Over the Counter Trade - Explained
What is an Over-the-Counter Trade?
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Table of ContentsWhat is the Over-The-Counter Market?What is an Over-The-Counter (OTC) Trade?How Does an Over-The-Counter Market Work?Securities in the OTC MarketDifferent Types of Securities That Are Traded on OTC PlatformsDifferent OTC Networks and Uses: Everything You Should Know About OTC MarketsOTC Securities: Real World ExamplesBrokers in OTC marketsLimited liquidityRisks of Trading in the OTC MarketAcademic Research on Over-The-Counter - OTC
What is the Over-The-Counter Market?
An OTC market is a market where two parties directly trade financial instruments like stocks, commodities, and currencies without any supervision. Small companies often use OTC markets to trade because they are unable to make it to the exchange listings. OTC trading does not need a physical location like at the London Stock Exchange or the Euronext. Instead, traders communicate through telephone calls, emails, and other electronic systems of trade.
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What is an Over-The-Counter (OTC) Trade?
Over-the-counter (OTC) is a trading mechanism where securities of unlisted companies are traded between brokers or dealers without the supervision of a formal exchange. In such a setup, the dealer network takes over the roles of a centralized exchange. Besides stocks, dealer networks also deal in commodities and derivatives. There are several small companies and businesses that are incapable of conforming to the stringent norms mandated by formal exchanges for listing securities. These businesses typically opt for OTC mechanisms for security trading. However, not all companies that employ the OTC trading mechanism are small - industry majors such as Allianz SE, BASF and Roche Holding Ag use over-the-counter solutions.
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How Does an Over-The-Counter Market Work?
In an OTC market, the traders agree on the prices of securities or other products amongst themselves. The prices for the securities may not be the same across all the customers in the market because it is not a formal market. Two participants in the OTC market are capable of trading without the awareness of other market traders.
Generally, OTC market trades are subject to fewer regulations because they are less transparent than normal exchanges. Stock exchanges simplify liquidity of assets and mitigate risks in case one party defaults. It also provides transparency over the prices of securities in the market. However, this is contrary to over-the-counter markets as they don't offer transparency on the prices of securities to the public. Generally, OTC markets provide a wider platform for investors as they do not have to limit themselves to investing in the companies the exchanges list for them. Investors also get a chance to invest in the small, ignored companies that have a possibility for growth.
OTC market allows traders to buy and sell securities directly from their accounts. The dealer may buy the securities at a lower price, and to make profits, they will increase the selling prices of the assets to investors. Investors can directly buy stocks or bonds from the dealers, or they can involve a broker to search for the best market prices. The United States government list their bonds and stocks in the exchanges for the public but have an OTC market as its chief market. It exclusively trades the state and municipal bonds over-the-counter.
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Securities in the OTC Market
The OTC market permits the trading of thousands of securities. The most common are penny stocks, which the market trades at a price of less than a dollar. OTC markets trade bonds, structured products, and currencies. Trade items can also include debt securities and derivatives that the exchange market cannot trade. The companies that do not meet the requirements to buy and sell in stock exchanges also trade in OTC markets to raise capital.
Different Types of Securities That Are Traded on OTC Platforms
While the majority of OTC stocks are shares of small firms, there are quite a few number of big and high-performance stocks that are traded via this method. Some famous companies can also be found on OTC markets. For example, the OTCQX trades stocks of foreign companies such as Nestle SA, Bayer A.G., Allianz SE, BASF, SE, Roche Holding Ag, and Danone SA. Also, American depository receipts (ADRs) which represents shares in equity that are traded on a foreign exchange are usually traded over the counter. In most cases, shares are traded over the counter because the underlying firm doesn't wish to list their stocks on formal exchanges, or doesn't simply meet the requirements to be listed on a formal exchange trading platform.
Also, some firms are unable to pay the $500,000 fees that is associated with listing on the NYSE, or the $75,000 fee required by NASDAQ. The latter problem is easily seen in newer and smaller firms that are already facing barriers in carrying out operations properly. Also, instruments like bonds are traded over the counter. Instead of listing them on formal exchanges, companies prefer to go through broker-dealers when issuing debt instruments. This action is carried out to save cost of the fees charged for listing on exchanges by matching and calls and puts from clients internally or from other brokerage firms. Derivatives are also among the other financial instruments that are traded solely on OTC markets.
Different OTC Networks and Uses: Everything You Should Know About OTC Markets
The OTC Markets Group control several of the most famous networks like the Best Market (OTCQX), the Pink Open Market, and the Venture Market (OTCQB). Although OTC networks are different from formal exchanges, they still have requirements that companies needs to meet before they can be listed on these markets. For instance, OTCQX requires all stocks to sell for at least $5; anything less will not make it to the market. It also forbids listing penny stocks, shell companies, and firms in the process of bankruptcy. The OTCQX Best market has the greatest number of firms with the highest capitalization and greater liquidity than the other markets.
For investors that are looking to follow a company from their date of establishment, or looking to invest in the next big thing, they can use OTC markets to search for stocks provided by these underlying companies. OTC markets provide a platform for investing in small and developing markets. Depending on the firm, they can also file reports to the Securities and Exchange Commission (SEC) regulators. OTCBB stocks generally have a suffix of OB and they are required to submit financial statements with the SEC either quarterly or on an annual basis. Another trading platform which investors can use to trade OTC stocks is the Pink Sheets, and they provide a wide variety of stocks.
Businesses trading under this network do not meet the requirements put in place by the SEC. While these stocks are more pocket friendly in terms of transactional costs and fees, they can be used as platforms for price manipulation (pump and dump schemes) and fraud. Pink Sheets stocks usually have the suffix of PK and they're not mandated to file financial reports with the SEC. NASDAQ is an exchange that operates as a dealer network, but doesn't have its stocks listed as OTC. This is because it has acquired the status of a stock exchange.
OTC Securities: Real World Examples
OTC Markets Group is the controller of the financial markets for OTCQX. This operator lists the most actively traded OTC stocks of underlying companies, and they provide details and information on the advances, as well as the decliners. In this group, a daily dollar volume can exceed $1.2 billion with over six billion shares trading hands. Companies that are actively traded in the platform provided by this operator include Tencent Holdings a Chinese multimedia company (TCEHY), Nestle SA (NSRGY), and Bayer A.G. a healthcare firm(BAYRY).
Brokers in OTC markets
A broker is a person that buys and sells assets on behalf of the investor. The Securities and Exchange Commission is responsible for regulating the brokers in the exchange markets. Broker-dealers are also present in the OTC markets, and they facilitate buying and selling of securities in the stock market.
OTC markets are an important aspect of finance, as they increase the liquidity of assets in the market allowing small companies to trade. Nevertheless, the securities that the OTC market trades may lack buyers and sellers. Therefore, the value of assets and securities varies depending on the broker that is trading the securities. In case a buyer has a significant position in the OTC market, it can be dangerous to trade securities in the future. The lack of liquidity of the assets in the market makes it difficult for investors to trade in the future.
Risks of Trading in the OTC Market
- One party in the trade may default before the process is complete, and may end up not paying the amount required in their agreement
- OTC markets are not as transparent as the exchanges, and they operate with few regulations. The lack of transparency in OTC markets causes the development of a brutal trade cycle during a time of financial crisis
- The absence of liquid assets in the market may cause trade dealers to withdraw from the OTC market.