Bonds trade in the over-the-counter (OTC) market while stocks trade on organized exchanges. Derivatives can trade in both – but there are key differences between OTC and exchange-traded derivatives.
Derivatives that are traded OTC are negotiated and executed offline. This means that the network of dealers, who are also regulated just like the bond and stock markets, negotiate with other dealers over the phone or online terminals, with the majority of these dealers being financial institutions negotiating on behalf of their clients.
The OTC derivatives market is private and has neither trading floors nor regular trading hours. And since these contracts are negotiated, it means that the derivatives can be highly customized to meet specific needs, making them slightly more complex than exchange-traded derivatives, but this allows for special features to be added.
Since these contracts are highly customized, there may be no secondary market for such instruments.
Similar to the stock market, derivatives can be traded on an exchange. Unlike their OTC counterparts, a derivatives exchange has either an electronic trading system or trading floor that is a separate corporate entity whose sole purpose is to facilitate trading derivative contracts.
Since there are rules and regulations for market players, there is increased liquidity, standardization, and less price volatility, as the exchange ensures fairness, order, and transparency in the marketplace.
In Canada, the only derivatives exchange is the Montreal Exchange (Bourse de Montréal), which lists options on stocks, indexes, USD, and futures on bonds, and banker’s acceptances (BAs).
Parties in the exchange-traded market such as banks and investment dealers, are the market makers and are on standby to buy or sell contracts when necessary.