What is OTC Trading?

Most assets are typically exchanged on centralised platforms such as the NYSE or NASDAQ, where specific regulations and criteria must be adhered to by all parties involved. On the other hand, an alternative facet of the financial realm is OTC (over-the-counter) transactions, which are conducted directly between buyers and sellers without intermediaries.

Centralised platforms like the NYSE and NASDAQ play a crucial role in facilitating asset trading by enforcing mandatory rules and requirements to ensure fair and transparent transactions. Conversely, OTC deals offer a different approach by allowing parties to engage in direct transactions, providing flexibility and autonomy in the negotiation process.

This article will guide you through the world of electronic trading. It will explain OTC trading and what assets can be traded in the OTC market. You will also learn about what types of OTC markets exist and how trading on this market differs from trading on a stock exchange.

Over-the-Counter trading involves the direct trading of financial instruments between two parties without the need for a centralised exchange. This decentralised market allows participants to trade a variety of instruments, including stocks, bonds, derivatives, and commodities, with the assistance of intermediaries like broker-dealers.

In OTC trading, buyers and sellers can negotiate prices and terms directly, leading to more transaction flexibility and customisation. This type of trading is often used for instruments that may not be listed on traditional exchanges or for transactions that require privacy or specialised terms that may not be available on public markets.

OTC trading provides a more personalised and flexible approach to trading financial instruments, allowing for direct communication and negotiation between parties. While it may involve more risk due to the lack of centralised oversight, OTC trading offers unique opportunities for participants to engage in transactions that may not be possible through traditional exchanges.

OTC market and trading on it has a complex structure and mechanisms of operation, has a number of distinctive qualities and characteristics that are inherent to it in comparison with other types of trading. Among them are the following:

Over-the-counter (OTC) trading provides investors an alternative way to access markets and trade instruments that may not be available on traditional exchanges. OTC currency trading expands the range of investment opportunities by offering access to a broader array of financial products and assets, including customised derivatives, certain types of bonds, and other securities that may not be widely available through standard exchange platforms. 

This can be particularly beneficial for investors seeking more diverse and tailored investment options beyond what is traditionally offered through formal exchanges.

In contrast to traditional exchanges, OTC market trading takes place without a central location. Instead, trades are facilitated through a decentralised network of dealers and brokers who directly negotiate transactions. This decentralised approach allows more flexibility and personalised dealing than centralised exchanges.

OTC markets facilitate the trading of diverse financial instruments, such as stocks, bonds, derivatives, commodities, and currencies. This market is mainly instrumental in trading less liquid and more complex instruments that may not be featured on major exchanges, providing an avenue for investors to access a broader range of investment opportunities.

OTC contracts offer a high degree of flexibility, allowing the involved parties to customise and tailor the terms to meet their needs. This means that the size of the trade, expiration dates, and settlement procedures can be adjusted to fit the unique requirements of the parties involved. This level of customisation makes OTC contracts highly adaptable and suitable for a wide range of trading scenarios.

In the OTC market, transactions are typically conducted privately without public disclosure. This level of privacy ensures that the details of the transactions remain confidential, offering a greater sense of privacy and discretion for the parties involved.

Today, the OTC market is very diverse and offers access to a wide range of asset classes, each of which has its own distinctive characteristics and offers certain advantages when trading them. Here are the main types of assets traded on the OTC market:

This group encompasses unlisted stocks, which consist of shares of companies that are not listed on formal exchanges such as the New York Stock Exchange (NYSE) or the NASDAQ. Typically, these are smaller or newly established companies.

Additionally, this group includes penny stocks, which refer to low-priced, speculative stocks that trade at relatively low market capitalisation. Due to their low price and speculative nature, these stocks often carry higher risk.

This group encompasses various types of bonds, including corporate bonds, municipal bonds and treasury securities.

Corporate bonds are issued by corporations and traded directly between parties without going through formal exchanges. Municipal bonds, issued by local government entities and traded outside formal exchanges, are part of this group. Lastly, treasury securities, which consist of government bonds and notes traded directly between buyers and sellers, also fall under this category.

Derivatives are financial instruments whose value is derived from the value of an underlying asset. Several types of derivatives exist, including options, swaps, forwards, and futures.

Options are contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a set price before a specified date. This allows buyers to take advantage of favourable price movements while limiting downside risk. 

Swaps are agreements in which two parties exchange cash flows or liabilities from different financial instruments. They can be used to manage interest rate or currency risk or to exchange the cash flows of fixed—and floating-rate debt obligations. 

