Comparing the Benefits of OTC and Exchange-Traded Derivatives

Price discovery and transparency mechanisms are typically better in exchange-traded markets than in OTC markets.  This is to be expected, as electronic communication networks (ECNs) in exchange-traded markets allow for complete and immediate transactions and pre-trade price data.  Despite the presence of active brokers in OTC markets, electronic media (e.g. Reuters, Bloomberg, Markit), post-trade price reporting through TRACE, and dealer runs, OTC markets are relatively opaque.  For not only do buyers and sellers in OTC markets privately negotiate terms in relative isolation from the prices and trades occurring elsewhere in the market, but also dealers prefer at least some market opacity.  Too much price transparency would increase competition and put pressure on bid-offer spreads to a point where dealers are discouraged from intermediating.  It has been suggested that due to their undisclosed nature, dark pools may detract from heightened price transparency in exchange-traded markets.
Which market allows for more effective risk management is actually two separate matters: which is better at managing counterparty risk, and which has better at hedging risk (e.g. cash flow, fair value, or net investment risk).

It is unclear which market has the edge in terms of reducing counterparty risk.  It is crucial to understand that clearinghouses and exchanges are not the same thing—that it is a clearinghouse that allows better counterparty risk mitigation by mutualizing losses from failures, netting trades, requiring parties to post collateral, and centralizing trade reporting.  Central clearing also reduces the need for trade participants to formulate complex in-house models to manage counterparty risk.  Many large U.S. derivatives exchanges also have their own clearinghouses, so it just happens that most exchange-traded derivatives are also cleared through the exchange’s clearinghouse.  Now that regulators are enforcing central clearing in OTC markets, the balance is less clear.  It used to be that the inherent opacity of OTC derivatives and limited post-trading infrastructure hampered risk management.  Because of the private nature of OTC markets, it was difficult to assess how different institutions were interlinked and how risk exposures were distributed.

It should be noted that having central counterparties does not completely eliminate systemic risk, as the risk is simply shifted to the clearinghouse.

In terms of hedging power, it could be said that OTC markets offer greater flexibility to meet individual buyers and sellers’ risk management needs.  Due to the lack of a standardization authority, parties have greater flexibility in the terms of the trade, latitude to negotiate, customizability, and ability to use non-standard products.  OTC markets are also better testing grounds for customized products before they are standardized.

Transaction costs in exchange-traded markets are competitive with, if not lower than those in OTC markets.  This is because regulations have pushed up OTC derivative trading costs, and the greater transparency in exchange-traded markets supports more competitive pricing.  Certain listed products have huge trading volumes (economies of scale), trades are fully automated (technology), and greater trade uniformity.  In the past, OTC derivatives had a clear cost advantage over exchange-traded derivatives, due to lower fees and taxes, and the lack of margin requirements.  It was often more costly to do business on an exchange rather than off-exchange, because of the substantial margin/collateral (in the range of 5-15% of the total notional value of the transaction) requirements for clearing or trading on exchanges.