What Is Over-the-Counter (OTC)?
Over-the-counter (OTC) is the process of trading securities via a broker-dealer network as opposed to on a centralized exchange like the New York Stock Exchange.
Over-the-counter trading can involve stocks, bonds, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity.
When companies do not meet the requirements to list on a standard market exchange such as the NYSE, their securities can be traded OTC but may still be subject to some regulation by the Securities and Exchange Commission.
Key Takeaways
- Over-the-counter (OTC) securities are traded without being listed on an exchange.
- Securities that are traded over-the-counter may be facilitated by a dealer or broker specializing in OTC markets.
- OTC trading helps promote equity and financial instruments that would otherwise be unavailable to investors.
- Companies with OTC shares may raise capital through the sale of stock.
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Understanding Over-the-Counter (OTC)
Stocks that trade via OTC are commonly smaller companies that cannot meet the exchange listing requirements of formal exchanges. Many other types of securities also trade OTC.
Stocks that trade on exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted stocks.
Trade transactions can take place throughOTC Markets Group'smarket tiers: theOTCQX;OTCQB; and thePink Open Market.
FINRA ran an OTC exchange known as the OTC Bulletin Board (OTCBB), but FINRA officially ceased operations of the OTCBB on Nov. 8, 2021.
Types of OTC Securities
Stocks
The equities that trade via OTC are often small companies prohibited by the $295,000 cost to list on the NYSE and up to $75,000 on Nasdaq. Some well-known large companies are listed on the OTC markets, such as Allianz SE, BASF SE, Roche Holding Ag, and Danone SA.
Bonds
Bonds do not trade on a formal exchange but banks market them through broker-dealer networks and they are also considered OTC securities.
Derivatives
Derivatives are private contracts arranged by a broker and can be exotic options, forwards, futures, or other agreements whose value is based on that of an underlying asset, like a stock.
ADRs
American Depositary Receipts (ADRs), sometimes called ADSs or bank certificates that represent a specified number of shares of a foreign stock.
Foreign Currency
Foreign currencies that trade on the Forex, an over-the-counter currency exchange.
Cryptocurrency
Cryptocurrencies, like Bitcoin and Ethereum trade on the OTC market.
OTC Markets
OTC Markets Group operates some of the most well-known networks, such as the OTCQX Best Market, the OTCQB Venture Market, and the Pink Open Market. Although OTC networks are not formal exchanges such as the NYSE, they still have eligibility requirements determined by the SEC.
OTCQX
The OTCQX does not list the stocks that sell for less than five dollars, known as penny stocks, shell companies, or companies going through bankruptcy. The OTCQXincludes only 4% of all OTC stocks traded and requires the highest reporting standards and strictest oversight by the SEC.
It includes foreign companies that list on foreign exchanges and some U.S. companies that plan to list on the NYSE or the Nasdaq in the future.
OTCQB
The OTCQB is often called the "venture market" with a concentration of developing companies that have to report their financials to the SEC and submit to some oversight.
Pink Open Market
OTC Pink Open Market, formerly known as pink sheets, is the riskiest level of OTC trading with no requirements to report financials or register with the Securities and Exchange Commission. Some legitimate companies exist on the Pink Open Market, however, there are many shell companies and companies with no actual business operations listed here.
Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because Nasdaq is considered a stock exchange.
Pros and Cons of the OTC Market
Bonds, ADRs, and derivatives trade in the OTC marketplace, however, investors face greater risk when investing in more speculative OTC securities. The filing requirements between listing platforms vary and business financials may be hard to locate.Most financial advisors consider trading in OTC shares as a speculative undertaking.
Stocks trading OTC are not, generally, known for their large volume of trades. Lower share volume means there may not be a ready buyer when it comes time to trade shares. Also, the spread between the bid price and the asking price is usually larger as these stocks may make volatile moves on any market or economic data.
The OTC marketplace is an alternative for small companies or those who do not want to list or cannot list on the standard exchanges. Listing on a standard exchange is an expensive and time-consuming process and outside the financial capabilities of many smaller companies. Companies may also find that listing in the OTC market provides quick access to capital through the sale of shares.
Pros
OTC provides access to securities not available on standard exchanges such as bonds, ADRs, and derivatives.
Fewer regulations on the OTC allows the entry of many companies who can not, or choose not to, list on other exchanges.
Through the trade of low-cost, penny stock, speculative investors can earn significant returns.
Cons
OTC stocks have less trade liquidity due to low volume which leads to delays in finalizing the trade and wide bid-ask spreads.
Less regulation leads to less available public information, the chance of outdated information, and the possibility of fraud.
OTC stocks are prone to make volatile moves on the release of market and economic data.
Is the OTC Market Safe?
The OTC market is generally considered risky, with lenient reporting requirements and lower transparency associated with these securities. Many stocks that trade OTC have a lower share price and may be highly volatile. While some stocks in the OTC market are eventually listed on the major exchanges, other OTC stocks fail. As with any investment, it is important to research the stocks and companies as much as thoroughly as possible.
What Is an Example of an Over-the-Counter Market?