Forwards are customisable contracts to buy or sell an asset at a specified future date at a price agreed upon today. They are tailored to the parties' specific needs, allowing for customisation of terms such as quantity, price, and delivery date. 

Futures contracts are similar to forwards but are standardised and typically trade on exchanges, although some trade over the counter. They obligate the buyer to purchase an asset and the seller to sell an asset at a predetermined price and date, providing a standardised and regulated environment for trading.

In this group, there are spot contracts, agreements between two parties to buy or sell a specific amount of a currency at the current market exchange rate with immediate delivery. The transaction is settled "on the spot," typically within two business days.

Additionally, the group includes forwards and swaps, which are financial contracts that involve agreements to exchange currencies at a specified rate on a future date. In a forward contract, the exchange rate is locked in at the time of the agreement, while in a currency swap, two parties exchange currencies and commit to reversing the transaction at a later date based on predetermined terms. These instruments are commonly used by businesses and investors to hedge against future exchange rate fluctuations.

There are two common types of commodities: physical commodities and commodity derivatives:

Physical commodities involve the direct trading of physical goods such as oil, gold, and agricultural products. Traders buy and sell these actual products.

Commodity derivatives refer to over-the-counter (OTC) contracts such as forwards and swaps that are based on commodity prices. Instead of trading the physical goods, traders exchange agreements based on the future value of the commodities.

Structured products are financial instruments that combine various financial assets into a single security. Some examples of structured products include:

These are complex securities backed by a diverse pool of loans or other assets. Investors in CDOs receive payments from the underlying assets, and the level of risk associated with a CDO depends on the quality of the underlying assets.

These are derivative contracts that provide insurance against the default of a debt instrument, such as a bond or loan. In a CDS, the buyer makes periodic payments to the seller in exchange for protection against default. If the debt instrument defaults, the seller must pay the buyer the face value of the instrument.

Private placements are a method of raising capital for companies and other entities through the sale of securities to a relatively small number of select investors. These investors can include institutional investors such as banks, insurance companies, pension funds, hedge funds, and high-net-worth individuals.

This group comprises the next assets classes:

Private equity involves investing in private companies or public companies with the aim of taking them private, which means delisting them from the public stock exchanges and making them privately owned.

Venture capital refers to the investment made in early-stage startups and small businesses that have high growth potential. It typically involves providing capital, managerial expertise, and network access to help these businesses grow and succeed.

Securitised products combine different types of contractual debt, such as mortgages, auto loans, or credit card debt obligations, and sell them as consolidated financial products to investors. These products aim to convert illiquid assets into more liquid securities to redistribute risk.

This group contains asset-backed securities and collateralised loan obligations.

Asset-backed securities (ABS) are financial instruments that represent ownership in a pool of underlying assets such as loans, leases, credit card debt, or receivables. These assets serve as collateral for the securities.

Collateralised loan obligations (CLOs) are financial products that pool together a variety of loans, often including corporate loans and other debt instruments. Investors in CLOs receive payments based on the performance of the underlying loans.

This group has negotiable certificates of deposits (CDs), which are large-denomination CDs that can be traded in the secondary market. These CDs offer the advantage of liquidity, as they can be sold to other investors before they reach maturity. This feature makes them attractive to institutional investors and individuals seeking flexibility in managing their investment portfolio.

The OTC market is categorised into different tiers based on the quality, size and level of disclosure of the companies on the market. Each of these levels has its own structure and peculiarities of functioning, which affects the trading process. Here are the 4 main levels of the OTC market:

The OTCQX is the top tier of the OTC market, catering to well-established companies that prioritise investor relations. To be listed on the OTCQX, companies must adhere to strict financial criteria, uphold exemplary corporate governance practices, and adhere to U.S. securities regulations.

Notable characteristics of the OTCQX include its rigorous financial benchmarks and stringent prerequisites. Additionally, companies seeking listing on the OTCQX must secure a reputable third-party sponsor, such as a bank or investment firm, to vouch for their credibility.

Furthermore, companies listed on the OTCQX must provide regular financial disclosures and maintain high transparency. These features contribute to the OTCQX's reputation as a premier platform for reputable and investor-friendly companies.

The OTCQB is a market tier tailored explicitly for emerging and developing companies in the United States and internationally. This platform is aimed at businesses in their growth phase and seeks to enhance transparency for their investors, thereby fostering a more informed investment environment.

Among its notable characteristics, the OTCQB imposes a minimum bid price requirement of $0.01, ensuring a baseline for trading activity. Additionally, it mandates an annual verification and certification process, which helps maintain the integrity and reliability of the companies listed on this tier.

