Over the counter trades are transactions which have not taken place on an exchange or a market (which includes all electronic exchanges, such as LIFFE and NASDAQ). Whereas when trading in a market, there is anonymity in the transaction, for OTC trades, the buyer and the seller, the counterparties are not only known to each other, they are chosen by each other.
An OTC transaction is a bilateral agreement, between the counterparties, and includes a contractual requirement to fufill one or more obligations at some future dates.
Equities are traded mainly on exchanges. This is because, when buying 200 Joe Smith shares, you don't really care where the shares come from. For this, 'The Market' is a perfect vehicle for getting you the shares that you want, at the right price. Much the same is true of government bonds.
A very different picture emerges, when it comes to loans and deposits. The borrower and lender are very much interested in whom the other counterparty is. As such, loans are nearly always OTC transactions, and the agreement includes a contract for future commitment to repayments. The issue of credit risk becomes important.
Exchange traded derivatives are mainly options and futures. Both of these derivatives have very strict rules. Expiry of all contracts for a given derivative instrument occurs only on certain dates. For futures, these occur at three month intervals.
By contrast, OTC derivatives are much more flexible. As there is no central market, it is up to the two counterparties to negotiate terms and conditions, including dates. OTC derivatives include:
Forwards: These are the OTC equivalent of futures, and are used for short term hedging or speculation on an index. These include Forward Rate Agreements (FRAs).
OTC Options: These include Contracts For Differences (CFDs).
Swaps: A swap is an equal and opposite exchange of two loans for the same principal amount, but with different terms for each loan. For example, an interest rate swap might be between a fixed rate of 5% and a floating rate of LIBOR (London Inter-Bank Offer Rate). Swaps are generally long term transactions, and can last for up to 30 years.
Repos: An agreement to sell a bond (often a government bond) at one price with a simultaneous agreement to repurchase the bond at a later date at a price agreed today. Effectively, a repo trade enables the holder of a bond to borrow money while using the bond as financial collateral with the lender.