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What is EXCHANGE-TRADED DERIVATIVE?

A DERIVATIVE contract, traded through an authorized EXCHANGE and cleared


through a CLEARINGHOUSE, that is characterized by standard terms and
conditions, and is subject to standard MARGIN requirements and clearing rules.
Trading in exchange derivatives may occur in physical OPEN OUTCRY form, or
increasingly in electronic form. The three main classes of exchange-traded
derivatives are FUTURES, OPTIONS, and FUTURES OPTIONS. Contracts are
available on a broad range of national and international ASSET references, including
INTEREST RATES, FOREIGN EXCHANGE, EQUITIES, and commodities. Also
known as LISTED DERIVATIVE.

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Exchange-traded versus Over-the-counter


(OTC) Derivative
An exchange traded product is a standardized financial instrument that is traded on an organized
exchange.
An over the counter (OTC) product or derivative product is a financial instrument traded off an
exchange, the price of which is directly dependent upon the value of one or more underlying
securities, equity indices, debt instruments, commodities or any agreed upon pricing index or
arrangement.
The most common types of derivative products are interest rate swaps, caps and their offshoots.
Over 90% of commercial bank derivative trading is interest rate related due to the natural ebb
and flow of their corporate finance and hedging activity.
The reason derivative products exist is that users often need customized products as the
standardization of exchange products can lead to hedging mismatches and gap exposures.
The main differences between exchange and OTC products can be viewed as follows:

Exchange Traded

OTC Traded

Pricing

Standardized

Customized

Maturity

Standardized

Customized

Quantity

Standardized

Customized

Frequency

Standardized

Customized

Quality

Standardized

Customized

Documentation

Standardized

Customized

Regulatory Body

One entity

Various

The primary difference is standardization versus customization. This leads to a crucial distinction.
When dealing in exchange traded products terms are standardized and the clearinghouse
guarantees that the other side of any transaction performs to its obligations. That is, it assumes
all contingent default risk so both sides do not need to know about each others credit quality.
This differs from customized OTC products where there is no clearinghouse to guarantee
performance.

The need to know the counterpartys credit standing is an essential distinction. The exposure
difference is quite significant. In summary:
Exchange Traded = Standardizes = Market Risk
OTC Traded = Customized = Market Risk + Counterparty Risk