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Why they are only traded OTC ? And why in general derivatives are all traded only OTC ?

Why do banks prefer to trade OTC rather than exchange market ?

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  • $\begingroup$ Hi noob2, I don't quite get what you said. $\endgroup$ – hawarden_ Sep 10 '20 at 13:02
  • $\begingroup$ Hi noob2, yes I think you misunderstood the question. I would like to know why forwards are only traded in OTC, and not in exchange-traded market. I'm not referring to FX exchange. $\endgroup$ – hawarden_ Sep 10 '20 at 13:14
  • $\begingroup$ "Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets." This is what I found in Wikipedia, but not quite get why it's not "standardized". $\endgroup$ – hawarden_ Sep 10 '20 at 13:17
  • $\begingroup$ It's just the nature of the contracts. This is a little like asking why variance swaps are only done OTC and not via exchange--they can't be sufficiently standardized to be traded on an exchange given counterparties usually have specific requirements that make somewhat standardizing pointless. $\endgroup$ – Chris Sep 10 '20 at 16:52
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The competition between FX forwards (interbank) and FX Futures (Exchange traded) has so far resulted in much more trading done with banks. The reasons for this (from the customers point of view) are:

  • The interbank market is highly flexible as to currencies, delivery dates and amounts (basically whatever the customer wants), whereas the futures trade for a limited set of delivery dates (for the EuroFX futures: one per month for the next approx 6 months https://www.cmegroup.com/trading/fx/g10/euro-fx_quotes_globex.html, and the amount has to be a multiple of 125,000 EUR). And minor currencies are not available as Futures at all. (Note that the "standardization" is a disadvantage if the customer wants (for ex.) 200,000 EUR on a different date than the third Wednesday of the month (the standard delivery date for EuroFX futures). Put differently, the flexibility is a big advantage for the banks).

  • Many companies do not have an account that can trade futures, but they generally have a relationship with a bank (which, even if it does not trade FX can introduce them to another bank that does).

  • The volume is larger Interbank so there is more liquidity there and that tends to attract more customers (feedback loop). This is very difficult to change.

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    $\begingroup$ IMO, the primary reason institutions trade forwards v futures is your first point--if I'm a SWF and want to trade \$687,000 notional NZDUSD currency exposure versus \$700,000 or want to settle mid-month or 7 months from now v on a quarterly schedule, I trade forwards. $\endgroup$ – Chris Sep 10 '20 at 16:54
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Futures are the exchange-traded equivalent of forwards. For something to trade listed you need to have a standardized contract. A forward is usually quoted as a rate reference to execution. For example:

Customer: "Quote me an SPX forward for 180 days." Bank: "1.0123 x 1.01234"

Customer: "I lift you for 20k units, vwap over 10 minutes starting now."

The bank will then trade the cash equivalent and write and OTC forward to the customer. The price of the forward will be 1.01234 x

Banks (used to) prefer OTC because the bank collects margin from customers and gives them nothing. Under the new rules banks sometimes have to give customers collateral, so it's not as good anymore. With listed/exchange trades everyone has to deliver collateral.

Also - I think the other poster had a good point. Some customers just can't trade listed in many markets. A lot of times you have non US clients who want US access. It's just easier to deal with a bank directly in that case. (Although there are many clients who have the ability to trade listed and don't have ISDA's - so it does go both ways)

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