Over-the-counter markets are characterised by a variety of aspects, activities and processes. This includes flexibility concerning the terms and conditions in the negotiation process, choice of preferred broker, discretion with order execution and counterparty risk management.
The two counterparties of any OTC transaction will (only) be known to these parties themselves (and eventually the involved broker). This means, they are not known to others. As buyer and seller know their counterparty OTC trading is not completely anonymous, but getting close.
As market participants only know about the deals they are involved with themselves, one could say OTC trading lacks transparency. Until the 2008 global financial crisis and the Lehman Brothers debacle, OTC trading has never been transparent. Therefore, policy makers wanted to have regulation in place to end this situation. This was one of the conclusions of the G-20 meeting in Pittsburgh (US) in 2009. At political level there was agreement to develop legislation to regulate OTC derivatives trading. As a result, around the globe, new legislation has been developed. Resulting regulatory packages assure transparency at the level of authorities. The legislation has also strengthened counterparty risk management concerning OTC derivatives, for instance, by trading more on exchanges or via clearing of OTC deals and collateralisation of open positions.
Buyers and sellers meet each other on specific market places to exchange goods, services or agreements. Buying and selling market participants execute orders, to conclude transactions. This can only be effectuated when they are able to find a counterparty.
Market liquidity (or asset liquidity) concerns a concept to describe the level of trading activity in a market (or a product). Clearly, some markets are traded more actively than others. This is dependent on a variety of factors, including the number of (potential) buyers and sellers, the number of orders they place in the market and the volume of those orders.
Each product-market combination has its own specific characteristics, including liquidity. Some OTC markets are traded more actively than some exchange-operated markets, while in other cases, the opposite applies. When identical products, with exactly the same specifications, are traded both in an OTC market and on an exchange, market liquidity may be comparable, but often differs significantly.
Deal-making at an exchange can pool trading activity relatively easy, especially as exchange-traded products are standardised. Besides, multilateral netting (via the so-called central counterparty) allows for opening and closing positions before the relevant contracts mature. The offset of opposing positions (long versus short) lowers counterparty risk significantly.
When an organisation wants to do business and is seeking to enter into an agreement, its employees are keen to know where the chance of finding a counterparty at a reasonable price is optimal. This means that market participants prefer a liquid market.
When entering into a bilateral deal all relevant conditions have to be stated in the contract. Counterparties themselves define the specifications, such as product details, the volume, the pricing unit and currency, and the delivery date and place. Next, conditions have to be agreed upon with respect to legal and tax issues. However, the latter aspects, most of the times, are applicable to all transactions. These are likely to be incorporated in a legal framework that applies to all future transactions between the two relevant parties that have agreed upon such a master agreement.
Altogether, in case of a bilateral deal, counterparties can tailor the contract. On the contrary, exchange-traded products always concern standard products. The exchange sets the contract specifications after which it is up to the market participants whether they want to enter into such an agreement, or not. In other words, at the exchange a market participant has only one choice: take it, or leave it. On the other side, OTC deals provide flexibility. OTC contracts can be structured, although this is not a necessity.