By Larry Wright
OTC (Over-the-Counter) stock trading is the practice of stock trade that involves direct dealing between a dealer and a brokerage, without the participation or involvement of third-party companies in any way (e.g., exchange regulator). Some people also refer to OTC stock trading as off-exchange trading, so don’t get confused. They both mean the same thing.
Moreover, stocks that operate on marketplaces are referred to as listed equities, while stocks that trade on over-the-counter markets are called unlisted stocks.
Dealers play the role of market makers by declaring the price at which stocks may be bought and sold. Therefore, sellers and purchasers negotiate via unique inter-dealer quote services operated by OTC Markets Group rather than through traditional exchanges such as New York Stock Exchange.
Ordinarily, OTC stocks are those issued by smaller firms that are unable to fulfill the exchange listing standards of more established stock exchanges. However, there are many more different sorts of assets that are traded here as well. Stocks, debt instruments, and derivatives that are not often traded on regular stock exchanges may be found on the over-the-counter market (OTC market).
Companies that are listed on OTC Markets include, but are not limited to, the following:
- Small enterprises that do not fulfill the standards of major stock exchanges such as the NYSE
- International enterprises who want to be presented to the investment community in the United States
- Penny stock firms
What Kind of Securities are Traded Over-The-Counter?
In monetary services, an over-the-counter market is a place where equity investments are exchanged via a broker-dealer network rather than on a traditional financial market, as discussed earlier. For the same reasons, OTC is not centralized and does not have a central clearinghouse to monitor and authorize transactions and takes place between different entities only.
In the commerce world, an illustration of an over-the-counter marketplace would be a deal that takes place between two people who purchase and sell shares in a firm that is not traded on a stock exchange. Almost any kind of investment, including stocks, commodities, and derivatives, may be traded on an over-the-counter platform.
Many OTC equities are stocks issued by underdeveloped or developing firms that do not meet the requirements to be registered on regulated exchanges since they do not trade sufficient stocks or even because their securities do not sell for more than a certain price.
Nevertheless, it should be noted that OTC isn’t merely restricted to smaller firms only. It has some larger enterprises too. Large corporations may choose an over-the-counter market for a variety of reasons, including the fact that they cannot pay the high listing expenses or that they do not choose to endure such costs. NASDAQ, for example, costs corporations up to $163,000 to really be included on its exchange, providing they meet the requirements too.
After their original offering, the vast majority of bonds are traded over the counter (OTC). A combination of the huge volume of deals, the variety of bonds traded, and the low frequency of bond trading make OTC markets a better partner for bonds than stock markets in most cases.
In addition to stocks and bonds, assets that trade over-the-counter (OTC) include:
- Cryptocurrencies such as Bitcoin and Ethereum
- Foreign currencies (Around $5 trillion in foreign cash crosses hands on the Forex, or over-the-counter currency exchange)
- Derivatives (these are agreements between two parties that are often orchestrated via the use of a broker. Futures, Options, Forwards, and other partnerships whose worth is reliant on the underlying assets, such as a stock, are examples of derivatives)
- American Depositary Receipts (ADSs or bank certificates represent a set number of shares of a foreign company)
Known Tiers of OTC Market
Companies that are listed on the OTC Markets Group are classified into four levels based on the information that is currently accessible. These levels are designed to allow investors to offer information about firms as well as the quantity of publicly available information. Moreover, the tiers provide no sign of the firm’s investment qualities and, therefore, should not be taken to be an endorsement of the company’s stock.
OTCQX
The OTCQX Market provides fair, transparent and effective dealing of recognized, investor-focused firms from the United States and throughout the world. When it comes to international companies and U.S. investors, OTCQX is a kind of intermediary, allowing them to convey critical data and information without following the typical strict guidelines. To be eligible for OTCQX, a business must be listed on an authorized international stock exchange and offer up an introductory letter from an approved OTCQX Sponsor.
This market was created to address a shortcoming that multinational corporations who were already registered on such an international stock exchange were experiencing. These companies know how important it is for investors to be able to assess and engage with commodities on the prevailing U.S. market. Previously, however, they were forced to list on the New York Stock Exchange (NYSE) or the Nasdaq Stock Market (NASDAQ), which was a time-consuming and expensive procedure with several complicated regulations.
