OTC Derivatives in an Hour

Note: This is a transcript of my YouTube on derivatives.

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Good morning. Today we’re talking OTC– Over the Counter– derivatives. It’s a topic that the news media always frames as being so complex that you shouldn’t even try to understand it. That might be because journalists stink at math or because journalists rarely studied contract law as undergrads but it’s more likely because the people who work in the OTC space– the ones that journalists interview– are too busy to explain it to journalists in plain English. They’re too in the weeds to not use arcane financial jargon.

So that’s what I’m going to try to do. To simplify the ideas and speak in plain English. I’ll probably fail but hey, maybe a better storyteller will see this and make it even easier to understand.

OK.

Let’s start with an homage to Trading Places– a comedy from 1983 that starred Eddie Murphy and Dan Ackroyd. The kind of movie that would not be made in our more sensitive times. The premise of the movie– if you didn’t live through the 80s– is that these two old brothers– white guys– Randolph and Mortimer Duke— white guy names– ultra-high-net worth, well-capitalized— which are fancy ways of saying super wealthy. The brothers own a commodity brokerage Firm— Duke and Duke. And the premise of the movie is that the brothers bet on everything– the more inappropriate and racist the better. So they bet each other that they can turn Eddie Murphy– comedy God– a street hustler in the movie who the brothers describe as a perfectly useless psychopath– they bet they can turn him into a successful executive… and during the same time, turn an honest hardworking man– a dog-whistle for a white guy-- played by Dan Ackroyd-- into a violent deranged would-be killer. You know… have them trading places. Kind of the racist version of My Fair Lady… which itself was deeply misogynist… and a pretty good musical. Which should have everyone a bit conflicted.

Anyway, the brothers succeed in turning Eddie Murphy into a successful managing director of Duke and Duke— which if you’ve worked in financial services in real life… shouldn’t surprise you because the best MDs are a little off. Now back in the movie, at the same time as they’re grooming Eddie Murphy, they’re destroying Dan Akroyd’s life completely. Eddie accidentally finds out about the bet and then with Dan, they turn the tables on the brothers. Don’t watch it if you’re easily offended– for instance, there’s a scene with Eddie and Dan where Dan is in blackface. But… watch if– like me– Eddie Murphy’s signature laugh brings you joy.

Ok… why’d I start with that? Because that bet between Randolph and Mortimer is analogous to OTC– Over the Counter– derivative. The brothers– like everyone on Wall Street- are risk managers who make bets– in their case, deeply racist bets– to earn a dollar… in their case, an actual one-dollar bill.

OTC Derivatives are bets– but unlike… say… sports betting– they’re not done because you have a feeling or because you’re a part of a tribe of rabid fans. They’re bets– backed by research that you’ve done– your investment thesis– that most of the time aren’t about making money but about not losing money if your investment thesis is wrong.

What I just described is called hedging. The example I always use to explain hedging is political elections– there aren’t a lot of companies that give political donations to only Democrats or only Republicans. Most companies donate to both as a way to hedge against betting on one and having the other win… and be like, “dude, why should I help you? You backed my competition.” In that way, corporate contributions are more risk management than political courage.

Because all business needs risk management. They need to hedge.

And that’s all this walk is going to be about. Yes, I’m going to get into the details of OTC Derivatives– to talk about the different products– from credit default swaps (CDS – credit default swaps) to interest rate swaps– and I’m going to talk about the common lifecycle of those products– from initiation to negotiation to confirmation to clearing and settlement. But I’m really talking about risk management. About hedging. About the kind of side bets you make to ensure that you’re protecting yourself against your main bets.

Ok… Let’s talk about the acronym OTC in OTC derivatives.

I’ve already said what OTC stands for– over-the-counter– and the word derivatives is just fancy talk for “drawing off something”-- “being based on something”-- “being derived from something else”... which once we’re done with this walk will make a lot more sense because the financial product called a derivative is one whose price performance is derived from that of another financial product– something called the underlying product. Usually some kind of security or bond or event.

