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Obviously one can transact currency via buying BTCs on an exchange transacting them to another person which itself sells the BTCs received on an exchange - this would limit the possibilities of transacting money to the liquidity of BTC exchanges and exposes the parties involved to the risk of exchange rate fluctuations.

Is there a possibility of avoiding these factors via OTC ?

e.g.: The party which wants to receive a payment, e.g. USD 1000, buys the smallest fraction of a BTC on an exchange (regardless to the value in USD) and "sells" this fraction of BTC to the party which owes the payment in exchange for the USD 1000.

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    Bitcoin is compatible with almost any financial contract or derivative that exists today.

    I think the scenario you are describing is this:

    Bob must pay to Alice $1,000 USD worth of bitcoins. Bob has $1,000 USD to send to Alice but has not yet bought the bitcoins. What ways are available to Bob that allows him to send the funds to Alice without exposure to exchange rate risk.

    You didn't mention a time component so there are two scenarios. One is where there is immediate settlement -- Bob wants to pay Alice the funds now.

    Since there is no "official" exchange rate, what is widely accepted as being an accurate or fair price at any point in time is whatever the "last" trade shows from the BTC/USD market on Mt. Gox.

    Other exchanges may have higher or lower spot market rates. At an exchange with good liquidity, that relatively smaller amount can be purchased at the spot market in a single transaction (without slippage) and the bitcoins can then be delivered to Alice immediately. Because there was essentially no time that elapsed after the bitcoins were purchased before delivery to Alice, there was then no exposure to exchange rate risk.

    Presumably you are inquiring about this for amounts that are larger where slippage would occur.

    There are traders who perform arbitrage (automated with bots, or performed manually) and generally remove price inefficiencies between the markets. This brings additional liquidity to the exchanges.

    Even if arbitrage were to keep the exchange rates between the exchange markets in exact synch, they only act after Bob has made purchases, thus he either loses to slippage when buying in bigger chunks or he exposes himself to exchange rate risk when buying over time. If Bob's purchasing is detected, other traders might become aware of his buying and frontrun him, causing him to realize actual exchange rate risk. And Bob also loses because the arbitrage providers are absorbing some of the value in the process.

    There are few options to Bob to avoid both slippage and exchange rate risk, other than to contract that work out by using a trader or broker who can minimize these factors.

    Now if the amount owed to Alice is not until some future point in time, Bob could consider buying a CALL option, ensuring a supply of bitcoins at a future date at price known today (and thus protects hum from a price move to the upside).

    Bob could instead buy the bitcoins today and then hedge against exchange rate risk by buying a PUT option (which allows him to gain should the exchange rate fall after he makes his purchase before he delivers the coins to Alice).

    Now obviously, if Bob deals solely in fiat, and Alice deals solely in fiat, then why even bring bitcoin in the middle? A bank wire transfer works pretty well for this for immediate (e.g., same-day) settlement of larger amount, and other methods are less expensive for future delivery.

    There is even the ability to use USD vouchers (redeemable codes) for this. Bob does a bank transfer to his account at the same exchange that Alice uses. He then sends Alice a redeemable code for 1,000. Some exchanges allow this, but generally there are limits as the exchange offers these voucher codes presumng the customer overall is using those funds for trading bitcoins and not just withdrawing the fiat after redeeming the codes.

    So to summarize, trades of larger transaction amounts cause slippage and there is not currently an efficient method that takes advantage of the supply from the over-the-counter markets to minimize the market inefficiency similar to wha other, more mature, financial trading ecosystems provide. That may come, it just isn't available today.

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