Over-the-Counter – Definition

Cite this article as:"Over-the-Counter – Definition," in The Business Professor, updated November 26, 2019, last accessed August 14, 2020, https://thebusinessprofessor.com/lesson/over-the-counter-definition/.

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Over-The-Counter (OTC) Definition

In a securities market, trading platforms can differ. While some are digitalized, others are not, and it isn’t mandatory for a firm to be listed on a securities exchange. The term ‘over-the-counter’ is used to refer to the way in which securities are traded for companies that are not listed on formal exchanges like NASDAQ or the New York Stocks Exchange (NYSE). Instead of making use of centralized exchanges, OTC traded securities are traded using a broker-dealer network. A broker dealer network is a trading method, where a broker or brokerage firm enters into a bigger market on behalf of an investor. Over-the-counter securities are usually traded via broker-dealer networks because they do not fulfill the minimum requirements needed to have a listing on a standard market exchange. For OTC securities, trades take place either by Pink Sheet listing services or via the Over the Counter Bulletin Board (OTCBB). Pink Sheets is a private firm that works with broker-dealers to bring small company shares into the market. They assist firms that do not meet the requirements of listings to be able to have their assets traded on broker-dealers. OTCBB is an electronic quotation and trading service that facilitates higher liquidity and provides better information to investors who are interested in trading OTC stocks.

A Little More on What is Over-The-Counter

Almost all the stocks –if not all– that are traded via OTC are usually smaller and emerging firms that do not meet the necessary requirements to be registered on a formal listings exchange. There are also other types of securities that trade via OTC, and these sometimes dispute the fact that only assets which don’t meet requirements are OTC listed. When a stock or a financial asset is traded via OTC, it is called an unlisted stock; whereas, a formal exchange stock is called a listed share or stock. Whether an investor chooses to use a Pink Sheet or the OTCBB, he or she will have to go through a broker-dealer. The broker-dealer negotiates with each other via a computer networks, and with the OTCBB using phone communications. For OTC securities, the dealers act as market makers using Pink Sheets and the OTC Bulletin Board, which is offered by the National Association of Securities Dealers (NSAD).

Important Notes

  • Over-the-counter (OTC) refers to the process of how securities are traded for firms that do not qualify for listing on formal exchanges.
  • OTC trading helps smaller and emerging firms create an additional source of income via investors. It also promotes equity and financial instruments that wouldn’t have seen the light of day to investors.
  • Securities are traded over-the-counter are traded using a dealer network instead of on a centralized network like listed stocks.

Firms that have OTC shares are eligible to raise capital for financing operations from the proceeds of their stock sales.

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.

Advantages and Disadvantages of OTC Marketplace

We stated earlier above that some highly known securities like bonds, ADRs, and derivatives are traded in the OTC marketplace. However, we also advise clients or investors to take great care when investing in speculative OTC securities. Simply put, investors should take more care when investing in stocks and options listed on OTC marketplaces, than they would normally do when investing in bonds and derivatives in these same marketplaces. They are several requirements between listing platforms that differ, and some details which are critical to investors like financials are hard to find for OTC stocks. A number of financial advisors see trading in OTC shares as a speculative undertaking. Thus, investors are advised to check their risk levels and compare it with their portfolio. If they can handle the risks involved in trading OTC stocks, they can choose to add it to their portfolio. However, OTC shares obey the financial law of “the more the risk, the higher the potential of profits.” Thus, investors can invest in OTC shares if they’re looking for a way to get excess returns. If a stock on this exchange makes it big, it has the potential of turning investors wealthy overnight due to their small cost of purchases. Also, since OTC stocks trade at a lower transactional fee, they provide a channel for share appreciation. This is also good news for the investor.

One problem with OTC shares is the absence of volume. Most OTC stocks are not substantially liquid, so one should expect to encounter problems when it comes to time to sell their stock. Since there is no volume, or the volume of trading is ridiculously low, most times it is hard to find a buyer when one wishes to sell his or her position. Also, the spread can be intimidating, and this makes it a bad idea to day trade penny stocks. The spread in this case refers to the difference between the bid-price and the ask-price. Also, volatility is also a problem with OTC shares, as a little economic data can make big moves in OTC marketplaces. OTC marketplaces serve as platforms for smaller companies that don’t want to traded on exchanges, or do not necessarily meet the requirements of being listed on formal exchanges. Most companies find out that listing on OTC marketplaces is a faster way to generate capital for business financing, moreover, listing on formal exchanges is quite expensive, stressful, and also time-consuming. For these reasons, most companies that don’t have the financial tools to get on formal exchanges decide to go with listings on OTC marketplaces.

Pros

  • The low price of OTC stocks, the low transactional fees, and also low commission can make it a great investment for turning in excess returns.
  • Fewer regulations on OTC stocks lifts the barrier to entry, thus making many smaller and developing companies have access to listings.
  •  Securities like bonds, derivatives, and ADRs are traded on OTC marketplace.

Cons

  • OTC stocks have lesser liquidity than formal exchange stocks, thus creating a hassle to sell off securities in time.
  • OTC stocks are prone to volatile market moves caused by little economic data.
  • Due to the reduced measure on regulating OTC shares, it is quite hard to find viable information that can help one invest in these markets.

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).

References for “Over-The-Counter – OTC

https://www.investopedia.com › Trading › Trading Instruments

https://en.wikipedia.org/wiki/Over-the-counter_(finance)

https://investinganswers.com/dictionary/o/over-counter-otc

www.bankpedia.org/index.php/en/118-english/…/23322-over-the-counter-otc-trading

https://www.imf.org/external/pubs/ft/fandd/basics/markets.htm

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