Companies must stay current with their financial reporting obligations to qualify for the OTCQB. This requirement promotes accountability and reassures investors that they are engaging with businesses that adhere to established financial standards.

The OTC Pink market represents the most adaptable segment within the over-the-counter trading landscape, characterised by diverse financial reporting and disclosure obligations. This tier encompasses a broad spectrum of companies, from well-established enterprises to high-risk speculative startups and financially troubled organisations.

One of the defining aspects of the OTC Pink market is the absence of minimum financial criteria, allowing a wide variety of businesses to participate. Companies are classified into three distinct categories based on their level of disclosure: Current Information, Limited Information, and No Information, which reflects the varying degrees of transparency provided to investors.

Compared to the more regulated OTCQX and OTCQB tiers, the OTC Pink market is notably more speculative and less transparent. This lack of stringent oversight can present opportunities and risks for investors as they navigate a marketplace filled with companies that may not adhere to the same rigorous standards as those in higher tiers.

The unofficial market, commonly known as the Grey Market, consists of securities not listed on any official exchange or OTC trading platform. These stocks do not have publicly displayed quotes; trading typically occurs through private transactions.

Some key characteristics of the Grey Market include a lack of transparency and readily available information. Unlike traditional markets, no active market makers facilitate trades in this informal setting.

Investors should know that participating in the Grey Market carries higher risks than trading on regulated exchanges. The absence of public information and formal trading platforms can make assessing securities' actual value and liquidity in this unregulated market challenging.

OTC trading and stock exchange trading are two separate approaches to trading securities, each possessing unique features, benefits, and drawbacks. Both of these types of markets are popular among different groups of traders and investors, but there are significant differences between them, as follows:

OTC trading is characterised by its decentralised nature. Transactions occur through a network of dealers and brokers instead of a centralised exchange. This method allows for more personalised negotiations between the involved parties, often with the assistance of market makers or brokers who facilitate the process.

In contrast, stock exchange trading is conducted on formal, centralised platforms such as the New York Stock Exchange (NYSE), Nasdaq, or the London Stock Exchange (LSE). This type of trading relies on a regulated electronic system or a physical trading floor, ensuring a structured transaction environment. The centralised nature of stock exchanges provides a level of transparency and security that is often sought by investors.

Regulatory standards for trading can differ significantly between over-the-counter (OTC) markets and stock exchanges. OTC trading is typically subject to less stringent regulations, with varying oversight and disclosure obligations that depend on the specific tier, such as OTCQX, OTCQB, or the Pink Market. Companies operating in these markets may face fewer requirements regarding the information they must disclose to investors.

In contrast, stock exchange trading is characterised by a high level of regulation enforced by government bodies and the exchanges themselves. This regulatory framework ensures that trading practices adhere to strict rules, promoting transparency and investor protection. Companies listed on stock exchanges must fulfil comprehensive disclosure requirements, including regular regulatory filings and detailed reporting, providing investors with a clearer picture of their financial health and operational status.

OTC trading allows investors to access diverse securities, including those not listed on formal exchanges, such as smaller companies, start-ups, and international firms. However, OTC trading may have lower liquidity than major exchanges, resulting in wider bid-ask spreads and potential challenges in executing trades due to fewer participants.

On the other hand, stock exchange trading provides investors access to well-established and well-regulated companies, typically offering higher liquidity and greater trading volumes. The presence of more market participants in stock exchanges generally leads to narrower bid-ask spreads, making it easier to execute trades compared to OTC trading.

Trading expenses can differ significantly between OTC trading and stock exchange trading. In the OTC market, costs tend to be elevated because of broader bid-ask spreads and less competitive pricing structures. Additionally, transaction fees can fluctuate based on the specific broker or dealer facilitating the trade.

In contrast, stock exchange trading usually incurs lower costs, attributed to the competitive environment that fosters tighter bid-ask spreads. Furthermore, the efficiency of automated trading systems and centralised order execution allows for quicker transaction speeds, making this method generally more effective for traders seeking timely execution of their trades.

OTC trading offers a valuable alternative to formal exchanges, particularly for large investors seeking access to unique financial products unavailable on traditional platforms. Additionally, OTC trading provides increased flexibility and privacy, as deals are not publicly disclosed. However, the absence of a central exchange and the higher level of counterparty risk necessitates careful consideration of risk management strategies by participants in the OTC market.

While OTC trading presents opportunities for institutional investors and other major players, it also comes with higher risks for buyers and sellers. The lack of transparency in pricing and conditions and the absence of a central exchange requires participants to approach OTC trading with caution and implement robust risk management strategies to mitigate potential downsides.