outside a derivatives exchange. A bank and a company can arrange the amount, date, and payments to fit a particular need, rather than choosing a standard exchange contract.

Banks, investment funds, and companies use this market. Many agreements use standard documentation, even when the payment terms are tailored. An OTC trade can also be arranged electronically; it does not have to involve a phone callIn finance, a call option is an option contract that gives its buyer the right, but not the obligation, to buy an agreed quantity of a particular commodity, security, or other financial instrument from the seller at a specified price. The asset or instrument to which the option relates is known as the underlying, and the specified purchase price is known as the strike price. The right may be exercisable at or before a specified date, depending on the terms of the option.Read on Wikipedia → or an informal agreement.

Agreeing a trade and handling it are separate steps

Once the parties agree on a trade, its obligations can remain between them. This is bilateral clearing. Their agreement sets out how payments, collateralIn lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as a lender's protection against a borrower's default and so can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.Read on Wikipedia →, and early termination will be handled. Collateral is money or assets provided to reduce the loss if a party fails to pay.

Eligible trades can instead go through a central counterparty, or CCPA central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk. An extensive overview of the academic literature can be found in Berndsen (2021).Read on Wikipedia →. It takes the buyer’s obligations to the seller and the seller’s obligations to the buyer. Each party then faces the CCP rather than the original trading partner.

An OTC trade can therefore be centrally cleared. The place where a deal is agreed does not, by itself, tell us how its obligations are managed.

How a bank quotes two prices

A bank acting as a market makerA market maker or liquidity provider is a company or individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the bid–ask spread or turn. This stabilizes the market, reducing price variation (volatility) by setting a trading price range for the asset.Read on Wikipedia → offers buying and selling prices. These are quoted from the bank’s point of view:

• The bid is the price the bank offers to buy.
• The ask is the price at which the bank offers to sell.

The difference is the spreadThe bid–ask spread is the difference between the prices quoted for an immediate sale (ask) and an immediate purchase (bid) for stocks, futures contracts, options, or currency pairs in some auction scenario. The size of the bid–ask spread in a security is one measure of the liquidity of the market and of the size of the transaction cost. If the spread is 0 then it is a frictionless asset.Read on Wikipedia →. A customer accepting the bank’s prices buys at the ask and sells at the bid.

In the chapter’s historical currency example, the bank buys one British pound for $1.2217 and sells one for $1.2220. The spread is $0.0003 per pound. A customer buying pounds pays the higher price. Even if the market does not move, immediately selling them back at the lower price would create a loss.

The spread is part of the cost of trading. A quoted price also needs an available quantity: it does not mean the bank will trade an unlimited amount.

Why a trading partner’s failure matters

Counterparty riskCredit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal payment, leading to disrupted cash flows and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.Read on Wikipedia → is the risk of loss because the other party does not meet its obligations. Collateral and central clearing can reduce this risk. They do not remove every possible loss or funding problem.

Connections between financial firms can spread the damage. If one bank fails, another may lose money on their contracts and struggle to pay its own obligations. This possible spread of financial distress is systemic riskIn finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the entire system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the risks imposed by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as "systematic risk".Read on Wikipedia →.

Hull uses Lehman Brothers as a historical example. When it filed for bankruptcy on 15 September 2008, it had more than a million open transactions with about 8,000 counterparties. Its heavy borrowing and dependence on short-term funding made a loss of confidence especially dangerous. Sorting out the contracts and rights to collateral took years.

The chapter describes later reforms aimed at more reporting, wider use of central clearing, and trading on organised platforms. Those descriptions refer to the book’s period, rather than a complete account of today’s rules.

Why the contract amount is not its current value

A contract to buy $100 million in exchange for pounds has a notional amountThe notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to as notional.Read on Wikipedia → of $100 million. That amount describes the scale of the transaction. The value of its agreed terms today might be only $1 million.

The distinction matters when reading market statistics. For December 2019, the chapter reports an OTC notional amount of $558.5 trillion and a gross market value of about $11.6 trillion. These measure different things; neither should be read as the loss that will occur if markets move.

The book also describes compression, which replaces overlapping contracts with fewer obligations while preserving the intended economic position. It can reduce reported notional amounts without a matching reduction in the risk being transferred. Central clearing can affect the count too, because one original trade becomes two contracts involving the CCP.

To understand an OTC position, look at its terms, current value, collateral, and clearing arrangements together. Its notional amount alone is not enough to measure the risk.

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