Over the counter
Capital MarketsTraded directly between two parties rather than on an exchange, so terms are negotiated and the credit risk runs to the counterparty.
Also written: OTC, OTC derivative, bilateral derivative
Over the counter describes a contract agreed bilaterally, usually between a company and its bank, rather than one bought through an exchange with a central clearing house standing in the middle. Almost all corporate currency hedging is over the counter, and so is most interest rate hedging.
The advantage is fit. An exchange sets contract sizes, delivery months and specifications for everybody, whereas a bilateral contract can be written for the exact amount, the exact date and the exact currency pair the exposure needs. For a treasurer hedging identified invoices, that precision removes the residual an exchange traded contract would have left behind.
The cost is counterparty credit risk and, historically, the absence of daily collateral. Each side is exposed to the other for whatever the contract is worth at any moment, which is why banks charge hedges against credit lines and why a company's ability to hedge is bounded by its own credit standing.
That historical picture has been changing in Europe. Clearing and margin requirements introduced under the European Market Infrastructure Regulation push categories of over the counter derivative toward central clearing or collateral exchange, with different treatment for non financial companies depending on the scale of their positions. The scope, the thresholds and the exemptions have been revised more than once, so the defensible answer in an interview is to describe the direction of travel toward collateral and to say that the detail depends on the current rules and on the counterparty rather than quoting a number.
Worked example
Illustrative. A mid market European group needs to hedge £3.7m falling due on the eleventh of a month. No exchange contract exists for that amount on that date.
Its bank writes a forward for exactly £3.7m settling on the eleventh. The fit is exact, and in exchange the group has taken a credit exposure to the bank and used part of its credit line to do it.