Over-The-Counter Market Definition
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.
A Little More on What is an Over-The-Counter Market
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.
How OTC Market Works
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.
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.
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.