That’s the product but it’s also… really… just a financial contract. Super-customized contracts based on super-customized hedging needs… which we’re going to get deep into. And that contract is privately negotiated between two parties without going through a centralized exchange. Hence “over the counter”... OTC… it’s also called off-exchange trading or pink sheet trading… because it all happens directly between two parties, without the supervision of an exchange. So if you get that OTC– over the counter– is also called off-exchange, then you can guess that the opposite of off-change (OTC) is “on an exchange”… products that are traded via exchanges. The New York Stock Exchange for instance.

One quick side note before going deep on the products. There’s something called an ISDA– a Master Agreement. I.. S.. D.. A.. (ISDA). It’s an acronym. Stand for International Swaps and Derivatives Association. An ISDA agreement is the most commonly used master service agreement (think contract) for OTC derivatives transactions internationally. It is part of a framework of documents, designed to enable OTC derivatives to be documented fully and flexibly. If you’re going to play in the OTC space that’s an important acronym to know from the get-go. I’m not going to mention it a lot but consider yourself warned.

Oh, and whenever I use the generic term– contract– on this walk… it’s very likely that the contract is an ISDA master agreement.

Ok.

What are the different kinds of products– the derivatives? High level: 1) options, 2) swaps, and 3) forwards. And I’ll get into each one. Suffice it to say that they are tailored to meet specific needs and are not traded on public exchanges. OTC. Can’t say that enough.

So the cool thing about OTC derivatives– their flexibility and customization– that allow market participants to manage some pretty complex risks and hedge exposures– all that cool stuff is also why they’re hard to automate, hard to scale, and hard to risk-manage. So the great irony becomes that your path to risk management itself needs to be carefully risk-managed. Russian doll within Russian doll within Russian doll. Or given the time of the year, a risk Turducken– a risk duck within a risk turkey. And we’ll go into all that risk– from counterparty risk to liquidity risk– further down the walk.

For now, let's dive deeper into the product side of OTC derivatives.

The list of the most common OTC products is Interest Rate swaps, Credit Default Swaps, Foreign Exchange Forward Contracts, Equity Derivatives, Commodity Swaps, and Total Return Swaps. These products– and I’m going to describe each– in plain English– provide their users with a variety of options to manage their exposure to different types of risks.

Each type of derivative may have its own unique set of lifecycle stages and processes… which we’re going to cover after the product descriptions. But it’s worth listening to the descriptions with that in mind: the idea that understanding the lifecycle of OTC derivatives is crucial for market participants to effectively manage their positions and ensure smooth execution of transactions.

Having that understanding helps to minimize risks and maintain the integrity of the financial markets.

The only other footnote would be that there are regulatory requirements and market practices that may also impact the lifecycle of these derivatives.

Alright. Let’s use the format of describing each product using minimum financial jargon and then– because even that is a bit torturous– describing them again using non-banking analogies to drive the core ideas home– their core value. So I’m going to describe each one in a way that you might not fully understand but then immediately after, I’m going to use a non-finance-based analogy… that you’ll definitely understand.

Ok. Let’s start with interest rate swaps. A real-life example would be two parties entering into an agreement where they exchange fixed and floating interest rate payments based on a notional amount. I know that’s jargon but wait for the analogy right after this. An interest rate swap allows one party to hedge against interest rate fluctuations while the other party takes on the risk in exchange for potentially higher returns. It’s Randolph Duke on one side of the bet and Mortimer Duke on the other.

The non-banking analogy for the ideas behind an interest rate swap would be two friends or brothers who agree to exchange their fixed interest rate mortgages for a period of time. Let's say Randolf has a mortgage with a fixed interest rate of 4%, while Mortimer has a mortgage with a floating interest rate that fluctuates– that’s all that means– it fluctuates with the market. Each brother has a hedging need. In order to hedge against potential interest rate increases, Randolf might want to enter into an agreement with Mortimer to swap their mortgages.

