OTC vs. exchange trading
The two primary forms in which gold is traded in the wholesale market are over-the-counter (OTC) and on exchange. Most of the OTC market has historically been structured around London whereas exchanges offering both gold spot and futures trading can be found in various market centres. In the gold market, as in most asset classes, there is a symbiotic relationship between OTC and on-exchange trading.
OTC markets are characterised by market participants trading directly with each other. The two counterparties to a trade bilaterally agree a price and have obligations to settle the transaction (exchange of cash for gold) with each other. This form of principal-to-principal trading is typically less regulated than trading on an exchange and is how most of the market has functioned historically. Often cited advantages for the OTC model are that it provides market participants with a high degree of flexibility (i.e. to customise transactions) and enables large trades to be executed anonymously. However, OTC markets typically lack high levels of transparency and expose market participants to credit counterparty risks. When market participants start to doubt the financial health of their counterparts, such as happened during the financial crisis of 2007/8, market liquidity can quickly disappear and lead to disorderly function of the market. OTC markets also face several regulatory challenges that have increased the typical costs of transacting under this model.
Exchanges are typically regulated platforms that centralise and intermediate transactions between market participants. Exchanges support transparent price discovery, typically through a central order book which market participants register their buying/selling interest on. Counterparty risks are transferred to a central counterparty (CCP) through the process of clearing. The CCP warehouses credit risk exposures and is protected against default events by market participants posting collateral (margin) and contributions to a central default fund. Generally, exchanges/CCPs support broad market access as firms can either connect directly as members or gain access through an agency bank or broker. Exchanges typically offer highly standardised contracts which can limit flexibility, but this drawback is often offset by capital and operational efficiencies which result from standardisation.