Although OTC market brings more convenience to participants by providing customized tools, there are also a series of risks. In a typical OTC transaction, both parties will bear the risk of counterparty default, and the clearing house has no performance guarantee. In addition, many independently negotiated OTC transactions cannot be transferred to a third party without the consent of both parties to the original transaction.
Transaction execution and confirmation
Over-the-counter transactions are completed on a bilateral basis by telephone or broker cross-network. In recent years, more and more participants trade and confirm through electronic platforms. When both parties submit electronic confirmation information containing transaction details, the transaction confirmation matching process is completed.
Commodity pricing
Many commodity traders use OTC and futures markets to find prices and even arbitrage. Over-the-counter pricing of most commodity derivatives is based on easily observed market prices (benchmark futures contracts or physical objects). Although the contract of the exchange regulates the types and quantities of delivery commodities, hedging or OTC speculation can still be carried out as long as there is a correlation between the subject matter of OTC trading and futures varieties.
Mortgage and liquidation
In typical over-the-counter market transactions, credit risk refers to the possibility of counterparty default. In order to reduce credit risk, market participants use a large number of bilateral mortgage contracts, that is, through ISDA's credit support additional agreement. At present, about 60% of off-site bilateral clearing contracts meet the additional agreement on credit support. A typical bilateral mortgage loan contract stipulates that the contract value should be evaluated regularly.
If the total value of the contract is higher than a certain threshold for one party, such as A, then the other party, such as B, will pay the collateral with a value equivalent to the difference between the total contract value and a certain threshold according to the provisions of the contract. After B pays the collateral, if the contract value changes in favor of B to make the difference between the contract value and a certain threshold narrow, B can redeem part of the deposit. In case B defaults, A can get collateral. If B fails to pay the collateral as required, A also has the right to terminate the contract.
The above specific threshold can be regarded as the credit line granted by one party to the other. Usually, cash and acceptable securities can offset the deposit. The value of these securities will be converted into a certain proportion according to their market value, and then offset with deposits. The mortgage contract provides protection against breach of contract. However, certain threshold sets are not protected. Furthermore, even if the threshold is set to 0, it cannot constitute complete protection. This is because if a company is in financial trouble, it is likely to stop paying collateral. At this point, when the other party exercises the right to terminate the contract, the contract value has changed greatly in favor of the other party.
In China, considering the healthy development of the OTC market, mortgage should include the following three points: (1) full re-mortgage of cash or other collateral; Appropriate counterparties based on credit support additional agreements, as well as credit risk assessment and financing valuation adjustment; Improve the guarantee and protection clauses when the counterparty defaults.
Off-site centralized liquidation
OTC derivatives are becoming more and more popular, and some specific institutions operating futures exchanges have begun to provide clearing services for OTC transactions. Compared with off-site bilateral clearing, central counterparty clearing reduces the credit risk of multiple counterparties, and the net settlement of multiple short positions or short positions of a series of products will reduce the demand for collateral. At the same time, it also enhances the transparency of the contract price of each transaction. The contract price provided by the clearing house for settlement at the end of the trading day.
The agreement reached by G20 at Pittsburgh Summit accelerated the trend of centralized liquidation. The agreement includes: all standardized OTC derivatives contracts should be traded on exchanges or approved electronic trading platforms, and must be cleared through central counterparties and reported to the trading database. At present, regulators in the United States, the European Union and Japan are implementing this reform.
However, unless the centralized clearing of OTC derivatives contracts becomes a mandatory requirement of globalization, some traders still support the traditional OTC market. These traders pay more attention to the flexibility brought by personalized trading, and they try to avoid brokerage fees and deposits required by exchanges. Some traders also prefer the low transparency and supervision of over-the-counter trading.