What is OTC Trade Life Cycle? | OTC Trading Explained with an Example

Summary

In this educational video, Say Jafre, certified by the International Compliance Association and CISI, discusses the OTC (Over-The-Counter) trade life cycle, contrasting it with exchange-traded life cycles. Jafre uses the example of purchasing an iPhone to explain OTC transactions, highlighting the role of market makers and the importance of vigilance in OTC financial products. The video outlines the stages of the OTC trade life cycle, including front, middle, and back office processes, emphasizing the additional stage of affirmation due to the ISDA master agreement requirement. Jafre also touches on the use of a Central Counterparty (CCP) to mitigate counterparty risk post the 2008 financial crisis.

Takeaways

• 📚 The speaker, Say Jafre, is certified by the International Compliance Association and CISI, and is associated with the FPA Financial Planning Academy at Utch.
• 🔄 The video discusses the trade life cycle in Over-The-Counter (OTC) markets, contrasting it with exchange-traded life cycles.
• 🏪 OTC refers to transactions that occur outside of formal exchanges, often facilitated by market makers like investment or merchant banks.
• 📱 An example is given comparing buying an iPhone from an online store (non-negotiable price) versus a known retailer (negotiable price and additional gifts), to illustrate OTC transactions.
• 📈 The OTC market is vigilant due to the nature of financial products or contracts involved, which may require more careful handling.
• 📋 The script outlines the OTC trade life cycle, which includes stages like front office (sales, initiation, execution, capture), middle office (enrichment, validation, verification, affirmation), and back office (confirmation, settlement, reconciliation).
• 📝 The importance of the ISDA (International Swaps and Derivatives Association) master agreement in OTC trading is highlighted, emphasizing its role in managing operational risks.
• 💼 The speaker's experience in the trade execution department at Northern Trust is mentioned, emphasizing the impact of back-office roles in the financial industry.
• 🌐 The script provides insights into the OTC derivatives market, mentioning forward contracts as an example of plain vanilla derivatives traded OTC.
• 📊 The video concludes with an invitation for viewers to learn more about OTC trade life cycles, derivatives, and financial products through FPA's training programs.

Q & A

What does OTC stand for in financial services?

OTC stands for Over-The-Counter, which refers to financial instruments that are traded directly between two parties without going through a centralized exchange.

Why is the term 'OTC' used frequently in the financial services industry?

The term 'OTC' is used frequently because it encompasses a wide range of financial products and contracts that are traded privately and not on a public exchange, making it a significant part of the financial services industry.

What is the difference between trading on an exchange and trading OTC?

Trading on an exchange involves standardized contracts and is conducted through a centralized platform, whereas OTC trading is more flexible, allowing for customized contracts and direct negotiations between buyers and sellers.

What is a market maker in the context of OTC trading?

A market maker in OTC trading is an entity, usually an investment or merchant bank, that facilitates transactions by providing liquidity and offering to buy and sell financial instruments.

Why is it important to be vigilant when dealing with OTC financial products or contracts?

OTC financial products or contracts require more vigilance due to their complex nature, the lack of standardized terms, and the higher risk of counterparty default compared to exchange-traded instruments.

What is the role of the International Swaps and Derivatives Association (ISDA) in OTC trading?

ISDA plays a crucial role in OTC trading by providing a standardized master agreement that governs the terms of transactions, reducing legal risks and facilitating the trading process.

What is the purpose of the additional stage of 'affirmation' in the OTC trade life cycle?

The 'affirmation' stage in the OTC trade life cycle serves to confirm the economic and non-economic details of a trade with the client, ensuring that both parties agree on the terms before proceeding with the drafting of the ISDA master agreement.

How does the settlement process differ between exchange-traded derivatives and OTC derivatives?

Exchange-traded derivatives typically have a regulated settlement system, while OTC derivatives may involve direct negotiations between parties, potentially using a Central Counterparty (CCP) to mitigate counterparty risk.

What is the significance of the CCP in OTC trade settlements?

The Central Counterparty (CCP) in OTC trade settlements acts as an intermediary to manage counterparty risk by collecting collateral from both parties and ensuring that the trade is settled as agreed upon.

What is the role of the front, middle, and back offices in the OTC trade life cycle?

The front office is responsible for sales and trade execution, the middle office handles trade enrichment, validation, verification, and affirmation, while the back office manages confirmation, settlement, and reconciliation.

How does the speaker's experience at Northern Trust relate to the OTC trade life cycle?

The speaker's experience at Northern Trust, specifically in the trade execution department, provides practical insights into the various stages of the OTC trade life cycle, emphasizing the importance of each role in the process.