OTC Derivatives

OTC derivatives are derivatives that are agreed directly between two parties instead of being bought and sold on an organised exchange. The main types are swaps, forwards and options whose value depends on an interest rate, exchange rate, credit event, commodity price or share price. Banks, asset managers, insurers, corporate treasurers and governments use them to hedge risks, adjust exposures and take positions that standard listed contracts cannot match.

The term combines two ideas. "Derivative" describes the contract; "over-the-counter" describes how it is traded, by negotiation with a dealer rather than through a public order book. OTC derivatives are therefore distinct from exchange-traded futures and options, which use standard terms and are always cleared. Since the 2008 crisis, much of the OTC market has been brought under regulation set by the G20 and national authorities.

Think of the difference between buying a suit off the rack and having one made by a tailor. An exchange sells off-the-rack contracts: fixed sizes, fixed dates, the same for everyone. An OTC derivative is the tailored suit. A company that must pay a supplier in yen on a particular Tuesday in March can ask its bank for a contract that fixes the exchange rate for exactly that amount on exactly that day.

The catch is that a tailored deal is a private promise between two people. If the other side goes bust before the payment date, the promise may not be kept. For years nobody outside the two firms could see how many of these promises existed or who owed what to whom. Much of the reform since 2009 has been about making those promises safer and more visible.

Most OTC trades are documented under a master agreement published by the International Swaps and Derivatives Association (ISDA), with the 1992 and 2002 versions the most widely used. The master agreement sets out general terms such as events of default and close-out netting, while each trade is recorded in a short confirmation. A credit support annex usually governs the exchange of collateral.

The common product families are:

• Interest rate contracts. The interest rate swap, in which one party pays a fixed rate and the other a floating rate, is the largest single product.
• Foreign exchange contracts. These include outright forward contracts, the FX swap and cross-currency swaps.
• Credit contracts. A credit default swap pays out if a named borrower defaults.
• Equity and commodity contracts. These include forwards, swaps and custom options on shares, indices, energy and metals, as well as niche products such as the weather derivative.

The Bank for International Settlements collects semiannual data from large dealers. At end-June 2025 the notional amount outstanding was about $846 trillion, up 16% on a year earlier, and interest rate contracts made up 79% of it. Notional figures overstate the money actually at risk, because they count the face value on which payments are calculated, not the payments themselves. A better gauge is gross market value, the cost of replacing all contracts at current prices, which stood at about $21.8 trillion on the same date.

The 2008 financial crisis exposed the risks of a large, opaque bilateral market. Supervisors could not easily see where exposures sat, and the near-collapse of AIG, which had sold large amounts of credit protection, showed how losses on OTC contracts could spread across the system.

At their Pittsburgh summit in September 2009, G20 leaders agreed that all standardised OTC derivatives should be traded on exchanges or electronic platforms where appropriate and cleared through central counterparties by end-2012, that all OTC contracts should be reported to trade repositories, and that non-centrally cleared contracts should face higher capital requirements. Margin requirements for uncleared trades were added later. The main pieces are:

• Central clearing. Standard trades are now cleared through a central counterparty (CCP), which stands between buyer and seller and collects collateral from both.
• Trade reporting. Each trade is reported to a trade repository so that authorities can see positions across the market.
• Margin on uncleared trades. A framework by the Basel Committee and IOSCO, first published in September 2013 and phased in from 2016 to 2022, requires both sides to exchange initial margin and variation margin.
• Trading venues. Certain liquid swaps must be traded on regulated platforms.

In the United States these rules come mainly from Title VII of the Dodd-Frank Act of 2010, with the CFTC overseeing swaps and the SEC overseeing security-based swaps. In the European Union the main law is the European Market Infrastructure Regulation (EMIR) of 2012, and other jurisdictions such as Japan, the UK and Canada have adopted their own versions.

• Counterparty risk. Uncleared contracts still depend on the other side paying, which is why positions are marked to market and collateralised daily.
• Concentration in CCPs. Central clearing moves risk into a small number of clearing houses, which must themselves be strongly managed and supervised.
• Liquidity strain. Sharp market moves can trigger large margin calls at the same moment, forcing firms to find cash quickly, as seen in UK pension funds in 2022.
• Valuation and complexity. Bespoke contracts may have no observable market price and must be valued with models, which can be wrong.

• Bank for International Settlements: Derivatives statistics
• International Swaps and Derivatives Association (ISDA)