Importance of OTC Derivatives in Modern Banking
OTC derivatives are significant part of the world of global finance. The OTC derivatives markets are large and have grown exponentially over the last two decades. The expansion has been driven by interest rate products, foreign exchange instruments and credit default swaps. The notional outstanding of OTC derivatives markets rose throughout the period and totaled approximately US$601 trillion at December 31, 2010. In the past two decades, the major internationally active financial institutions have significantly increased the share of their earnings from derivatives activities. These institutions manage portfolios of derivatives involving tens of thousand of positions and aggregate global turnover over $1trillion. The OTC market is an informal network of bilateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets. International financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefit from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance.
The advantages of OTC derivatives over exchange-traded ones are mainly the lower fees and taxes, and greater freedom of negotiation and customization of a transaction, as it involves only a seller and a buyer and no standardization authority.
The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
Read more about this topic: Over-the-counter (finance)
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