Under this kind of agreement, Randolf will pay Mortimer the fixed interest rate of 7% on Mortimer's mortgage, while Mortimer will pay Randolf the fluctuating interest rate on Randolf's mortgage. Why? Because this allows Randolf to hedge against potential interest rate increases, while Mortimer takes on the risk in exchange for potentially higher returns if interest rates stagnate or decrease.

Both Randolph and Mortimer have done their research. They’ve just arrived at opposing conclusions. One thinks interest rates are going to rise (or is scared that they’re going to rise) and one thinks the opposite (they’re not scared by that chance). Both Randolf and Mortimer think the other is wrong. Or more likely, Randolph thinks Mortimer might be right (in a worst-case scenario) so… why not pay him to mitigate Randolf’s risk– in the event that Randolf’s investment thesis goes pear-shaped? That’s a classic hedge.

Note to self… I hate both those names– Randolf and Mortimer… so that’s the last time you’ll hear those names on this walk. Or in my life.

Next product: a Credit Default Swap. A real-life example would be two parties entering into a contract where one party– Rick– pays a premium to the other party– Birdperson –in exchange for protection against the default of a specific bond or loan or company. The risk that the company that they care about goes Chapter 11 or the stock or bond that they care about tanks. This type of derivative allows investors to hedge against the credit risk of a particular issuer. For example, if Rick holds a bond issued by the Galactic Federation and is concerned about the corporation's financial stability, Rick can enter into a credit default swap with Birdman who agrees to compensate Rick in the event of default– in the event that the Galactic Federation goes chapter 11. This helps the investor (Rick) to mitigate his risk and protect his investment. It’s a bad swap for Birdman in the Rick-and-Morty-verse because Rick can manipulate the outcomes… but you get the picture.

A non-banking analogy for the ideas behind credit default swap would be a dude named Bob who lives on the island next to Jurassic Park. He’d obviously be concerned about the possibility of their pterodactyls flying off the Park’s island and damaging Bob’s hut… so Bob might decide to purchase insurance from InGen – a hedging play with the corporate owners of Jurasic Park. In exchange for a premium, InGen would agree to compensate Bob if his hut is ever damaged or destroyed. InGen would obviously take that bet because there’s no way those pterodactyls are going to fly off the island. That would be crazy, right?

This arrangement allows Bob to hedge against the risk of potential loss, while InGen assumes the risk and potentially earns a profit from Bob’s premiums. In the event that any dinosaur goes rogue– very unlikely– Bob can receive financial compensation from InGen… if Bob somehow survives. That’s a dinosaur default swap… so just plug in the word credit wherever I used the word pterodactyl or dinosaur.

Next product– a Foreign Exchange Forward Contract. A real-life example would be a manufacturer in one country that imports raw materials from another country. Let’s say the manufacturer is concerned about the potential increase in the foreign currency exchange rate, which would make the imported raw materials more expensive. To hedge against this risk, the manufacturer enters into a foreign exchange forward contract with a financial institution– the other side of the bet. In this kind of contract, the manufacturer agrees to buy a specific amount of foreign currency at a fixed exchange rate on a future date. It effectively allows the manufacturer to protect itself against potential currency fluctuations. The financial institution takes on the risk and provides the manufacturer with certainty in their raw material costs. That is how foreign exchange forward contracts can be used to manage currency risk and ensure stability in international business transactions.

A non-banking analogy for the ideas behind a Foreign Exchange Forward Contract would be two friends– Jack and Rose– planning a cruise vacation from Southampton, England, to New York City. Let’s say they’re both concerned about the potential fluctuations in the exchange rate between their local currency (the pound) and the foreign currency of the country they plan to visit (in this case the US dollar). To hedge against this risk– the risk that their vacation money won’t go as far– Jack and Rose decide to exchange their currencies at a fixed exchange rate in advance. They enter into a forward contract with a currency exchange service, agreeing to exchange a specific amount of their local currency for the foreign currency at the predetermined exchange rate on the date they plan to travel. This allows them to lock in a favorable exchange rate and avoid any potential currency fluctuations that could make their trip more expensive… if they survive the iceberg. The currency exchange service takes on the risk and provides them with certainty in their travel expenses. Not that important for Rose because she comes from money… but hugely impacts Jack because he… he actually won the ticket to the cruise in a poker game. He’s not rich. But he’s clever. And he could’ve definitely fit on that door.

