An exchange traded derivative is a financial instrument that trades on a regulated exchange and whose value is based on the value of another asset. Simply put, these are derivatives that are traded in a regulated fashion.
Exchange traded derivatives have become increasingly popular because of the advantages they have over over-the-counter (OTC) derivatives, such as standardization, liquidity and elimination of default risk. Futures and options are two of the most popular exchange traded derivatives. These derivatives can be used to hedge exposure or speculate on a wide range of financial assets like commodities, equities, currencies and even interest rates.
Exchange traded derivatives are well suited for the retail investor, unlike their over-the-counter cousins. In the OTC market, it is easy to get lost in the complexity of the instrument and the exact nature of what is being traded. In that regard, exchange traded derivatives have two big advantages:
Exchange traded derivatives are not favored by large institutions because of the very features that make them appealing to small investors. For instance, standardized contracts may not be useful to institutions that generally trade large amounts of derivatives because of the smaller notional value of exchange traded derivatives and their lack of customization.
Exchange traded derivatives are also totally transparent, which may be a hindrance to large institutions who generally do not want their trading intentions known to the public or their competitors.
Institutional investors tend to work directly with issuers and investment banks to create tailored investments that give them the exact risk and reward profile they are looking for.