Companies wishing to educate and communicate with investors in the United States now have an effective and simple option in the shape of the OTCQX. Companies listed on the OTCQX are not obliged to file reports with the Securities and Exchange Commission, and they may avoid expensive compliance requirements by presenting their home country’s declaration in English. OTCQX likewise has smart tools that help global IROs spread information to investors all over the world via employing a channel of media and data collaborations.
It is worth noting that shell companies, penny stocks, and businesses that are in foreclosure or undergoing bankruptcy are never transacted on the OTCQX stock exchange.
OTCQB
The OTCQB Venture Market also provides comprehensive information on early-stage or growing worldwide and U.S. enterprises that do not yet match the standards for listing on the OTCQX, as well as information about their financial performance. Companies who want to be registered on the OTCQB must submit yearly reports and undergo annual validation too. Additionally, their stocks must be traded at a minimal $0.01 bid, and the firm must not be bankrupt to be represented on the OTCQB.
Pink Market
Pink Market enterprises often don’t require any minimum financial criterion in order to participate. Additionally, it encompasses a vast range of various types of firms, including shell companies, diversified international enterprises, penny stocks, and firms that might or might not have any true accounting or economic reports available.
Grey Market
There is an unauthorized market for securities that do not match the standards of the other levels, which is known as the Grey Market. There is typically no or little information available regarding the firm itself, as well as its financial records. Shares that are traded on the Grey Market are those that have either been withdrawn from formal trading on stock exchanges or have not yet begun dealing on stock exchanges.
OTC and Stock Exchanges
Despite the fact that over-the-counter (OTC) markets continue to be an important part of global financial services, OTC derivatives have gained particular prominence. Because of the increased flexibility offered to market players, they are able to tailor derivative contracts that better accommodate their individual risk exposure preferences.
Furthermore, over-the-counter trading contributes to increased overall volatility in the money system, since firms who cannot trade on conventional exchanges obtain access to money via over-the-counter trading.
OTC trading, on the other hand, is subject to a wide range of hazards too. One of the most important is counterparty risk, which refers to the probability that the other party would fail on a contract well before the contract’s completion or expiry. Furthermore, during an economic meltdown, the lack of accountability and lower liquidity compared to the official exchanges might set off a chain of events that can be catastrophic.
The fact that derivative contracts may be designed in a flexible manner might exacerbate the problem. Because of the more sophisticated architecture of the securities, it is more difficult to assess their fair value than it would otherwise be. As a result, the danger of speculation and the occurrence of unforeseen events might jeopardize the integrity of these marketplaces. For example, the synthetic CDOs, which had a substantial role in the international economic meltdown in 2007-2008, were exclusively traded on the over-the-counter markets.
Indeed, the practice of over-the-counter trading has a dirty image in the eyes of some major investors and financial enthusiasts. Part of this is due to the fundamental nature of how it functions. In contrary to the complete openness of the stock markets, where pricing is listed for everyone to see, the over-the-counter market is a covert negotiation between a buyer and a seller. Depending on the circumstances, the vendor may offer the merchandise to one bidder at one price and then another buyer at a different price.
It’s no surprise that over-the-counter (OTC) marketplaces have been the target of fraud and criminal activity. The practice of investing in penny stocks paves the way to unlawful pump and dump tactics, whereby someone promotes (pumps) a company and then sells (dumps) the company after you because other investors have purchased it, causing the stock’s costs to increase.
For average investors, the only safe method to purchase (or sell) OTC stocks is via a reputable broker-dealer who uses a large internet platform such as OTC Markets to facilitate the transaction. They function more or less like “discount” stock exchanges, with certain regulations and monitoring and, in the case of OTC Markets, the classification of equities into tiers.
Even in such a case, take into consideration the tier you want to use as well as the credibility of the broker-dealer who’ll be negotiating your deals.
How Do You Purchase a Security on the OTC Market?
