Otc

The name comes from the days when securities were literally sold across the counter at a bank or broker. Today the counter is a telephone or electronic network, but the principle is the same: a buyer and a seller, or their dealers, agree a price directly.

There is no central exchange matching every order. Much of the world's financial activity is traded this way.

Government and corporate bonds, foreign exchange and many derivatives such as swaps are largely OTC, and so are shares of smaller companies that do not meet the listing standards of a major exchange. Large institutions use OTC markets because they can tailor the size, timing and terms of a deal.

The flexibility comes with trade-offs. Prices are less visible, so a buyer may not know whether the dealer's quote is competitive without asking several dealers.

Spreads, the gap between the price a dealer will buy at and sell at, tend to be wider for less actively traded instruments. There is also counterparty risk, meaning the risk that the other side fails to honour the deal.

On an exchange, a clearing house stands between the parties and guarantees settlement. In an OTC trade, the two parties rely on each other and on legal agreements and collateral, although regulation has pushed many standard derivatives into central clearing.

For a finance team, the practical lessons are to obtain more than one quote, to understand who the counterparty is and what collateral is needed, and to record trades properly. Because OTC trades are not on a public screen, the company's own records and confirmations are the main evidence of what was agreed.

Regulation has changed the picture since the financial crisis. Standard derivatives are increasingly required to be reported to a central database and, where they are simple enough, cleared through a clearing house.

These rules were introduced to make the OTC market more transparent and to reduce the damage if one participant fails.