OTC derivatives traders can choose from a range of trading strategies, and these are evolving as technology and regulation influence best execution.
We look at the some of the most frequently used traditional and emerging trading strategies, to understand the benefits and drawbacks of each.
Direct/bilateral negotiation
Where the buyer and seller engage in one-on-one discussions to agree on the terms of a trade, without the use of intermediaries like brokers or automated systems.
Benefits
A primary advantage of direct negotiation is the ability to keep trade details private, which is important for large or sensitive deals, and helps avoid adverse market impact.
Contracts can be highly customised, which is useful for OTC derivatives where notional amount, duration and payoff structures can vary widely.
The involvement of just two parties minimises transaction costs and increases opportunities for mutually beneficial prices outside of the spreads seen in more competitive or liquid markets.
Drawbacks
Limited liquidity is a challenge where fewer counterparties are involved. There is also a risk of information asymmetry where one party has more market knowledge than the other.
Negotiations may also be slower especially for complex instruments which causes costly execution delays in fast-moving markets.
Bilateral negotiations have increased counterparty risk especially where there is no central clearinghouse.
Request for quote (RFQ)
Under RFQ, traders request a quote from multiple counterparties. Interested parties respond with bids and offers, from which the trader can compare the quotes and choose the most attractive counterparty with which to execute. Benefits
RFQ offers access to multiple liquidity providers which facilitates price discovery. RFQ offers efficient execution compared to other bilateral negotiation processes, especially for complex derivative transactions. Traders can also leverage existing relationships with counterparties to negotiate the best deals.
Drawbacks
RFQs can be relatively slow compared to automated trading methods and there is a risk of information leakage which influence prices. Further, there is potential for conflict of interest where traders act as both market makers and traders, using their own knowledge to influence prices.
RFQ also lacks the full transparency of an exchange-traded environment. This makes it difficult for traders to assess broader market conditions and trends compared to fully transparent electronic order books found in exchange markets.
Dark pools
Dark pools are private, non-public trading venues or exchanges where OTC derivatives can be traded without disclosing the size and price of the trade, nor the identity of the traders to the broader market. Benefits
Minimal market impact and deeper liquidity are the dark pool’s main attractions. Since trades are executed without public visibility, large orders do not influence market prices, allowing traders to avoid price slippage. Meanwhile dark pools offer access to deeper liquidity than is typically available on public exchanges or conventional OTC platforms.
Private liquidity pools may also provide better execution prices than is possible on public exchanges or through traditional OTC broker-dealers.
Drawbacks
The very attractions of dark pools also bring some of its disadvantages. Market participants reliant on open market data to understand true market conditions may be hampered by dark pools. Further, dark pools can undermine price discovery since significant trades occur outside the public eye.
It is this lack of transparency that has drawn the eye of regulators that believe dark pools can contribute to market fragmentation while also making it difficult to monitor market manipulation or ensure fairness in trading practices.
Trades executed in dark pools are not immediately reported or publicly visible, which can lead to discrepancies in market pricing.
Algorithmic trading
Algorithmic trading uses automated systems to execute trades using predefined rules, data inputs and real-time market information. This can involve automated processes for price discovery, trade matching and execution based on specific triggers or market conditions.
Common algorithmic trading strategies are volume-weighted average price (VWAP) and Time-Weighted Average Price (TWAP), which break up trades by volume or time to avoid moving prices unfavourably.
There is constant evolution in the algo trading space, and the influence of artificial intelligence and machine learning will ensure these strategies continue to develop at pace. Benefits
Algorithmic trading is all about speed and efficiency. Automation ensures trades are executed promptly and accurately, even in fast-moving and fragmented markets.
Slicing and dicing trades that seek liquidity across multiple sources, minimises market impact and increases liquidity.
There are also lower transaction costs. while less manual intervention means fewer human errors. And since algorithms can monitor market conditions continually, they can adapt in real-time to changing conditions like liquidity shifts, volatility, or new quotes. This real-time adaptability is crucial in OTC markets, which are less structured and often more volatile than exchange-traded markets.
Importantly where prices are less transparent, algorithmic trading systems can provide more accurate pricing by aggregating quotes from various sources.
Finally, algorithms help manage the risk of adverse price movements and comply with trade limits and reduce operational risks by automating trade processes.
Drawbacks
OTC markets’ relative opacity, lighter regulation and lack of central order books can make it difficult for algorithms to access accurate or complete market data. Missing data, which algorithms depend on for decision-making, can lead to poor execution decisions or unexpected outcomes.
The wide range of liquidity sources in OTC markets can make it harder for algorithms to complete large orders efficiently.
The pricing of complex OTC derivatives, which may involve bespoke terms, can be challenging for algorithms to fully understand and to accurately price or execute without substantial human intervention.
