Over-the-Counter Derivatives Markets

The OTC derivatives markets comprise an informal network of market participants that are willing to create and trade virtually any type of derivative that can legally exist. The backbone of these markets is the set of dealers, which are typically banks. Most of these banks are members of a group called the International Swaps and Derivatives Association (ISDA), a worldwide organization of financial institutions that engage in derivative transactions, primarily as dealers. As such, these markets are sometimes called dealer markets. Acting as principals, these dealers informally agree to buy and sell various derivatives. It is informal because the dealers are not obligated to do so. Their participation is based on a desire to profit, which they do by purchasing at one price and selling at a higher price. Although it might seem that a dealer who can “buy low, sell high” could make money easily, the process in practice is not that simple. Because OTC instruments are not standardized, a dealer cannot expect to buy a derivative at one price and simultaneously sell it to a different party who happens to want to buy the same derivative at the same time and at a higher price.