This paper examines the benefits and use cases of over-the-counter (OTC) equity derivatives (EQDs). Additionally, it analyzes developments in the OTC EQD market, including the size and changes based on geography, product offerings and maturities of the notional outstanding.
Institutional investors, asset managers, hedge funds, pension funds, endowments, public and private companies, insurance companies, banks and other market participants use OTC EQDs for a wide range of reasons, including hedging, investment exposure, market access and diversification.
- Hedging: OTC EQDs offer flexibility and the ability to customize investment hedges.
- Investing: OTC EQDs can be structured to provide specific directional exposure and a more efficient means of investing in an underlying equity, index or basket.
- Market access: OTC EQDs can provide access to equity markets and companies that are either unavailable or too illiquid for investment via cash equity or exchange-traded EQD markets.
- Portfolio diversification: OTC EQDs provide an efficient means of diversifying investment portfolios by enabling more precise control of portfolio allocations.
The size of the OTC EQD market has been relatively stable over the past 15 years, ranging between $6.3 trillion and $7.6 trillion in notional outstanding. It comprises a relatively small percentage – 1-2% – of the overall OTC derivatives market.
From a product perspective, the OTC EQD market consist of swaps, forwards, options, contracts for difference and ‘other’ products.
- Notional outstanding of equity forwards and swaps has grown compared to that of OTC equity options.
- The US is now the dominant region for OTC EQD total notional outstanding measured by the nationality of the underlying issuer of the reference equity, whereas European developed countries were once the leaders.
- Most OTC EQDs have a short maturity – 63% of notional outstanding has a remaining maturity of one year or less.
The regulatory framework for these products has evolved in recent years. OTC EQDs have become more regulated and transparent, with trade reporting, margining and other rules now in place. The US Commodity Futures Trading Commission, the US Securities and Exchange Commission, the European Securities and Markets Authority and the UK Financial Conduct Authority have fully implemented regulations for OTC derivatives, including EQDs.
Documents (1) for Overview of OTC Equity Derivatives Markets: Use Cases and Recent Developments
FAQs
The International Swaps and Derivatives Association (ISDA) is a private trade organization whose members, mainly banks, transact in the OTC derivatives market. This association helps to improve the market for privately negotiated over-the-counter (OTC) derivatives by identifying and reducing risks in that market.
What is the International Swap Dealers Association agreement? ›
An ISDA master agreement is a standard document regularly used to govern over-the-counter derivatives transactions. Published by the International Swaps and Derivatives Association (ISDA), an ISDA master agreement is a standardized contract for over-the-counter (OTC) derivative transactions.
What are the six types of OTC derivatives? ›
The following kinds of OTC trading are available based on the underlying assets below:
- Interest Rate Derivatives. In this case, the underlying asset is a standard interest rate. ...
- Commodity Derivatives. ...
- Equity Derivatives. ...
- Forex Derivatives. ...
- Fixed Income Derivatives. ...
- Credit Derivatives.
OTC Derivatives can include transactions that give right to interchange derivative instruments that depend on price or return of a security or price of a foreign currency or a precious metal or a precious stone or an interest rate and changes in them with derivatives of these instruments and with said underlying assets ...
What are the three pillars of ISDA? ›
In this regard, ISDA is very pleased to see that the NAFMII Agreement contains what are hailed as the “three pillars” of derivatives documentation for risk management purposes, namely, the concepts of “single agreement”, “flawed asset” and “close-out netting”.
Can you trade without an ISDA? ›
ISDA master agreements are required between any two parties trading derivative securities in a privately-negotiated or over-the-counter (OTC) agreement rather than through an established exchange. The majority of derivatives trading is done through private agreements.
What are the two major types of swap contracts? ›
The two most common types of swap contracts are:
- Interest rate swaps: These allow counterparties to exchange interest rate payments. ...
- Currency swaps: These allow counterparties to exchange principal and interest payments in different currencies.
A swap dealer with respect to any physical commodity will be deemed a swap dealer, at a minimum, for the entire “other commodity” class. As a result: o A market participant that “makes a market in swaps” for one region of the U.S. power market would be a swap dealer for crude oil, gasoline, heating oil, gold and wheat.
What is an example of a swap agreement? ›
For example, one investor holds an asset that pays 10 percent interest, and another investor holds an asset that pays five percent. To minimize the effects of interest rate volatility, they agree to exchange interest payments in the case that rates change.
What are the 4 types of derivatives? ›
There are four main types of derivatives: forward contracts, futures contracts, options contracts, and swap contracts.
Risks of OTC markets
Regulatory risk: OTC markets are generally subject to less stringent regulations compared to exchanges, making them more susceptible to manipulation and fraud. Price volatility: Lower liquidity and limited public information can lead to higher price volatility in OTC markets.
Who trades OTC derivatives? ›
Over-the-counter (OTC) market securities are traded without being listed on an exchange. Securities trade OTC through a dealer or broker specializing in OTC markets. OTC trading helps small investors enter the market.
What makes OTC derivatives risky? ›
Higher credit risk: OTC derivatives, lacking regulatory oversight, introduce an elevated level of credit or default risk. The absence of a supervisory body increases the potential for counterparty default, exposing participants to financial uncertainties and losses.
Who uses OTC derivatives? ›
Institutional investors, asset managers, hedge funds, pension funds, endowments, public and private companies, insurance companies, banks and other market participants use OTC EQDs for a wide range of reasons, including hedging, investment exposure, market access and diversification.
Is IRS an OTC derivative? ›
An interest rate swap (IRS) is an OTC derivative contract in which two parties periodically exchange interest payments of different types, on a specified notional principal, during a set period of time. IRS are part of a family of financial products known as interest rate derivatives.
What is the purpose of signing ISDA? ›
The ISDA Master Agreement gives all participating parties legal structure and security for their transactions. Moreover, it regulates any and all trades they participate in because the terms of the master agreement automatically carry over to future transactions.
What are the goals of ISDA? ›
ISDA fosters safe and efficient derivatives markets to facilitate effective risk management for all users of derivative products.
What is the purpose of the ISDA schedule? ›
Also known as Schedule to ISDA® Master or simply ISDA Schedule or Schedule. A document which parties to a derivatives transaction typically use to alter the terms of, or add terms to, the pre-printed standard form ISDA® Master Agreement.
How do ISDA protocols work? ›
An ISDA protocol is a multilateral contractual amendment mechanism which has been used to address changes to ISDA standard contracts and other documentation since 1998. The fundamental benefit to an adhering party to a protocol is that it eliminates the necessity for costly and time-consuming bilateral negotiations.
