Over-the-counter (OTC) refers to the trading of securities between two counterparties outside of a formal exchange, without the involvement of an exchange regulator. This is known as off-exchange trading. OTC trading takes place in an over-the-counter market. These markets are decentralized structures that don’t have physical locations and take place through dealer networks.
OTC is different to exchange trading, which occurs via standard exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. Unlike exchange trading, investors are not required to only trade standardized products in over-the-counter trading. This means that you don’t have to trade in any defined range of quality or quantity of products to meet exchange requirements. By the way, if you want to learn about market makers and their role, click here.
Understanding Over-the-Counter (OTC)
Stocks that trade on formal exchanges are known as listed stocks, whereas stocks that trade via OTC trading are called unlisted stocks. OTC marketspaces usually consist of small companies that don’t meet the requirements of exchange listings under formal exchanges. There are also other types of securities that make use of OTC trading. The trading of unlisted stocks is carried out via networks of market makers. These networks provide a platform for participating market dealers. The trades are done online or via telephone by dealers.
Securities
Although OTC markets generally consist of small companies, there are also plenty of other equities that also participate in OTC trade. OTC markets tend to be made up of stocks that do not meet the requirements of formal exchange markets. They also involve companies that have filed for bankruptcy or are unable to maintain a certain price per share. These companies would not be permitted to trade on a formal exchange but would be able to do so on OTC markets. There are also larger and more established companies present in OTC markets. Although established companies tend to opt mainly for listed stocks via formal exchanges, they are also seen trading on OTC markets too.
For example, Nestle SA, BASF, and Allianz SE are all traded via the OTCQX market. American depository receipts (ADRs) are also traded OTC often. These represent shares in stocks traded on foreign exchanges.
The reason why OTC trade is so popular is because the company either cannot meet certain exchange requirements or they cannot afford to be listed. There are huge costs involved in order to get listed on established exchanges such as the NYSE.
Other financial instruments such as bonds, derivatives, and ADRs can also be traded in the OTC marketplace via dealer networks. Examples of OTC derivatives include swaps, forwards, and exotic options.
Networks
OTC trade transactions take place through listing services. OTC securities conduct trade via brokers who will directly negotiate with each other over computer networks or via phone. These dealers will act as market makers through the various OTC marketplaces.
OTCQX is the most well known top tier OTC marketplace, followed by the Over the Counter Bulletin Board (OTCBB) and The Pink Sheet company.
These three well-known OTC networks are private online trading services that work with brokers in order to bring smaller company shares into market spaces. They are aimed at facilitating higher liquidity and transparency of OTC trading.
Regulation
OTC networks are managed by the Financial Industry Regulation Authority (FINRA) and the OTC Markets Group. These agencies write and enforce rules concerning the governing of brokers and broker-dealers.
The Importance of OTC in The Financial World
OTC markets are an essential part of global finance. They allow small businesses, financial institutions, and other investors to manage their credit exposure, lower their cost of capital, and increase their trading competitiveness both locally and in the rest of the world. They provide greater flexibility to participants within the market and allow participants to adjust derivative contracts in order to suit their risk exposure.
OTC trading serves to increase the overall availability of liquid assets in financial markets. This is due to the fact that companies unable to trade on formal exchanges can gain easier access to additional capital through OTC markets.
The Risks of OTC Trading
There are downsides to OTC trading that one should be aware of before investing. OTC trading increases the amount of risk you are exposed to. One of the most significant risks to consider is counterparty risk. This refers to the possibility of the counterparty’s default before the contract has been fulfilled or expired.
Another important risk to take note of is that OTC markets come with a lack of transparency and generally weaker liquidity compared to formal exchanges. These factors can easily turn OTC markets into a disaster if a financial crisis occurs. Because there is less regulation of OTC markets, there is less information available for the public. There is a high chance of outdated information and an increased possibility of fraud.
OTC stocks are known for their movements when new market information is released or updated data on the economy becomes available.
An example of a volatile movement is collateralized debt obligations (CDOs) that were traded via OTC markets that caused a significant impact on the 2008 financial crisis.
Conclusion
OTC trading serves as an alternative legal trading mechanism for smaller companies or investors who are not wanting to trade listed stocks on standard exchanges. There is a lot of added risk that comes with OTC trade, yet there is also the potential for a significant return. Financial advisors will generally never advise OTC trading due to this added component of risk and because it is overall more complex compared to trading listed shares.
Investors should consider their portfolios and manage their investment risk tolerance very carefully before committing to OTC trade.
