Over-the-counter
Also written OTC · Over-the-counter (OTC) · Over-the-counter market · Over-the-counter (OTC) market
A bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.
In plain language
Not every trade happens on a screen with a standard contract. In an over-the-counter (OTC) market, two parties negotiate the terms of a contract directly with each other. Price, quantity, quality and delivery details are all agreed between them, not set by an exchange.
The workbook's clearest example is the forward contract: a bilateral OTC transaction whose terms are fixed on the day the two parties enter into it, and can be changed later only if both parties agree. This is the opposite of an exchange-traded contract, where the exchange fixes standard terms in advance, and any two anonymous participants can trade on them.
How it works
Two markets, contrasted directly (Chapter 5, section 5.3).
| OTC market | Exchange-traded market | |
|---|---|---|
| Contract terms | Negotiated bilaterally | Standardised by the exchange |
| Settlement | Directly between counterparties | Through a clearing house, which becomes counterparty to both sides |
| Trust required | Depends on trust between the counterparties | Backed by the clearing corporation's guarantee and margins |
| Which products | Forwards and swaps | Futures and options |
| Who participates | Mostly institutions comfortable dealing with each other | Anonymous participants, including retail |
The cost of that flexibility. OTC contracts carry liquidity risk: because terms are tailor-made, other participants may have no interest in taking over the position, and OTC contracts are not listed on any exchange. They also carry counterparty (default) risk: if a party has an incentive to walk away from a now-unfavourable contract, no clearing house stands behind the trade to guarantee it. In India, forward markets for agricultural commodities and interest-rate swap markets operate in the OTC space, alongside exchange-traded index and stock derivatives.
A worked example
Two companies, Meridian Textiles and Bharat Cotton Traders, agree an OTC forward: Meridian will buy 50,000 kg of cotton at ₹210 per kg from Bharat, six months from now. No exchange is involved. The price, quantity and delivery date are exactly what the two parties negotiated.
Six months later, market cotton prices have risen to ₹250 per kg. Bharat now has an incentive to default: selling in the open market would fetch it ₹40 per kg more than the agreed ₹210. If Bharat walks away, Meridian's only recourse is whatever legal remedy the contract provides. There is no clearing house guaranteeing the trade — exactly the counterparty risk the workbook describes.
Had the same exposure been taken through an exchange-traded cotton futures contract instead, the exchange's clearing corporation would stand between both sides, backed by margins collected from each, removing this specific default risk, at the cost of using the exchange's standard contract size and delivery terms rather than Meridian's own negotiated 50,000 kg.
Why NISM asks about it
Chapter 5 (Derivatives), sections 5.2.1 and 5.3, introduce OTC transactions through forward contracts, then contrast OTC and exchange-traded markets directly. Expect a question matching a described product, forwards and swaps versus futures and options, to its market type, and a question on the liquidity and counterparty risk OTC trading carries that exchange trading does not.
Common exam traps
- Forwards and swaps are OTC; futures and options are exchange-traded. This pairing is stated directly in the workbook and is frequently tested.
- OTC counterparty risk exists because there is no clearing house. An exchange-traded contract removes this specific risk through the clearing corporation's guarantee.
- OTC does not mean illegal or unregulated. Corporations, traders and investing institutions extensively and legitimately use OTC transactions to meet requirements a standard exchange contract cannot.
- Do not confuse the OTC market (a way of trading) with an OTC derivative (a specific instrument type) — the market structure and the instrument are related but distinct ideas.
Check yourself
1.Which of the following pairs are OTC derivatives as per the workbook?
- a)Futures and options
- b)Forwards and swaps
- c)Futures and swaps
- d)Options and forwards
Show the answer
Answer: (b) Forwards and swaps
The workbook states: "Forwards and swaps are OTC derivatives; futures and options are exchange-traded derivatives."
The mixed pairs each combine one OTC and one exchange-traded product.
Where this is taught
Free preparation for NISM Series XXI-ARelated terms
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
- Cash settlementSettling a derivative on expiry or exercise by exchanging the price difference, without delivering the underlying asset. SEBI mandates physical settlement for stock derivatives, not index derivatives.
- Non-deliverable forwardA cash-settled, usually short-term currency forward in which the notional amount is never exchanged — only the difference between the contracted rate and the reference rate changes hands.
- Foreign exchange swapAn OTC derivative in which two currencies are actually exchanged on one date (the short leg) and re-exchanged at a later date (the long leg), at rates agreed at the time of the contract.