Modern investors have a variety of choices for acquiring securities and are accustomed to making trades swiftly with transparent pricing. Trading of well-known securities often takes place on formal exchanges, which are large institutions that follow a series of rules for helping to assure an active market, liquidity of assets traded and robust supply and demand.
Trading, however, can also take place on the alternative "over-the-counter" market, or OTC. It's a less formal, less-regulated, off-exchange market where investors can find lesser-known securities that aren't available on major exchanges.
In contrast to trading on the major exchanges, such as the New York Stock Exchange or the Chicago Mercantile Exchange, over-the-counter trading is organised among groups of dealers and does not take place through a single institution. The dealers function as "market makers" who agree to hold a certain number of securities to guarantee their availability. They also quote ask and bid prices for other dealers and for their own customers.
Accessibility, Lower Entry Costs
OTC trading is common in certain markets such as forex and commodities derivatives. Frequently, stocks are listed over the counter because the companies offering them don't yet have the resources to meet listing requirements on official exchanges. Thus, listing on the OTC can be an easy way for companies to raise capital before they are established in their industries. These companies are often referred to as "micro-caps."
For investors, these listings can present advantages over others on formal exchanges because they are often less expensive and offer the chance to buy large quantities of a particular security at an early stage of a company's growth. Another advantage to OTC trading is that the securities there may not be widely offered. As a result, the bidding for well-priced deals may be less competitive.
Where To Trade
OTC dealers often communicate their bid- and ask-price quotes over the telephone, email or other forms of electronic messaging. They can also be posted on electronic bulletin boards. Some brokers who frequently trade through the official exchanges may also offer access to transactions on the OTC market.
These dealers, however, can segregate their trading between two markets: the customer market where they deal directly with customers in phone or electronic transactions; and the inter-dealer market, where they will buy and sell exclusively with other dealers with the aim of offsetting any risks they may have assumed in the customer market. The latest bid-ask prices are immediately made public for trading on official exchanges, but that is not necessarily the case in the OTC market where investors and dealers participate in "bilateral" trading.
OTC security prices are commonly reported in the OTCBB, an electronic inter-dealer quotation system that displays quotes, last-sale prices and volume information for many OTC equity securities. The OTCBB is operated by the Financial Industry Regulatory Authority (FINRA).
According to the OTCBB's eligibility rule, companies that want their securities quoted on the board must be sponsored by a market maker firm that is a registered broker-dealer. They must also file current financial reports with the SEC or with a banking or insurance regulator.
Another forum for trading is OTC Link LLC, an electronic inter-dealer system that displays quotes, last-sale prices and volume information of exchange-listed securities, OTC equity securities, foreign equity securities and some corporate debt securities. In addition to displaying quotes, OTC Link allows dealers to send and receive messages, and negotiate trades. This system is also registered with the SEC and is a member of FINRA.
OTC Link classifies securities into three marketplaces according to the amount of information available about them:
- The OTCQB marketplace: includes the securities of companies that are current in their reporting to the SEC, a U.S. bank, or a thrift or insurance regulator.
- The OTCQX marketplace: includes securities of companies that are current in their reporting to the SEC, a U.S. bank, or a thrift or insurance regulator; or, in the case of companies that are not required to report to the SEC, meet and remain current in their reporting obligations to OTC Link under its own Alternative Reporting Standard.
- The OTC Pink marketplace: includes equity securities with no financial standards or reporting requirements.
Risks Of OTC Trading
While OTC trading can offer the potential for elevated profits, it can also present risks such as a lack of public information about securities being traded.
Most large public companies file reports with the SEC that are available to investors. However, information about smaller companies listed on OTC exchanges can be difficult to find. This makes them more vulnerable to investment fraud schemes and less likely to have pricing based on complete information about the company. Additionally, companies listed on this market have to meet fewer reporting standards on characteristics such as minimum amounts of net assets and minimum numbers of shareholders.
Many companies on the OTC market are new, have no proven track record and may have no assets, operations or revenues. OTC trading also carries the risk of a low volume of trades, which can mean trades of any size can have a large percentage impact on the price of the stock. Further, OTC dealers can withdraw from market making at any time. This causes liquidity to dry up and hampers the ability of market participants to buy or sell. As with any form of trading or investing, be sure to do your research and/or consult a professional in the field.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…