To understand the mechanism of OTC derivatives, you may want to know how it has started in the financial industry.
Here we will explain the beginning of OTC derivatives and how it is traded for beginners.
Stock exchange market
It has all started from a stock exchange market(well not necessarily), many hedge funds were trading stocks actively dozens of years ago and also making money as it is their job.
In the actual stock market, you need to expect a rise of prices of a stock and find the best time to buy that.
If a stock price falls no shareholders will make money with that stock then, but just lose their funds.
The problem was that no one could hedge positions and moderate risks of price fluctuations in a stock market.
A broker to invent a financial product
All investment banks and brokers are looking to make more money and they are always thinking more new financial products which attract investors.
And they have come up with an idea, “if many investors are wanting to sell stocks, I will create another market where they can do such thing.”
Of course you can not sell a stock and make a profit by falling prices, but you if there is a counter party. And that counter party is the brokers.
So the new product called “stock CFD”(it is a OTC derivative) is made by the brokers and the counter party is the brokers.
How does CFD (OTC deivatives) trading work?
Well the structure of CFD tradings is really simple.
The broker is the market maker(or a kind of a exchange market for traders), so the broker will take care of all CFD orders and positions.
When you sell, the broker buys, so it seems like you are actually selling stocks and making profits by falling prices, but actually what happening is that you are just exchanging prices with the broker and the broker will lose their money by falling prices in this case.
The price movement of a stock CFD product is exactly same as the real exchange markets’ one.
The point in here is that you are just exchanging prices with the broker and the interest between traders and the broker will conflict completely 100%.
Why CFD is called OTC derivatives?
CFD stands for contract for difference, because it is a contract between brokers and traders to exchange prices for different prices.
OTC stands for over the counter, because the contract is made directly between traders and brokers just like you buying something from a shopping market.(In this case you are just exchanging prices under contract)
The product is called Derivative because it is a derivative product(created product) from an actual stock market(underlying market).
So CFD is a OTC derivatives created by brokers.
Hope this FAQ helps.
