Over-the-counter (OTC) refers to trading securities not in the centralized market but directly between two parties.
OTC trading has its distinctive features in trading targets and trading methods.
Illiquidity and insufficient public information may lead to credit risk of OTC trading.
Over-the-counter (OTC) trading is conducted directly between two parties without the oversight of an exchange. Prices are not necessarily publicly disclosed in OTC trading, while exchange trading provides public price and liquidity.
There are various types of OTC securities. Stock exchanges impose strict listing conditions on securities to be listed and accept only those that meet these conditions, so relatively, not as many securities can be exchange-traded.
OTC securities are usually unlisted and are not required to meet the strict listing conditions issued by the stock exchanges. Compared with listed securities, securities traded over-the-counter are more abundant and diverse. It is worth noting that unlisted securities are not inferior. Some securities are not traded on stock exchanges simply because the issuers of the securities have not applied for listing.
In the United States, newly issued shares, federal securities, local government bonds, and corporate bonds can be traded through OTC trading.
Advantages and disadvantages of OTC
Securities must comply with strict listing conditions set by the stock exchange to get listed, and issuers must meet strict disclosure obligations. Therefore, the application for the listing of securities is a high-cost financing activity for the issuers, as they have to bear heavy expenses and pay various fees to intermediaries.
This may not be good for companies with smaller financing and joint-stock companies wishing to keep their financial and operational secrets. In this sense, the existence of OTC markets has a positive impact on the financial markets.
We should also note that exchanges in the OTC market only serve as intermediaries. Generally, they don’t provide delivery guarantees for investors, and the credit risk needs to be borne by investors themselves. Lack of regulation in some OCT markets may lead to opaque quotes, making it more difficult for investors to defend their rights in the event of disputes.
OTC trading provides access to securities not available on standard exchanges, such as delisted stocks, bonds, and derivatives.
OTC trading allows capital raising for companies that wish to maintain financial and operational secrecy.
The wider price spreads and few regulations in OTC trading make it possible for speculative investors to earn higher returns.
The unregulated nature of OTC trading means a higher risk of counterparty default, and it is hard to defend rights.
Stock OTC trading can be risky because companies do not need to provide as much information as exchange-listed companies.
OTC securities could be difficult to buy or sell due to a lack of liquidity.
OTC Markets Group
OTC markets used to have two key players, the Pink Sheets and the FINRA-operated Over The Counter Bulletin Board (OTCBB). However, FINRA officially ceased operations of the OTCBB on Nov 8, 2021. Now, the main player in OTC markets is OTC Markets Group (formerly known as Pink Sheets), an American financial market providing price and liquidity information for over 10,000 OTC securities.
OTC Markets Group provides services in three core areas: trading services, market data, and corporate services.
OTC securities are classified into three market tiers: OTCQX, which has the most stringent listing requirements; OTCQB, which is for entrepreneurial and development stage US and international companies; and the Pink Public Market, which includes companies in financial distress or bankruptcy. Of these three tiers, the Pink Public Market is the largest in terms of the number of companies and trading volume.