Benefits and Risk Considerations of OTC Trading
In 2022, crypto markets learned a harsh lesson in counterparty risk following a series of credit failures, which ended with FTX's bankruptcy and the collapse of some of the industry’s leading lenders and trading firms.
In the aftermath, firms started scrutinizing who they did business with and where they’d hold their assets. Choosing a counterpart is no less important now than it was in 2022, and this post aims to explore the benefits of trading OTC and how it can reduce counterparty risk.
OTC Overview
Over-the-counter (OTC) trading refers to the buying and selling of financial instruments or crypto assets directly between two parties without the supervision of a formal exchange. This type of trading is often used for larger blocks or customizable derivatives that might be better suited to dealing with a service provider over an exchange.
“Effective due diligence is the cornerstone of prudent credit risk management. By thoroughly evaluating counterparties, institutions can make informed decisions, mitigate potential losses, and build sustainable relationships. It’s a balance between identifying profitable opportunities and protecting against downside risks. Post-trade settlement further complements this by verifying the timely exchange of assets and minimizing the risk of settlement failures. Together, these processes provide a robust framework for identifying, mitigating, and managing risks throughout the transaction lifecycle.”
— Nazia Siddiqi, Head of Credit Risk at Galaxy
Credit Risk
An overlooked aspect of OTC is reducing your counterparty risk through post-trade settlement. This allows you to negotiate terms and confirm a price, settling the trade afterward, as opposed to trading on an exchange, which requires firms to post assets prior to trading.
Ignoring the creditworthiness of your counterpart can be catastrophic, potentially leading to:
A complete loss of assets if the counterparty defaults
Exposure to hidden liabilities or poor risk management practices
Risk of contagion effects from interconnected crypto ecosystems
Liquidity crises leaving assets stranded or inaccessible
Regulatory actions against counterparties can freeze operations and assets
Reputational damage from association with problematic counterparties
Post Trade Settlement
Trading on a post-trade basis can help mitigate risk and improve operational efficiency, which can potentially offer:
Risk reduction: Minimizes counterparty exposure by not keeping assets on exchange
Enhanced client relationships: Provides faster, more accurate service to clients via dedicated teams
Capital optimization: Allows for more effective use of capital by reducing settlement cycles, offering more flexibility
Improved liquidity management: Enables better cash flow forecasting and utilization
Hidden Risks
It’s critical for investors to assess whether the firm you’re trading with has balance sheet gaps or inadequate controls and risk management systems. As we learned in 2022, many firms did not have sufficient liquidity to meet obligations and were exposed to related parties with interconnected risks.
Another red flag is the inducement to trade via below-market pricing and overly high yields. Cheaper spreads may mask inadequate risk management or operational shortcomings, while higher yields often indicate higher underlying risk, not necessarily better value.
Attractive pricing can be used to lure clients into trading with firms that have unsustainable business models, while overly focusing on the tightest spreads can blind traders to long-term counterparty stability issues.
Benefits of OTC Trading
Trading with a specialist via OTC offers many benefits which may be overlooked by crypto participants. In addition to reducing counterparty risk, there are several benefits related to trading and operational efficiency, including:
Large trade execution: OTC allows for trading large volumes and limiting market impact as a specialist can use algos and execute across multiple venues at once
Reduced slippage: By negotiating prices directly, traders can minimize slippage that can occur from placing large orders on exchanges
Enhanced privacy: OTC trades are not visible on public order books, providing more discretion for traders who don’t want to leave footprints on exchange
Customized terms: Traders can negotiate specific terms for each transaction, including settlement currency (stables or fiat)
Lower fees: OTC trades typically involve lower fees compared to cumulative fees for large trades on exchanges
Faster settlement: OTC trades can often be settled more quickly than exchange trades, especially for large volumes
Personalized service: OTC desks often provide direct contact with sales & trading and bespoke services
For more information about this post or if you'd like to set up a call with our team please contact us.
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