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A Guide to Trading OTC Contracts

ChAI
Published by ChAI
May 29 2024
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A Guide to Trading OTC Contracts

OTC’s (over-the-counter) are derivative financial contracts that can be made customisable between two parties, rather than through a centralised exchange, and derive their value from an underlying asset such as commodities, currencies, interest rates, or stocks.

Common examples of OTC contracts include:

  • Forwards: Agreements to buy or sell an asset at a predetermined price and date in the future.
  • Swaps: Contracts to exchange cash flows, such as those related to interest rates or currencies
  • Options: Contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price.

Here we provide a high-level guide to understand OTC trading, including the advantages, risks and common mistakes.

How OTC Derivatives Trading Works

OTC derivatives trading occurs directly between counterparties, typically through bank dealing desks, or brokers like ADM, ED&F Man or ICAP, acting as market makers. The process involves:

  1. Negotiation of the contract terms (the contract price, quantity, maturity, etc.) between the buyer and seller.
  2. Execution of the trade through a dealer network or electronically via an OTC trading platform provided by the brokers and banks.
  3. Ongoing management and settlement of the contract until expiration or termination, via middle office and back office operations.

Advantages of OTC Commodity Derivatives

  • Customisation - OTC commodity derivatives allow traders to customise contract terms like delivery dates, locations, and quantities to precisely match their hedging or speculative needs. This flexibility is advantageous compared to standardised exchange-traded contracts.
  • Access to Niche Markets - Some niche commodities or grades may not have sufficient liquidity for exchange trading. OTC contracts provide access to these specialised markets that are too small for centralised exchanges.
  • Price Risk Management - Commodity producers and consumers can use OTC forwards, swaps, and options to lock in future prices, hedging against adverse price movements and providing more stable revenue/cost projections.
  • Leverage - OTC commodity derivatives often require lower margin requirements compared to exchange-traded products, allowing traders to gain leveraged exposure with less upfront capital.
  • Privacy - The bilateral nature of OTC trading allows parties to negotiate large transactions privately without revealing their positions to the broader market.

Common Commodity Markets where OTC Contracts are Traded

The most commonly traded commodities in OTC markets include:

Energy Commodities:

  • Crude oil and refined products (gasoline, heating oil, etc.)
  • Natural gas

Agricultural Commodities:

  • Grains (wheat, corn, soybeans, etc.)
  • Softs (coffee, sugar, cocoa, etc.)
  • Livestock (live cattle, lean hogs)

Metals:

  • Precious metals (gold, silver, platinum, palladium)
  • Base metals (copper, aluminium, zinc, nickel)

Energy and agricultural commodities have very active OTC markets for derivatives allowing producers, consumers, and traders to hedge price risk and meet customised delivery needs.

Further Examples of over-the-counter (OTC) Commodity Derivative Contracts:

Energy Commodities:

  • Crude Oil Swaps - Oil producers and consumers can enter into OTC swaps to hedge against fluctuations in crude oil prices. For example, an airline may use an OTC swap to lock in jet fuel prices for future deliveries.
  • Natural Gas Forwards - Natural gas producers can sell forward contracts OTC to lock in prices for future production and delivery.

Agricultural Commodities:

  • Grain Forwards - Farmers can sell forward OTC contracts to grain merchants or processors to lock in prices for their future crop deliveries.
  • Livestock Swaps - Meat packers can use OTC swaps to hedge their future costs of purchasing live cattle or hogs.

Metals:

  • Precious Metals Options - Mining companies may use OTC options to hedge exposures to fluctuating gold, silver or platinum group metals prices.
  • Base Metals Swaps - Producers and consumers of industrial metals like copper, aluminium or zinc can enter into OTC swaps to manage price risk.

Summary

The OTC market provides flexibility to trade commodity derivatives with tailored sizes, grades, and locations compared to standardised exchange-traded contracts. While exchanges offer liquid, centralised trading, the OTC market allows participants to negotiate bespoke terms for hedging or trading across a wide range of physical commodity markets.

However, OTC trading lacks transparency and central clearing, so robust risk management practices are crucial. To mitigate risks, OTC derivative trades often involve collateral agreements, credit checks, and clearing through central counterparties. Proper due diligence on counterparties and effective collateral management are crucial to mitigate this risk.

ChAI Protect

At ChAI we offer a product that mimics all of the characteristics of an options strategy, but is embodied as an insurance product. We offer this in markets where there is no exchange traded product (for example in packaging materials) and directly replicate the risk our clients have in terms of the price indices they have exposure to.

This means that our insurance product also covers some of the advantages of an OTC type of product, where ChAI protect offers similar flexibility to our customers in that they are able to trade across a range of specialised niche Commodity markets, and raw material grades, and also trade in bespoke locations across the globe compared to standardised exchange-traded contracts.

Additionally, as ChAI protect is an insurance product, there are no minimum volumes, standard specifications, and no margin calls. You can also use simplified mark-to-market accounting.

Inclusions & exclusions can be seen here.

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