Exchange-Tradede

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An instrument that trades on an organized exchange is said to be exchange-traded. Examples of exchange-traded instruments include:

  • most large-capitalization stocks
  • futures
  • standardized options on stocks or futures
  • some corporate bonds
  • certain investment funds, called exchange-traded funds (ETFs)

For most of the above instruments, the alternative to being exchange-traded is to trade over-the-counter (OTC). For example, penny stocks trade over-the-counter. Forwards are over-the-counter derivatives that can be used in place of futures, albeit with possible credit risk. There is no over-the-counter alternative to ETFs. For them, the off-exchange alternative would be open-ended mutual funds, shares of which are continually issued and redeemed by the sponsor at the end-of-day net asset value based on investor demand.

Being exchange-traded has a number of advantages. Exchanges facilitate price transparency and liquidity. Exchange-traded derivatives are standardized, which reduces legal expenses and risk. Exchanges can facilitate mechanisms for mitigating settlement risk, such as margining and clearing houses, although similar solutions are possible in over-the-counter markets as well. Finally, exchange-traded markets tend to be better regulated than over-the-counter alternatives, which reduces risk of abuse or fraud.

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