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

Investment Banking Operation with FPA

25 Jan 202417:21

Summary

TLDRIn 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.

Outlines

00:00

📈 Introduction to OTC Trade Life Cycle

The speaker, Say Jafre, introduces the topic of the OTC (Over-The-Counter) trade life cycle, contrasting it with the previously discussed Exchange Trade life cycle. OTC refers to financial transactions that occur outside of formal exchanges and are negotiated directly between buyers and sellers, often facilitated by market makers like investment banks. Jafre uses the example of purchasing an iPhone to explain OTC transactions, highlighting the flexibility in pricing and terms compared to standardized exchange-traded products. The video aims to delve into the specifics of the OTC trade life cycle, starting with an overview of derivatives traded OTC, such as forwards, options, and swaps, with a focus on forward contracts in this session.

05:01

📝 Understanding Forward Contracts in OTC

Jafre explains the concept of a forward contract, using the example of a wheat forward contract where 100,000 kg is agreed to be bought at 10 Rupees per kg, with physical delivery and settlement in 3 months. The paragraph outlines the key elements of a forward contract, including quantity, price (strike price), and settlement terms. It also introduces the trade life cycle stages common to both OTC and exchange trades: front office (sales, initiation, execution, capture), middle office (enrichment, validation, verification, affirmation), and back office (confirmation, settlement, reconciliation). The front office section is detailed, discussing the sales process, initiation and execution of the contract, and the capture of details in the risk management system.

10:01

🔍 Deep Dive into Middle Office Processes in OTC

This section delves into the middle office processes specific to OTC trades, emphasizing the additional stage of affirmation not typically found in exchange-traded life cycles. The middle office is responsible for trade enrichment, where economic and non-economic details are calculated and fees are determined. Trade validation ensures the accuracy of trader, client, and counterparty information. Verification involves reconciling standard settlement instructions with the risk management system. Affirmation is a critical OTC-specific stage where economic and non-economic details are sent to the client for confirmation, which is essential to avoid operational risks and ensure accurate contract terms before the drafting of the ISDA (International Swaps and Derivatives Association) master agreement.

15:05

💼 Back Office Functions and Settlement in OTC

The final paragraph discusses the back office functions in the OTC trade life cycle, focusing on confirmation and settlement. It explains the critical nature of settlement in OTC derivatives, especially for forward contracts, which may involve physical delivery. The paragraph introduces the concept of a Central Counterparty (CCP) used to mitigate counterparty risk, where both parties deposit a nominal amount with the CCP as collateral before settlement. The CCP service involves charges and is crucial for ensuring that trades are settled as agreed. The summary also touches on the reconciliation process, which involves核对 cash and position, and emphasizes the importance of each role in the trade life cycle for economic development. The speaker concludes by inviting viewers to learn more about OTC and financial products through the FPA and offers to connect for career discussions.

Mindmap

Keywords

💡OTC (Over-the-Counter)

OTC refers to financial instruments that are traded directly between two parties, such as banks or corporations, rather than through a centralized exchange. This term is central to the video's theme as it explains the nature of transactions that occur outside of formal exchanges. In the script, OTC is used to contrast with exchange-traded instruments, highlighting the direct negotiation and flexibility that OTC transactions offer, as exemplified by the iPhone purchase analogy.

💡Market Maker

A market maker is a financial institution, typically an investment or merchant bank, that facilitates transactions by providing buyers and sellers with quotes for both buying and selling. In the context of the video, market makers act as intermediaries in OTC trades, helping to draft contracts and ensuring liquidity in the market. The role of the market maker is crucial in OTC markets as they can influence the terms of the trade and provide services that generate revenue.

💡Derivatives

Derivatives are financial contracts whose value is derived from underlying assets such as stocks, bonds, commodities, or market indices. They are used for hedging risks, speculating on price movements, or gaining exposure to assets without owning them. The video discusses derivatives traded on OTC markets, such as forward contracts, options, and swaps, emphasizing their role in managing risk and facilitating trade.

💡Forward Contract

A forward contract is a type of derivative where the buyer and seller agree to a future transaction at a specified price, with delivery and payment occurring at a future date. In the video, a forward contract for wheat is used as an example to illustrate the OTC trade life cycle, highlighting the agreement on quantity, price, and settlement terms, which are key elements in understanding the mechanics of OTC trades.

💡Settlement

Settlement in the context of financial markets refers to the process of fulfilling the terms of a contract, which can involve the exchange of assets or cash. The video discusses two types of settlement: physical, where the underlying asset is delivered, and cash, where the difference in value is paid. Settlement is a critical aspect of the OTC trade life cycle, as it ensures that the obligations of the contract are met.

💡Trade Life Cycle

The trade life cycle encompasses the stages a financial trade goes through from initiation to completion. The video outlines the stages for OTC trades, including front office activities like sales and capture, middle office processes such as enrichment and validation, and back office functions like confirmation and reconciliation. Understanding the trade life cycle is essential for managing the risks and operational aspects of trading.

💡Affirmation

In the OTC trade life cycle, affirmation is an additional stage where the economic and non-economic details of a trade are sent to the client for confirmation. This step is crucial for verifying the accuracy of the trade details and ensuring that both parties agree on the terms before the contract is finalized. The video emphasizes the importance of affirmation in mitigating operational risks and ensuring a smooth trade process.

💡ISDA (International Swaps and Derivatives Association)

ISDA is a trade association that standardizes and governs the derivatives market, providing a master agreement that serves as a legal framework for OTC derivatives transactions. The video mentions ISDA in the context of the necessity for a master agreement when trading OTC derivatives, highlighting the role of ISDA in reducing legal and operational risks in the OTC market.

💡Central Counterparty (CCP)

A central counterparty is a financial institution that interposes itself between the buyer and seller in a trade, becoming the buyer to the seller and the seller to the buyer. This reduces counterparty risk and ensures that trades are settled as agreed. The video explains the role of CCPs in the settlement process of OTC trades, where they act as a buffer to ensure that both parties fulfill their obligations, even in the event of a default.

💡Reconciliation

Reconciliation in the financial context involves comparing and verifying transaction records between two parties to ensure accuracy and consistency. In the video, reconciliation is discussed as a back office function that ensures the alignment of cash and position records with the trade details, which is essential for maintaining the integrity of the financial system and preventing discrepancies.

Highlights

Introduction to the concept of OTC (Over-The-Counter) in financial services.

Explanation of the term 'over the counter' using the example of buying an iPhone.

Differentiation between OTC and exchange-traded products.

Role of market makers in facilitating OTC transactions.

Definition and types of derivatives traded OTC, including forwards, options, and swaps.

Detailed walkthrough of a plain vanilla forward contract as an OTC example.

Importance of the settlement aspect in forward contracts.

Description of the OTC trade life cycle stages: front office, middle office, and back office.

Process flow from sales discussion to initiation and execution in OTC contracts.

Capture stage's role in inputting trade details into the risk management system.

Enrichment stage activities in the middle office, including calculating commissions and fees.

Validation and verification processes to ensure trade accuracy.

Introduction of the affirmation stage in OTC trade life cycle for client confirmation.

Explanation of the ISDA master agreement's role in OTC trading.

Risks associated with operational errors in OTC contracts and the mitigation strategies.

Settlement process in OTC derivatives, including the use of a Central Counterparty (CCP).

Reconciliation of cash and position in the back office after settlement.

Career opportunities and the impact of working in the financial industry.

Information about FPA's training programs for financial certifications.