Next product: Equity Derivatives. A real-life example would be trading options on a stock. Let's say an investor believes that the price of a particular stock will increase in the future. Instead of buying the actual stock, the investor can purchase what’s referred to as a call option, which gives them “the right” to buy the stock at a specified price (known as the strike price) within a certain time frame. If the stock price does indeed increase, the investor can exercise the option and buy the stock at the lower strike price, making a profit. However, if the stock price decreases or remains below the strike price, the investor is not obligated to exercise the option and can simply let it expire. That’s why the call it an option. It’s literal. Now remember, that investor is one side of the bet. The other side is someone or some institution whose research says that the stock in question will not rise to the strike price… so they’re willing to be paid for taking the risk.

A non-banking analogy for the ideas behind equity derivatives would be two friends who are avid collectors of rare Pokemon trading cards. One of the friends believes that the value of a rare Pikachu Illustrator card will increase in the future, so instead of buying the actual card right there and then, they make a pinkie promise with their friend who owns the card that says… if over the next couple of months… you really want the card… regardless of what I can get for it at the local game night… from fellow nerds, I promise to sell it to you… for $1M dollars. That first friend is purchasing a call option on that card from that second friend. This call option gives that first friend the right to buy the card at a specified price within a certain time period. If the value of the Pikachu Illustrator card does indeed increase, that first friend can exercise the option and buy the card at the lower strike price, making a profit. However, if the value of the card decreases or remains below the strike price, that friend is not obligated to exercise the option and can simply let it expire. Again, that’s why it’s called an option. It’s an actual option that the first friend has bought. And just in case you’re wondering, I didn’t pull that $1M number from thin air. That’s actually the market price of a rare Pikachu Illustrator card. Because people have too much money.

Next derivative: Commodity Swaps. A real-life example would be two parties entering into a contract where one party agrees to pay the other party a fixed price for a specific commodity, such as oil or gold, at a future date. In exchange, the other party agrees to pay the first party the fluctuating market price for the commodity at the same future date. This one’s fun because it allows BOTH parties to hedge against price fluctuations and manage their exposure to the commodity market. Bad example but a company like Southwest Airlines that relies on oil for its operations may enter into a commodity swap to lock in a fixed price for future oil purchases, protecting itself from potential price increases. It’s not just that Southwest is always going to need oil to run its business. It’s that they need to reduce the risk that oil’s going to get really expensive…. Soooo expensive that they either have to raise their prices (lose competitiveness) or reduce their profits. In return, the counterparty, in Southwest’s case their banking partner or their commodity trading partner, can profit from any price differences in the future. The other side of Southwest’s bet isn’t doing them a favor. They’re hedging their bets… for instance that the price of oil will stay flat. So even if it does stay flat, they made money from selling that option to Southwest. They made more money than their competitors who didn’t sell options. The larger point here– and it's important– is that both sides of any derivative are there to press their agenda, to protect their profits, to hedge against events and eventualities that pose a risk to their bottom line. Both sides.

A non-banking analogy for the ideas behind Commodity Swaps would be two friends– a different set of friends than those Pokemon losers– two friends– Tucker and Dale– who are planning next year’s annual barbecue. Tucker wants to ensure that he can buy a specific quantity of pork at a fixed price in the future, regardless of any price changes. Dale, who runs a meat shop, agrees to enter into a commodity swap with Tucker. That’s a fancy way of saying that Tucker agrees to pay Dale a fixed price for the meat, while Dale agrees to provide the meat at the market price on the agreed-upon future date. This arrangement allows both friends to hedge against potential, evil price fluctuations in the pork market… in the future. Tucker can lock in a favorable price for the barbecue, while Dale can offset his risk and potentially profit from any price differences. By the way, if you haven’t seen the movie Tucker and Dale vs Evil, stop watching this walk and go rent it.

