Derivatives · Intermediate · 4 min

Exchange-traded vs. OTC

You can tell exchange-traded from OTC derivatives and explain what a clearing house changes for prices, standardization and counterparty risk.

Same index, different backer

A future on an exchange and a CFD with a broker can follow exactly the same stock index. On the chart, they move almost identically.

Behind them, they are built very differently: one sits in a standardized market with a clearing house, the other is a private contract with a company. This lesson explains the difference, building on the lesson on exchanges and OTC trading earlier in the course.

Cleared vs. counterparty

Exchange-traded derivatives, such as futures and listed options:

have standard terms set by the exchange: size, expiry dates, settlement,
trade in a public order book, with prices everyone can see,
are cleared by a central counterparty, a clearing house that becomes the buyer to every seller and the seller to every buyer. It requires margin from all participants every day, as the CFTC describes. If one trader fails, the clearing house steps in.

The OCC, the clearing house for US listed options, describes in its risk disclosure how this standardization and central clearing work.

OTC derivatives, such as CFDs and many bank products:

are agreed directly with a provider or bank,
have terms and prices set by that provider, often without a public order book,
depend on the provider being able and willing to pay.

For private investors, the most common OTC derivative is the CFD. Its price follows the underlying, but the contract is with the provider. As you saw in the rubric on markets, the provider may also be the counterparty that profits when you lose.

Exchange-traded is not automatically better for everyone. Contract sizes can be large and some markets are hard to access. But it removes the risk of one specific counterparty and makes prices transparent.

Who stands behind it?

A fictional trader holds two positions on the same index: a future on an exchange and a CFD with a small provider.

The provider runs into financial trouble and stops processing withdrawals.
The future is unaffected. The clearing house, not the provider, stands behind it, and daily margin settles gains and losses.
The CFD balance is now a claim against the provider. EU rules protect segregated client money, but the trader may wait months to get it back.

Both positions followed the index perfectly. Only one depended on a single company.

Common mistakes

Assuming every derivative trades on an exchange. CFDs and many bank products are OTC.
Ignoring counterparty risk. OTC contracts are only as good as the party behind them.
Comparing OTC prices without a reference. Check them against the underlying market.
Thinking exchange-traded means low risk. Leverage still applies.

The takeaway

Exchange-traded derivatives are standardized and cleared centrally. OTC derivatives are agreed with a counterparty, so you depend on that party.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the type where a clearing house stands between buyer and seller.

Tap the chart.

On an exchange, a central counterparty takes on both sides and requires margin from everyone.
2Which of these is usually traded OTC by private investors?

CFDs are contracts with the provider. Futures and listed options are traded on exchanges.
3What does a central counterparty do?

This removes the risk that the original counterparty fails, as long as the clearing house stands.
4Why can OTC prices be harder to compare?

Without a public order book, you see the provider's prices, not the whole market.

of 4 correct.