Over the Counter Trade - Explained
What is an Over-the-Counter Trade?
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Table of ContentsWhat is an Over-The-Counter (OTC) Trade?How does an Over-The-Counter Transaction Work? Academic Research on Over-The-Counter - OTC
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.
How does an Over-The-Counter Transaction Work?
While in a formal exchange, market makers such as brokers and dealers negotiate trades through the exchange, in the case of an over-the-counter setup, they negotiate directly with one another with the aid of communication devices such as telephones and networked computers. Besides unlisted stocks, bonds and such other financial instruments that are not typically traded on a formal exchange can also be classified as OTC securities.From the point of view of an investor, however, the difference between over-the-counter and formal exchanges does not manifest itself in pragmatic terms. This is because advancements in electronic trading systems have made it possible for traders to obtain higher liquidity as well as better information irrespective of the transaction medium. However, there still exist certain key differences between OTC and major exchanges. One such noteworthy difference is that in an OTC, the party is shielded from offers of other counterparties, which is not true for a formal exchange. As with formal exchanges, there also exist several reputed OTC networks. The most noteworthy among these are the OTCQX Best Market, the OTCQB Venture Market and the Pink Open Market - all managed by the OTC Markets Group. Unlisted stocks are tradeable at the Over the Counter Bulletin Board (OTCBB) or at Nasdaq. It is worth noting here that although Nasdaq has a dealer network framework similar to OTC, it is classified as a stock exchange and not as an over-the-counter network.Recent statistical data suggests that as much as 40 percent of all stock trades in the United States were executed off-exchange. Approximately $350 trillion worth of transactions were cleared and almost $700 trillion worth of notional amounts were outstanding.On the one hand, while major corporations such as Allianz, BASF and Danone trade via OTC, there exists mega corporations such as Wal-Mart that initially entered OTC markets, but later switched over to formal listings in stock exchanges.All said and done, OTC derivatives play a significant role, not only in modern banking, but in global finance as a whole. Three noteworthy factors have contributed to the exponential growth of OTC derivatives, especially in the last two decades of the 20th century. They are:
- Interest rate products
- Foreign exchange instruments
- Credit default swaps
Moreover, the advancement in technology, especially in the fields of computing and telecommunication (collectively known as information technology) within the same period also played a pivotal role in advancing the OTC derivatives market.
Academic Research on Over-The-Counter - OTC
- Determinants of bid-asked spreads in the over-the-counter market, Benston, G. J., & Hagerman, R. L. (1974).Journal of Financial Economics, 1(4), 353-364. This paper samples over 300 random OTC stocks to explain the effects of economies of scale. It concludes that monopoly does not naturally occur at the dealer level. Moreover, tests performed on both systematic as well as unsystematic risk concluded that as far as transactions costs are concerned, there exists a correlation between unsystematic risk and spread.
- Competition and the pricing of dealer service in the over-the-counter stock market, Tinic, S. M., & West, R. R. (1972). Journal of Financial and Quantitative Analysis, 7(3), 1707-1727. This paper highlights the immense changes that stock exchanges in particular, have undergone since the mid-20th century. It also predicts that there will be drastic changes in government regulations pertaining to the stock markets in the foreseeable future. Nevertheless, new and unconventional approaches have been aggressively adopted to create markets for common stocks.
- Mandatory disclosure and stock returns: Evidence from the over-the-counter market, Ferrell, A. (2007). The Journal of Legal Studies, 36(2), 213-251. This study investigates the abstract mandatory disclosure requirements that were imposed on the OTC market by regulatory bodies in the U.S. in 1964, and analyzes their effect on volatility and returns. It concludes that there are strong correlations of abstract mandatory disclosure with both volatility of OTC stock returns as well as OTC stocks yielding positive abnormal returns.