That was Commodity Swaps… so it’s probably wise to make a quick distinction between commodity derivatives and commodity futures… which are related but distinct concepts. Commodity derivatives are a broad category that includes various financial instruments used to manage price risks associated with commodities. Like the swaps I mentioned or options or forwards. Commodity futures, on the other hand, specifically refer to contracts that obligate the buyer and seller to trade a specific commodity at a predetermined price and date in the future. Those kinds of contracts are typically traded on regulated exchanges– like the one up in Chicago– and have standardized terms and conditions. Think pork futures. Wheat futures. Lean Hog futures. Which are just pork futures on Ozempic. Both commodity derivatives and commodity futures serve the purpose of managing price risks, but they may vary in terms of trading platforms, contract specifications, and market liquidity. In real life that Southwest example is more likely to be a futures contract, not a commodity swap.

Next product: Total Return Swaps. A real-life example would be two parties entering into a contract where one party agrees to pay the other party the total return on a specific asset, such as a stock or bond, over a certain period of time. In exchange, the other party agrees to pay the first party a predetermined fixed rate, such as a benchmark interest rate, plus any capital appreciation or dividends received from the asset. And that’s jargon filled but wait for the analogy. This allows both parties to gain exposure to the performance of the asset without actually owning it. That’s what makes it special. For example, Berkshire Hathaway, this is Warren Buffett’s company, has the most expensive stock in the world, with shares trading at over $400,000 each. An investor who wants exposure to Berkshire Hathaway can enter into a total return swap with a financial institution– the other side of the bet. The investor pays the financial institution the total return on the stock, while the financial institution pays the investor a fixed rate plus any dividends or capital gains generated by the stock.

This screams for a non-banking analogy for Total Return Swaps. So… two friends– Earn and Van– who want to invest in a popular Atlanta-based rapper’s career. Paper boi… that’s the rapper’s stage name. Earn believes that Paper Boi's future earnings will be significant, so instead of buying shares of Paper Boi's company or purchasing his music directly, he enters into a total return swap with Van. What do I mean? Earn agrees to pay Van the total return on Paper Boi's earnings over a certain period of time, while Van agrees to pay Earn a predetermined fixed rate plus any additional income generated by Paper Boi, such as royalties or concert revenue. Paper Boi isn’t even in the discussion. He’s off doing something illegal. This arrangement allows both friends–Earn and Van– to gain exposure to the artist's financial success without directly owning shares in Paper Boi's company. Again… if you haven’t binged the show Atlanta, stop watching this walk and go binge.

Ok… those are the big ones– product wise. But really, as long as there’s two sides to a bet– and money to be made… or actually investments to be hedged… you can create a derivative… as long as you both have a good lawyer.

Which gets us to: the lifecycle of OTC.

The lifecycle of an OTC derivatives involves several stages, including initiation, negotiation, confirmation, clearing, and settlement. Let’s zip through that because we’re quickly running out of time.

Initiation The OTC lifecycle begins with the initiation of the derivative contract. Parties interested in entering into a derivative transaction negotiate and agree on the terms of the contract, including the type of derivative, underlying assets, notional amount, and maturity date.

Negotiation: During this stage, the parties may engage in discussions to finalize the terms of the contract. This usually takes a while and includes determining the pricing mechanism, payment obligations, and any additional conditions or provisions. I used two big sets of jargon– pricing mechanism and payment obligations. Quick translations from jargon. A price mechanism is what allows buyers and sellers to come to an agreement on the value of the item being exchanged. And payment obligation is the responsibility of one party to make a payment to another party. Do we agree on the price? Price mechanism. And do we agree on how we pay each other? Under what conditions do we pay one another? Payment obligation.

The next step in the OTC lifecycle:

Confirmation: Once the terms of the contract have been negotiated– remember those ISDA agreements that I mentioned at the front of the walk– once those are filled out, the parties proceed to the confirmation stage. At this point, a written confirmation is prepared, detailing the agreed-upon terms of the OTC derivative contract. This confirmation serves as a legally binding document and reduces the risk of misunderstandings or disputes.