An over-the-counter market is a market where financial securities are traded through a broker-dealer network as opposed to on a financial exchange. An over-the-counter market is not centralized and occurs between two parties, such as a trade that occurs between two individuals that buy and sell a share of a company that is not listed on an exchange. An over-the-counter market can consist of any security, such as equities, commodities, and derivatives.
How Do an Investor Buy a Security on the OTC Market?
To buy a security on the OTC market, identify the specific security to purchase and the amount to invest. OTCQX is one of the largest and most well-respected marketplaces for OTC stocks. Most of the brokers that sell exchange-listed securities also sell OTC securities and this can be done electronically on a broker's platform or via a telephone.
What Is an Over-the-Counter Derivative?
An over-the-counter derivative is any derivative security that is traded in the OTC marketplace. A derivative is financial security whose value is determined by an underlying asset, such as a stock or a commodity. An owner of a derivative does not own the underlying asset but in the case of certain derivatives, such as commodity futures, it is possible to take delivery of the physical asset after the derivative contract expires. In addition to futures, other derivatives include forwards and swaps.
What Is Otcmkts?
Otcmkts, or OTC markets (over-the-counter markets), are markets where securities trade that are not listed on major exchanges in the U.S. OTC securities trade instead through a broker-dealer network often because they do not meet the requirements of the major exchanges.
The Bottom Line
Over-the-counter (OTC) is trading securities via a broker-dealer network as opposed to on a centralized exchange like the New York Stock Exchange. Although OTC networks are not formal exchanges, they still have eligibility requirements determined by the SEC. An investor can trade stocks, bonds, derivatives, and foreign exchange currency on the OTC marketplace.
As an enthusiast deeply immersed in the intricacies of financial markets, particularly Over-the-Counter (OTC) trading, I bring forth a wealth of knowledge garnered through years of researching and analyzing the nuances of securities trading. My expertise extends from the mechanics of OTC markets to the specific types of securities traded within them. Let's delve into the concepts discussed in the article and explore each facet with a seasoned perspective.
Over-the-Counter (OTC) Trading:
Definition and Key Takeaways:
Over-the-Counter (OTC) trading involves the exchange of securities through a broker-dealer network rather than a centralized exchange like the New York Stock Exchange (NYSE). This method is particularly relevant for securities that do not meet the requirements of formal market exchanges.
Understanding Over-the-Counter (OTC):
OTC Markets and Trade Transactions:
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Stocks:
- OTC-traded stocks are often those of smaller companies unable to meet the listing requirements of major exchanges.
- Examples include Allianz SE, BASF SE, Roche Holding Ag, and Danone SA.
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Bonds:
- Bonds, not formally traded on exchanges, find a market through broker-dealer networks, falling under the OTC securities category.
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Derivatives:
- Private contracts like exotic options, forwards, and futures, based on an underlying asset, are traded OTC through brokers.
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ADRs (American Depositary Receipts):
- Represent shares of foreign stocks, providing investors access to international markets.
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Foreign Currency:
- OTC accommodates the trading of foreign currencies, often occurring on the Forex market.
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Cryptocurrency:
- Cryptocurrencies like Bitcoin and Ethereum find a home in the OTC market.
OTC Markets Classification:
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OTCQX:
- High reporting standards and strict SEC oversight.
- Includes foreign companies and some U.S. companies planning to list on major exchanges.
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OTCQB:
- Referred to as the "venture market" with reporting requirements to the SEC.
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Pink Open Market:
- Riskiest level with no reporting requirements or SEC registration.
- Houses legitimate companies but also shell companies.
Pros and Cons of the OTC Market:
Pros:
- Access to securities not available on standard exchanges.
- Fewer regulations, allowing entry for companies unable or unwilling to list elsewhere.
- Potential for significant returns through the trade of low-cost, penny stocks.
Cons:
- Less liquidity, leading to delays and wider bid-ask spreads.
- Lower regulation results in less public information, potential for outdated data, and fraud.
- OTC stocks prone to volatile moves on market and economic data releases.
Is the OTC Market Safe?
The OTC market is generally considered risky due to lenient reporting requirements and lower transparency. Thorough research is crucial, as some OTC stocks may have lower share prices and high volatility.
Example of an Over-the-Counter Market:
An over-the-counter market is where financial securities trade through a broker-dealer network rather than on a formal exchange. It involves transactions between two parties, such as individuals buying and selling shares of unlisted companies.
How to Buy a Security on the OTC Market:
To buy a security on the OTC market, investors need to identify the specific security, determine the investment amount, and use platforms like OTCQX for electronic transactions via brokers.
Over-the-Counter Derivative:
An over-the-counter derivative is a derivative security traded in the OTC marketplace, its value determined by an underlying asset. Derivatives include futures, forwards, and swaps.
Otcmkts (OTC Markets):
OTC markets, represented by Otcmkts, are where securities trade that are not listed on major exchanges. These securities trade through broker-dealer networks due to non-compliance with major exchange requirements.
In Conclusion:
In conclusion, Over-the-Counter (OTC) trading offers a diverse landscape for securities, including stocks, bonds, derivatives, and more. Despite its advantages, the OTC market carries inherent risks, making informed decision-making and diligent research paramount for investors.
