79. The Difference Between Over the Counter (OTC) and Exchange-Based Markets

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When trading stocks or futures you normally do so via a centralized exchange such as the New York Stock Exchange or the Chicago Mercantile Exchange. In addition to providing a centralized place where all trades are conducted, exchanges such as these also play the key role of acting as the counterparty to all trades. What this means is that while you may be buying for example 100 shares of Google stock at the same time someone else is selling those shares, you do not buy those shares directly from the seller but instead from the exchange.

The fact that the exchange stands on the other side of all trades in exchange traded markets is one of their key advantages as this removes counterparty risk, or the chance that the person who you are trading with will default on their obligations relating to the trade.

A second key advantage of exchange traded markets is that as all trades flow through one central place, the price that is quoted for a particular instrument is always the same regardless of the size or sophistication of the person or entity making the trade. This in theory should create a more level playing field which can be an advantage to the smaller and less sophisticated trader.

Lastly, because all firms that offer exchange traded products must be members and register with the exchange, there is greater regulatory oversight which can make exchange traded markets a much safer place for individuals to trade.

The downside that is often cited about exchange traded markets is cost. As the firms who offer exchange traded products must meet high regulatory requirements to do so, this makes it more costly for them to offer these products, a cost that is inevitably passed along to the end user. Secondly, as all trades in exchange traded products must flow through the exchange this gives these for profit entities immense power when setting things such as exchange fees which can also increase transaction costs for the end user.

Unlike the stock market and the futures market which trade on centralized exchanges, the spot forex market and many debt markets trade in what’s known as the over the counter market. What this means is that there is no centralized place where trades are made, instead the market is made up of all the participants in the market trading among themselves.

The biggest advantage to over the counter markets is that because there is no centralized exchange and little regulation, you have heavy competition between different providers to attract the most traders and trading volume to their firm. This being the case transaction costs are normally lower in over the counter markets when compared to similar products that trade on an exchange.

As there is no centralized exchange the firms that make prices in the instrument that is trading over the counter can make whatever price they want, and the quality of execution varies from firm to firm for the same instrument. While this is less of a problem in liquid markets such as FX where there are multiple price reference sources, it can be a problem in less highly traded instruments.

While the lack of regulation can be seen as an advantage in the above sense it can also be seen as a disadvantage, as the low barriers to entry and lack of heavy oversight also make it easier for firms offering trading to operate in a dishonest or fraudulent way.

Lastly, as there is no centralized exchange the firm that you trade with when you trade in an over the counter market like forex is the counterparty to your trade, so if something happens to that firm you are in danger of loosing not only the trades you have with that firm but also your account balance.

It is for these reasons that there is so much focus among forex traders as to which firm to trade with, with special attention being paid to the financial stability of the firm and the execution that they provide.

As we proceed through this forex trading course we will continue to gain a better understanding of the structure of the market and traders should be well prepared after going through those lessons to make an informed decision for themselves on this issue.