Clearing: After confirmation, the OTC derivative contract undergoes a clearing process. See my video on the Securities Trade Lifecycle. But in short, clearing involves a central clearing counterparty (CCP) acting as an intermediary between the two parties. The CCP becomes the buyer to every seller and the seller to every buyer, ensuring the financial integrity of the transactions.

Settlement is the next and final stage. During this stage, the agreed-upon obligations of the contract are fulfilled. This includes the exchange of payments, delivery of assets, or any other actions required based on the terms of the contract.

It's important to note that the lifecycle of OTC derivatives can vary depending on which companies are involved, the specific type of derivative, and the market in which it is traded.

What else would you need to know about the lifecycle? This is a bit obvious but one point on the role of counterparties: Because these are privately negotiated contracts, each party involved is responsible (contractually/legally) for fulfilling their obligations. This introduces something called counterparty risk, which is the risk that one party may default on their obligations.

There are– as you can imagine– a ton of risks when dealing with OTC products. Not just counterparty risk.

The five big ones are 1) Counterparty… which I just mentioned.

2. Market Risk: you are sensitive to changes in market conditions and underlying assets. Market risk refers to the potential for losses due to adverse price movements or volatility. To mitigate the risk, you should closely monitor market trends and factors that may impact the value of your positions.

3. Liquidity Risk: with OTC you will have less liquidity compared to products traded on public exchanges. This can make it challenging to get out of your contract by buying or selling it. You should always consider the liquidity of any product– really– and always have contingency plans in place.

4. Regulatory Compliance: in many jurisdictions, you are subject to regulatory oversight. You should ensure that you comply with relevant regulations and reporting requirements. You should also stay updated on any changes in regulations that may affect your OTC activities.

5. Operational Risk: the process that you use to get from initiation to settlement is always more complex than it needs to be… so risky. You should have robust operational procedures in place to mitigate the risk of errors or process failures.

What other considerations should you make when playing with OTC?

Well, other than having a world-class Risk Management practice– what I just talked about– you also need to be good at:

Documentation: think legal agreements, ISDAs, confirmations, and collateral arrangements.

Collateral Management: think securing yourself against the possibility of payment default by whoever is on the other side of the bet.

Valuation and Pricing: there’s a very good chance that you’ll be dabbling in complex valuation models and pricing methodologies. So you better have excellent pricing sources and the ability to accurately value your positions.

You need world class:

Reporting and Record Keeping: if for no other reason than the Regulatory requirements around maintaining comprehensive records and ensuring timely and accurate reporting.

Risk Disclosure: you’ll need to provide clear and transparent disclosures to whoever is on the other side of the bet because both sides should have a comprehensive understanding of the risks that the transaction entails.

What else?

Market Surveillance: You’ll need to actively monitor market activities and conduct surveillance to detect any potential market abuse or manipulation.

You’ll need

Technology Infrastructure: for everything I just listed because robust technology is essential in every function and in every financial transaction.

Legal Expertise: because the heart of the OTC is just a contract, an ISDA. And by legal expertise, let’s also include regulatory expertise, compliance expertise. You get the picture.

Counterparty Due Diligence: kind of important to make sure you’re betting someone who has a good reputation, financial stability, and who adheres to regulatory requirements.

What else?

Margin Expertise: some OTC products may require the posting of margin to cover potential losses.

You need to care about:

Market Transparency: Even though you’re trading privately… you need to mitigate the risk that that privacy limits market transparency.

You should be crystal clear about your

Risk Appetite: That means determining the appropriate level of exposure that you’re signing up for.

Counterparty Relationships: are important. Building and maintaining strong relationships with whoever is on the other side of the bet is important. Think effective communication channels, maintaining regular contact, and fostering a mutual understanding of expectations and responsibilities.

What else?

Market Knowledge: Keeping abreast of market trends and news.

You should be crisp about your

Trading Strategies: Because OTC is most about hedging those strategies. Carefully analyzing market conditions, assessing risk-reward ratios, and executing based on well-defined strategies.

