Different between Over The- Counter and Exchange Traded

Derivatives is a very broad term, just as the word animals is. Basically, a derivative is
a financial instrument that derives its value from an underlying instrument, ranging from
stocks to commodities. Examples of derivatives include options, futures, forwards, swaps
(e.g. credit default swaps), contract-for-difference and so on.

In every derivative transactions, there are always two parties (obvious) and a legal
contract. This gives rise to two types of derivatives based on how the contract is
negotiated:

1. Over-The-Counter (OTC) For OTC derivatives, the contract between the two parties
are privately negotiated and traded between the two parties directly. Therefore, the
contract can be tailor-made to the two parties liking. This arrangement is very flexible,
but there are disadvantages:
1. The value of your derivative is as good as the credit-worthiness of your counter-party.
If your counter-party goes bust, your derivative becomes worthless.
2. It is very hard to pass on the derivative to a third-party because the contract is already
signed between the two original parties.
3. It is very hard to discover the market price of a derivative contract because there is no
transparency in the pricing and it is very hard to value unique contracts uniformly on a
mass scale.
2. Exchange-Traded (ET) For ET derivatives, the situation is different. They are traded
via an intermediary, the exchange, which is a strong institution with deep pockets.
Therefore, technically speaking, even if Tom and Dick trade a derivative between each
other, their counter-parties are not each other- rather both of their counter-parties is the
same exchange. In other words, if Tom sell an ET derivative to Dick, the exchange acts
as a buyer to Tom and a seller to Dick. The advantages of such an arrangement is:
1. Since all market participants counter-parties is the exchange, the derivative contracts
are standardised.
2. There is no credit risk between market participants. For example, if Tom has no need to
fear if Dick defaults on the contract. If that happens, it is the exchange that has to bear
the consequences.
3. There is a very visible and transparent market price for the derivatives.