A derivative instrument which is traded and privately negotiated in over-the-counter (OTC) markets, i.e. directly between the two parties involved, without going through organized exchanges or other intermediaries such as brokers or dealers. The main products that are always traded over the counter include forward contracts, swaps (such as credit default swaps), forward rate agreements (FRAs), and exotic options.

For example, the terms of the deal in trading forward contracts can be customized to suit the needs of both the buyer and the seller and may include mark-to-market and daily margining. The OTC derivative market is mostly unregulated as the transacting parties are not required to disclose information about their trades. The main participants in OTC markets are banks and other institutional investors such as hedge funds. Because OTC derivatives are not traded on an exchange, there is no clearing corporation to assume the risk associated with a counterparty not fulfilling its obligations (known as the counterparty risk), and each party will have to rely on the other to deliver and perform.

Currently, with respect to size, the OTC derivative market is substantially larger than the organized market, with a whopping US$708 trillion outstanding notional amount (by mid-2011) according to the Bank For International Settlements (BIS). The lion’s share of which goes to interest rate derivatives (67% of total notional amount).