You also need

Monitoring and Analysis: You should always be staying on top of your performance and anything that can impact the outcome of the OTC contract.

Other considerations:

Market Access: You need a reliable trading platform and market information.

And everything I just outlined is wrapped in Hedging Considerations, Liquidity Considerations… Just a ton of considerations given the complexity of the bets you’re making.

Despite all these risks and considerations, OTC will continue to be widely used in financial markets because every investment strategy is different and every one of them needs a hedge.

A contract that’s written between two unique strategies– two differing investment theses– two different compensating hedges– well… that contract will be bespoke. If you don’t know what bespoke means, it means “made for a particular customer or user.” In the case of the OTC contract, it’s bespoke because with the exception of credit default swaps and interest rate swaps (which have turned into common products)... every new set of counterparties will need the ability to tailor their contracts to meet their specific needs– think snowflake contracts that allow for more efficient risk management and hedging strategies.

OTC derivatives are here to stay. If for no other reason than they let bankers get creative. They provide the opportunity for highly-educated (but bored) smart people, to play with a wide range of underlying assets: currencies, stocks, commodities, the weather, anything really… as long as there’s someone on the other side of that bet. And while they’re mostly used for hedging, Wall Street will be Wall Street– so they’ll also be used for speculation… for instance on more vanilla products like credit default swaps (CDS)... people can and do speculate on changes in CDS spreads.

That kind of anything-goes potential also means that OTC derivatives are subject to regulatory oversight in many jurisdictions. In the US, think: the SEC– the Securities and Exchange Commission (SEC). Think CTFC - the Commodity Futures Trading Commission (CFTC). And then multiply that by every country and region in the world. Most have or will have implemented rules and regulations to promote transparency and mitigate risks associated with OTC instruments.

If you’re interested in trading OTC derivatives– and I don’t see why you would if you’re watching a YouTube video– find yourself an OTC contract specialist– a lawyer who is deeply knowledgeable about finance. They should have a world-class understanding of the underlying assets you’re going to play with, the contract terms, and all the risk factors involved.

From a tech perspective, you’ll want to automate the lifecycle of your OTC products… all the stages we talked about earlier– initiation, negotiation, confirmation, clearing, and settlement. Each stage needs technology– needs a data strategy, infrastructure, workflow, calculators, pricing, monitoring… everything… to ensure the smooth execution and fulfillment of the OTC contract.

And it’s even harder than that because people will always be creating new forms of derivatives, and as business changes– which it does every day– certain new types of derivatives will probably come with their own unique set of lifecycle stages and processes. And technology needs.

I think the biggest technology problem to solve is that contracts… the law really– is still mired in the analog mindset… far from digital transformation. Tons of bespoke contracts. Instead of being data-driven, contracts are mostly templates on shared drives. Instead of being reproducible from a limited set of data fields and rules, every contract brings the uniqueness of the lawyers who crafted it. And because it’s a document– even something as standardized as an ISDA– even if it has a thoughtful meta-data structure in your document management system– or your contracts management system– you’re still going to need to do full-text search on what’s essentially a blob of text.

And I’m not sure how long those practices will take to change because lawyers are smart enough to feel appropriately threatened by automation.

If you’re an engineer in the OTC space, your first task will never be to understand the tech. Instead, understand the lifecycle of every OTC product that your partners engage in. Figure out technology’s role in effectively managing your partner’s positions… technology’s role in ensuring the smooth execution of transactions. And most importantly, technology’s role in helping to minimize risks and to maintain the integrity of the financial markets.

And I don’t just mean how technology can satisfy regulatory requirements— because the very nature of OTC products…. Their flexibility, their bespokeness– will mean that they’ll always be miles ahead of regulations. Tech’s role can and should be to stay ahead of unintentional negative, systemic impacts on the wider markets.

So… start by understanding your company’s OTC lifecycle. Figure out all the market participants and their motivations for hedging. Figure out how tech can help navigate the complexities of these financial instruments and by god, figure out how tech can help manage risks effectively.

That’s it. I hope you learned something.