The first step in purchasing a security on the over-the-counter market is to select the precise security you would like to acquire as well as the quantity of money you wish to spend. Always see your budget beforehand and make sure you never invest more than you could afford to lose.
Different marketplaces give information on a variety of assets in which you should invest your time and money. For example, the OTCQX marketplace for over-the-counter equities is one of the biggest largest and best in the world. Find a brokerage that will allow you to acquire over-the-counter (OTC) securities. Guarantee that you are partnering with a really reliable and known brokerage as they very much decide how successful your stock vocation would be. Indeed, they have a critical role to play and, therefore, spend as much time as you can to research and locate the best broker.
The majority of brokers who deal in exchange-listed securities also deal in over-the-counter (OTC) stocks. Once you’ve established a relationship with a brokerage and opened an account, you may fill your record with the funds you want to use to acquire your OTC asset. This may be accomplished online using your broker’s portal or through a phone conversation with your brokerage firm.
Also, please note that all brokerages have different requirements and variable terms and conditions. Make sure you read all of them thoroughly before you sign up. If you have any queries, please feel free to inquire your broker about them.
What Are the Pros and Cons of Working with An OTC Market?
The over-the-counter (OTC) market contains shares of firms that do not intend to comply with tight exchange regulations. Some firms may not want to bear the costs associated with the exchanges. The New York Stock Exchange (NYSE) has established a set of fees and penalties for its exchange of goods or services.
Administrative expenses might amount to as much as $250,000 each year. Depending on the scale of the firm, their listing costs might range from $50,000 to $150,000. There may also be other fees and charges. Therefore, it is clear that OTC markets are comparatively cheaper and easier to handle.
Here are a few simple benefits of trading in over-the-counter marketplaces.
- It serves as a payment system for minor and less liquid firms that do not meet the requirements to be listed on a traditional stock market exchange.
- It provides investors with more flexibility in terms of selecting equities from among those offered by vendors in both the primary and secondary exchanges.
- There are no problems associated with defective or short deliveries in this open trade system.
- Because of the intimate relationship between market makers and clients, communication becomes easier and more transparent from market participants to clients.
- OTC is a cost-effective technique for corporations to raise capital since the costs of new issues are cheaper, as are the costs of providing investor service.
- OTC marketplaces are more cost-effective than traditional stock exchanges, which benefits both investors and firms. Investors will be able to invest in enterprises that will affect the world on a much more cost-effective platform in the future.
- It is used to execute large deals with a counterparty without the need to go via the public order books.
- Family businesses and tightly held corporations may go public via the Over-the-Counter Market.
- Dealers have the opportunity to operate in both the fresh issue and secondary markets at their discretion.
In recent years, there has been an improvement in the over-the-counter (OTC) marketplaces. As a consequence, traders are benefiting from more liquidity and good knowledge. Despite the fact that electronic quotes and trading have improved the OTC market, the industry is associated with many dangers that will be less frequent in official exchanges than in OTC markets.
Here are a few of the hazards:
Regulations
When investing over-the-counter, investors may be exposed to increased risk. The Financial Industry Regulatory Authority (FINRA) regulates brokers and merchants in over-the-counter (OTC) markets in the United States. Exchanges, on the other hand, are susceptible to more stringent regulations than OTC markets. The stricter the standards, the safer the platform.
Transparency
It is not until after the deal has been completed that OTC pricing is made public. As a result, a trade between two parties may be conducted via an over-the-counter marketplace without either party knowing the pricing point of the exchange. Consumers may experience bad circumstances as a result of the lack of openness in the market.
Trading on a stock market, on the other hand, is performed, and the results that are open to the public. This might provide some investors with an additional sense of security and confidence in their transactions. The manner in which securities are exchanged has a significant impact on price decisions and consistency.
Volatility
Another issue to consider when investing in OTC stocks seems to be that they may be very chaotic and unpredictable. As a result, while trading over the counter, risk management strategies should be used to reduce the likelihood of stock manipulation.
Conclusion
Trades on OTC Markets are not properly delineated, and it is possible that they are associated with certain commercial and financial risks; yet, they may be an excellent chance to invest in start-up firms or foreign enterprises.