Over-the-counter, OTC, refers to the trading of commodities, contracts, or derivatives not listed on an exchange. OTC instruments tend to be used for situations such as forward prices beyond the quotes on exchanges or for customized derivative instruments. Many market participants use OTC derivatives for financial risk management as a complement to physical and exchange-traded financial strategies. OTC instruments are offered by financial services companies, banks, hedge funds, and some marketers.
An example of an OTC derivative in electricity markets would be a price ceiling at the California-Oregon Border (COB). In this example, a bank guarantees a marketer that he will never pay more than $65/MWh for round-the-clock power across the summer months. If the price exceeds $65, the bank will compensate the marketer for the difference between the higher price and the $65 ceiling. Risk premiums embodied in OTC instruments are typically higher than exchange-traded instruments since OTC products are more custom and tend to be less liquid.