Question

Compare centralized exchanges to OTC markets. In your opinion, why are bonds typically traded on OTC markets?

Answer 1

Difference Between Exchange Trading & OTC Trading:

Centralization Of Market:In a market that operates with exchange trading, transactions are completed through a centralized source. In other words, one party acts as the mediator connecting buyers and sellers. There is a specified number of traders that will trade on that single centralized system. On the other hand, over-the counter markets are generally decentralized. Here, there are many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that costs for intermediary services are as low as possible.

Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as a guarantor for all the trades. But, OTC contracts are customized as there is no specified guarantor and hence the risk increases a lot.

Counterparty Risk: When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or other security within the agreed upon time frame. It might also deliver a different kind of stock or bond than promised. These risks are broadly referred to as counterparty risk. In an exchange, however, counterpart risk is not an issue. The trading occurs through brokers who are closely monitored by both the exchange and the Securities and Exchange Commission. Investors buy exchange traded securities with greater confidence and therefore pay more for such stocks. Because of this, businesses are better off selling shares through an exchange rather than in a private transaction.

Visibility: As Exchange market is an open market wherein there is a clear visibility for prices, start date, expiration dates & counterparties involved in a deal etc. But, this is not the case with OTC market as all the terms & conditions associated with any deal is between the counterparties only.

Parties Involved: In exchange traded markets, the exchange is the counterparty to all of the trades. Additionally, there is price standardization and execution. One negative these exchanges involves less price competition. OTC, or over the counter markets, have no centralized trading facility. This promotes heavy competition between counterparties and lower transaction costs. The lack of regulation can introduce fraudulent firms and transaction execution quality may decrease.

Conclusion:

In exchange markets, there’s a regulator (exchange) through which transactions are completed, while in OTC markets there is no regulator.

Exchange markets have less chances of price manipulation, while the many competing traders in OTC markets can manipulate prices.

Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest traders.

Part 2) opinion:

First and foremost, the numbers of bonds are plentiful. For example, there is only one Goldman Sachs Inc. equity but hundreds of bonds with different yields, maturities, and even currency denominations of the same company.

Secondly, the monetary value of bond trades are generally larger than equity trades. In the US, the average size of an equity trade is less than $10,000 whilst the average bond trade exceeds $500,000. This leads us to believe that the chunk of bonds are transacted by large institutional investors, such as banks, mutual funds, insurance companies or even pension funds.

Thirdly bonds trade much less frequently than equities. Equities seem to have a consistent supply of buyers and sellers in the market every day, however the same cannot be said for bonds. Bonds are generally very liquid in the few weeks after being issued but liquidity generally tends to run dry.

Therefore, as can be seen, unlike equity markets, there is rarely that continuous two-way market of buyers and sellers. Instead, liquidity is hence most importantly provided by dealers who function in two ways.

Firstly, dealers or brokers place their own capital at risk by purchasing bonds from an investor, even if they do not have another investor willing to buy those bonds. This is known as ‘buying on their own book'.

This means that they are taking the risk on themselves to eventually find a buyer to whom they can sell the bonds, at a profit. Secondly, the dealer/broker can also take an order from a client who wants to buy a quantity of a particular bond and will search for an investor who is prepared to sell the bonds