Exchange-traded versus OTC: counterparty and issuer risk

What you will learn

• The difference between exchange-traded and over-the-counter (OTC) derivatives.
• How a central counterparty and daily settlement reduce counterparty risk.
• What happens to your money if a broker or certificate issuer fails, and which protection schemes may apply.
• A simple checklist to identify who your counterparty really is.

Explanation

Every derivative is a promise. Counterparty risk is the risk that the other side cannot keep its promise, for example because it becomes insolvent. How large this risk is depends mainly on where and how the contract is traded.

Exchange-traded derivatives

Futures and listed options (for example on Eurex) have standardised contracts. After a trade, a central counterparty (CCP), a clearing house, steps between buyer and seller. This process is called novation: the CCP becomes the buyer to every seller and the seller to every buyer. The CCP protects itself with initial margin, daily variation margin (daily settlement, covered in lesson 2), a default fund paid in by its clearing members, and its own capital. Your direct contact is your broker, which is a clearing member or works through one.

OTC derivatives

OTC (over-the-counter) means the contract is agreed directly between two parties, not on an exchange order book. Examples for private clients are CFDs and forex contracts with a broker. The broker is your counterparty: it sets the prices and must pay your profit. In the EU, the EMIR regulation (European Market Infrastructure Regulation) requires central clearing and reporting for many standardised OTC derivatives between large firms, but a retail CFD remains a bilateral contract with your broker.

Issuer risk

Issuer risk applies to certificates and warrants (lesson 10). They are bonds of the issuing bank. If the issuer fails, holders are unsecured creditors and may lose part or all of the investment, even if the underlying moved in their favour. In the EU, bank resolution rules (bail-in) can also convert or write down such claims. Unlike ETFs, which hold special assets separate from the fund company (covered in the course ETFs, Funds & Long-Term Investing), certificates have no such protection.

Protection schemes

• Client money segregation: EU investment firms must keep client funds separate from their own money. This protects cash, but an unrealised profit on an open OTC position is a claim, not segregated cash.
• Investor compensation: in Germany, the EdW (Entschädigungseinrichtung der Wertpapierhandelsunternehmen) covers many securities firms. It pays 90% of a qualifying claim, up to €20,000 per investor, if the firm cannot return client money or securities. Banks belong to deposit and investor protection schemes with different rules. Check which scheme your provider belongs to.
• No scheme covers trading losses or the fall in value of a product.

Worked example

Hypothetical example: you are long a contract on an index with a value of €10 per index point. The index rises 400 points in three months. The largest single daily move is 60 points. Fees and taxes are excluded.

1. Total gain: 400 × €10 = €4,000.
2. OTC forward, paid at maturity: the full €4,000 is a claim on one counterparty until the end. If that party fails one day before maturity, up to €4,000 is at risk.
3. Exchange-traded future: gains are paid to you each day as variation margin. At any time, the unsettled exposure is at most about one day's move: 60 × €10 = €600, and that exposure is to a CCP with several layers of protection.
4. Compensation scheme: suppose a German securities firm fails and your qualifying claim is €12,000. EdW pays 90% × €12,000 = €10,800. For a claim of €30,000: 90% = €27,000, but the cap applies, so the payment is €20,000.

Common mistake

Practice activity

Hypothetical: you hold (1) a futures position at a regulated broker, (2) €8,000 of knock-out certificates from Bank A, (3) €5,000 margin plus €3,000 unrealised profit in CFDs at a German securities firm that belongs to EdW. On paper, write for each position: who is your counterparty, and what is the main risk if that counterparty fails? Then calculate the maximum EdW payment if the qualifying claim in (3) is €8,000.

Key takeaways

• On exchanges a CCP stands between buyer and seller; daily settlement keeps exposure to about one day's move.
• In retail OTC products such as CFDs, your broker is your counterparty and sets the price.
• Certificates and warrants are unsecured bank debt; issuer insolvency can cause losses regardless of the underlying.
• Compensation schemes have limits (EdW: 90% up to €20,000) and never cover trading losses.

Next step

In the next lesson you will get a general orientation on how derivative gains and losses are taxed in Germany.