- Click or call? Auction versus search in the overthecounter market, Hendershott, T., & Madhavan, A. (2015). The Journal of Finance, 70(1), 419-447. This paper analyzes the impact of modern electronic trading systems on traditional over-the-counter trading setups. The authors deliberate over the possibilities of the two systems coexisting and evaluate if certain innovations in electronic trading technology makes it possible to engage with multiple bond dealers simultaneously. They conclude that recurring onesided electronic auctions are practicable sources of liquidity.
- The impact of bond rating changes on corporate bond prices: New evidence from the over-the-counter market, May, A. D. (2010). Journal of Banking & Finance, 34(11), 2822-2836. May samples TRACE bond data and scrutinizes variations in bond returns on a daily basis. The paper concludes that stock markets typically display much weaker reactions to upgrades than bond markets. Furthermore, bond markets react drastically to abrupt changes in ratings, fluctuations in ratings of lower-rated businesses and upgrades that elevate a firms status from speculative to investment-worthy.
- Over-the-counter loans, adverse selection, and stigma in the interbank market, Ennis, H. M., & Weinberg, J. A. (2013). Review of Economic Dynamics, 16(4), 601-616. Ennis and Weinberg scrutinize an interbank credit model where intertemporal trade opportunities between banks and external investors are curtailed by physical and informational discords. Banks hold assets of diverse valuations and procure loans from OTC markets. Often these asset valuations are ambiguous to external investors. This ambiguity manifests itself in the form of fluctuating asset prices as a reaction to a banks activities in the loan market.
- The impact of SEC-required disclosure and insider-trading regulations on the bid/ask spreads in the over-the-counter market, Hagerman, R. L., & Healy, J. P. (1992). Journal of Accounting and Public Policy, 11(3), 233-243. This paper analyzes the findings of Levs 1988 study in which he correlates the effect of a reduction of asymmetric information induced by accounting regulation with a reduction of the bid and ask spreads. Hagerman and Healys paper disproves Levs theory after subjecting it to a series of empirical tests.
- The overthecounter market and New York Stock Exchange trading halts, Fabozzi, F. J., & Ma, C. K. (1988). Financial Review, 23(4), 427-437. Fabozzi and Ma sample OTC stocks that have been placed under temporary suspension by the New York Stock Exchange (NYSE) and scrutinize their activities in the market using transactiontotransaction statistics. The goal is to scrutinize price adjustments between market equilibria during trading halts at the NYSE. The paper concludes that the effect of a suspension by the NYSE is much more pronounced in OTC markets.
- Federal Regulation of the Over-the-Counter Securities Market, Frey, A. H. (1957). University of Pennsylvania Law Review, 106(1), 1-51. Freys paper conducts a study of how federal regulations affect the sale or purchase of current over-the-counter (OTC) securities. Accordingly, it does not take into account original issues of securities (via IPOs or private placement). Frey analyzes the role of the Securities and Exchange Commission (SEC) in regulating over-the-counter transactions involving current securities.
- Long-run operating performance of initial public offerings in Japanese over-the-counter market (19912001): evidence and implications, Yan, D., & Cai, J. (2003). Asia-Pacific Financial Markets, 10(2-3), 239-274. Yan and Cai sample over 700 Japanese OTC initial public offerings for the period 1991 - 2001. The authors comprehensively scrutinize empirical results and conclude that there exists drastic and persistent operating underperformance that is unaffected by industry or mean reversion adjustments. The paper also exposes a significant decline in market expectations in the years following issue. Furthermore, companies tend to display remarkable business expansion during the period of issuance of IPOs.
- The impact of Value Line special situations recommendations on stock prices: Evidence from the overthecounter market, Pawlukiewicz, J. E., & Preece, D. C. (1991). Financial Review, 26(4), 547-568. This paper scrutinizes statistics provided by the Value Line Investment Service and analyzes its significance to investors planning to purchase or sell particular stocks. It concludes that such statistics produces extremely abnormal returns for shareholders as it nears the date of issue. Another remarkable observation is that the statistics provided do not show any distinction between listed and overthecounter securities when it comes to overall price response.