There are many risks that come with over the counter derivatives. However, it has gained more popularity lately since it is so much easier to make transactions and speeds up trade offers between trusting parties. Since over the counter derivatives are based on trust, fraudulent activities are rampant and left many traders at the risks of financial loss. Here are some of the most common risks that you will have to face when dealing with over the counter derivatives.
Trade Order Lacks Transparency
What makes over the counter derivatives risky is the lack of transparency for other market participants or trade regulators. This affects the willingness to trade specific commodities and eventually limits the liquidation of the market. This means higher profits for some and a losing end for others who are not aware of actual demand curves. This is one of the most debated topics suggesting that derivatives are one of the causes of the financial crisis in 2008. New laws and regulations are already being implemented but derivative trading will always be accessible and over the counter derivatives are increasing in popularity over the traditional listed derivatives which provide clearing houses where everyone can put their trust into.
Lack of Adequate Collateral
Since most over the counter derivatives lack sufficient collateral to back the trade, traders are placed at high counter-party risks. This means that there are possibilities that the other party will not meet the agreed terms and conditions of the trade. There are also possibilities where the other party won’t pay for the total cost of the goods and will leave the other trader at a terrible financial loss. The most common solution is to post sufficient collateral such as initial margins or mark-to-market margins which balances the risk in both parties.
High Operation Risks
Settling derivate contracts are prone to operational risks due to human error. In such situation, if there is enough collateral provided, the loss can be shared by both parties. However, in some situations were trust has already been established and no collateral has been posted, the initial trader will suffer the consequence in majority of the situation. This is why listed derivatives are more secure than over the counter derivatives.