Some times, some of us may be required to manage and be responsible for the deliverables even in areas we lack exposure and expertise. Leave alone this. Some times, some of us may have come across people in responsible positions who, even with quality education and qualification from premier educational institutions, are unable to identify and differentiate the basic features of markets, products and services.

I have faced one such embarrassing situation very recently. I was traveling from Hyderabad to Chennai. The fellow air passenger was a very senior sales personnel working for a leading and competing IT organization responsible for a very large potentially rich foreign geography.

Of course, when two IT guys meet, they normally discuss about the spiraling oil prices, US sub prime crisis, their possible impact on Indian IT industry leading further down to annual increments. If they develop further camaraderie they will discuss stock market investments; if they travel to the same destination, they may even meet up for an evening drink. If everything gels well, they may even exchange their resumes for a possible opening in their respective organizations!

Well. Our discussions also followed similar pattern. While I was passionately talking about the risks involved in OTC markets in general and exchange-traded markets in particular, I was rudely jolted by the observation of my fellow passenger that there are only two parties to a transaction in any exchange-traded markets – the ultimate seller and the ultimate buyer (say seller of shares and buyer of shares in a stock market) and there is only one agreement between them.

Well. This from very senior sales personnel was totally unexpected. With my background I felt confounded. Hence I was forced to make the observations made in the first two paragraphs of this blog.

Having started this discussion, it is my duty now to revisit the topic and list out the functionality and differences between these two markets- Exchange-traded and OTC.

Exchange traded market is one in which all transactions are routed through a central source. In other words, one party is responsible for being the intermediary that connects buyers and sellers. This means for a sale of security in an exchange traded market, the seller sells the security to the exchange and the buyer buys the security from the exchange. Hence there are two contracts for a sale and buy of security between the ultimate seller and ultimate buyer. It may be noted the exchanges do not buy or sell for their account.

In this exchange-traded market, the counter party credit risk is taken away and the exchange house assures and guarantees the buyer and the seller. For this purpose, the exchange house charges an initial margin from the buyer and the seller. In addition, the transaction is marked to market on a daily basis or at such other intervals as desired by the exchange house for better enforcement of transactions and security measures. Normally, in exchange-traded markets, transactions can be put through only for standard lots – in number and amount and the settlement is uniform.

Now let us turn over to OTC markets. Unlike exchange-traded markets, OTC markets are decentralized. The seller and buyer take up transactions directly and sometimes intermediaries (like brokers) do facilitate. Whenever intermediaries are involved, transaction costs go up. The OTC market is more unregulated and hence the buyer and the seller are exposed to counter party risk. They are also exposed to pre-settlement and settlement risk. The best part of the OTC market is that the transaction can be tailor made to suit the requirements of the buyer and seller – no standardization is followed either with regard to amount or delivery unlike exchange-traded market. No initial margin or mark to market is insisted upon upfront.

Only when we are confident about the counter party and only when the exchange-traded market does not offer the type of security or transaction one is interested in, s/he resorts to OTC market.

Well. To complete the story, our flight reached Chennai. I was very hungry since no breakfast was served in the flight. My cab driver was waiting in the arrival area with the placard. Like me possibly my fellow passenger was also hungry and he too reached out for his cab hurriedly. We wished well each other. We could not take further and encash our ‘camaraderie’