Wednesday, November 21, 2007

OTC and Licensed Markets

OTC transactions are all financial products not traded on a licensed exchange or market. Consistent with this distinction, OTC financial transactions are also known as off-exchange transactions. In Australia, there are two principal licensed financial markets: the Sydney Futures Exchange (SFE), and the Australian Stock Exhchange (ASX) - the SFE was purchased by the ASX. Generally, any financial products that are traded outside the SFE or ASX are therefore termed OTC financial transactions.

A principal difference between OTC and exchange traded products is the flexible nature of the OTC product. They can be tailored specifically to the client's needs in terms of product structure, settlement terms and dealing method (ie an OTC product is a privately negotiated bilateral transaction). In contrast, exchange-traded products are subject to fixed terms and conditions which are determined by the exchange, and sometimes require the approval of the responsible Minister.

In the case of exchange-traded products, deals are normally with the exchange or clearing house as a principal and are subject to binding rules and procedures. The facility of the exchange is offered on the condition of adherence to the Business Rules of the exchange. The products traded on exchanges are usually in a standard format with little or no scope for variations to accommodate specific client circumstances, except of course, price.

Exchange-traded products are distinguished by constant contract terms (fungibility), which allows for novation of contracts with a central clearning house. Novation allows for credit risk management to be transferred from the principal to the clearning house. Exchange-traded products are cleared and settled by the exchange; OTC products are cleared and settled by the individual participants. Clearing Houses manage market risk largely through margin calls, where as OTC participants manage market risk individually.

Transaction costs can be surprisingly high for OTC transactions. Results of OTC research showed that average costs for cash, securities and foreign exchange transactions were in the region of $160 to $380 per transaction. More involved transactions such as swaps and interest rate options, were in the region of $2,500 per deal. In contrast, exchange-traded futures showed an average cost per deal of around $350.

OTC products tend to have standardised contracts, as a starting point, with numerous variations to suit the end-users particular needs (eg. bank bills drawn to suit a client's cash flow or foreign exchange rate forwards matched to a client's date of receipt).

OTC products are responsible for a large number of bilateral transactions. Since this bilateral method of operation in OTC financial products is usually not automated, or on a regulated third party exchange, is relied heavily on the orderly self-regulated behaviour of its participants.

Over time, participants have developed commonly accepted procedures for transacting, documenting and settling OTC transactions that have resulted in an efficient and secure trading environment.

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Market Intermediation

Market intermediaries can be considered to be 'facilitators' of financial transactions, acting between buyers and sellers, and investors and borrowers. This can be done as a principal - lending and borrowing off their own balance sheet, or as a broker matching participants without taking a principal position. Market intermediaries traditionally use their influence or position to bring together investors and those in need of funding, and matching those in need of foreign currencies and those with surplus foreign currency. Intermediaries earn income for providing such 'matching' and/or risk spreading, or carrying services. This matching can involve the pooling of many small buy or sell positions then, matching these with the opposite position for a fee or a margin.

It is this concept of pooling or 'matching' that distinguishes an intermediary from an end-user. Because of a diverse range of financial markets product types, many of which are not attractive or simply not available to some end-users, the financial intermediary is able to offer a 'package solution' that is far more attractive, or affordable.

It is important to note that as a consequence of this 'matching' activity, financial intermediaries provide OTC products with liquidity, ie the presence of a large number of buyers and sellers of products.

The intermediation process produces several other advantages for end-users and the financial system. They include:

1. Risk Bearing

The financial intermediary may accept a number of financial risks when dealing with end-users, including:


  • The risk that lenders will want to retrieve their money after it has already been loaned to borrowers, or that borrowers will want to repay early before it is due to be repaid to the intermediary's lenders
  • The risk that the loans made to borrowers may not be repaid, that payments under derivative contracts are not made or that currencies are not delivered as required in foreign exchange transactions
  • The risk that interest rates will move unfavourably, rendering transactions unprofitable
  • The risk that exchange rates will move unfavourably rendering transactions unprofitable
  • The risk that price relativities between products will move unfavourably rendering hedging arrangements ineffective and unprofitable

Talk to one of our Forex Specialists and learn more about 'risk' in the Forex market

2. Economies of Management Costs

By managing transactions in sheer volumes, intermediaries can achieve economies of scale. Administrative and other costs associated with evaluating potential investments can be spread over a large number of transactions, thereby reducing unit costs.

The result of Stage 1 of the OTC Benchmarking Project showed that there are significant economies of scale in otc operations. Total operating costs per deal drop consistently as firm size increase.

Financial intermediation may also provide economies of scope with the provision of 'one-stop shopping' for clients. This reduces the search costs of the participants in the financial services sector.

3. Liquidity Management Allowing Mismatch of Transactions

Intermediaries match the imbalance between the financial requirements of various end-users. Seldom do clients' needs match in terms of credit risk, maturity dates, interest rate, liquidity, or currency risk. By pooling transactions, intermediaries are able to accommodate this mismatch.

4. Rational Allocation of Financial Resources

Financial intermediaries allocate capital against the risks which are taken. The cost of that capital is reflected in the prices to the end-users, normally in an internally consistant risk management framework. This process goes a long way towards ensuring that scarce resources are properly priced, thereby assisting the financial system in the efficient allocation of those resources across the competing needs.

5. Allocation Economies

Facilitating large volume lending and borrowing transactions that are beyond the resources of individual participants.

Primary and Secondary Trading

All financial transactions, including OTC financial products have 'primary' or 'secondary' trading. This distinction indicates whether the transaction relates to an instrument which is new or not. Secondary trading refers to trades which are subsequent to the initial issue to the market, or issuance. All transactions which are originated by bilateral negotiation between two counterparts, and which do not produce a tradable interest (or property), are considered initial issuance or primary trades. Examples include foreign exchange or derivatives transactions.

Primary trading is where financial products are issued for the first time by the issuer. Sometimes these transactions are referred to as capital market transactions. An example of a primary trading transaction would be where the Commonwealth Treasury raised funds by issuing bonds, or treasury notes. These transactions also include securities issued directly to underwriters, who in turn on-sell the securities to end investors. Market capitalisation is the current value of all primary issuance at a date.

Secondary Trading is the term used to describe the situation where products are on-sold or traded between participants after the initial issuance. Secondary trading may occur many times over, and the seller may have absolutely no relationship with the original borrower of the funds, or with the primary issue itself.

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1 comment:

Unknown said...

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