In finance, the Over-the-Counter market, or OTC market is a facility where financial instruments such as FOREX, stocks, commodities and derivatives of such products are traded directly between two parties or via a broker-dealer network. Sometimes referred to as off-market trading, in an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, currency, or other financial products.
OTC trading does not require a stock market – there is no physical location. Trading is performed electronically without the supervision of an exchange. The lack of supervision and oversight is the main contrast with an officially recognized stock exchange. The role of a stock exchange provides benefits to traders such as facilitating liquidity, providing reporting transparency and maintaining an orderly market displaying the current market price or most recent traded price of the asset.
An OTC market however is not required to display such price information. Additionally, OTC markets are not limited by the standardization of products that is required by an exchange. Agreements are bilateral, that is, they are made only between the two parties. Therefore, the contract can take on any form necessary such as duration, size, scope, value or any other exotic function that is required. For this reason, the credit risk for each participant with its counterparty increases significantly when trading products in this manner.
In addition to trading physical assets, the OTC derivative market is significant in a number of asset classes. Interest rates, FOREX, stocks, and commodities are frequently traded but it is the size of the credit derivative market that regularly draws the attention of financial regulators.
Over-the-Counter Stock Trading
Smaller company stocks, those which do not meet the requirement of an exchange can be found on an organized for of OTC market. Colloquially known as the pink sheets (see the “Wolf of Wall Street” for more on trading Pink Sheet stocks). Occasionally, companies that have struggled or have seen their value decline to negligible levels may be relegated to the OTC market. A minimum $5 share price is the usual trigger for this demotion. Stocks subsequently trade on the Over-the-Counter (OTC) market, also known as the over-the-counter bulletin board (OTCBB). This a quotation service offered by the National Association of Securities Dealers (NASD). It provides quotes and volume information for securities traded over the counter (that is, securities not listed on the Nasdaq, NYSE, AMEX or other exchanges).
Some larger foreign may also obtain a listing by these means but may also see sizable volume levels being traded. This may make it possible to short an acquirer stock in the local currency in a stock swap deal. Thus avoiding the need for a FOREX transaction and the costs involved in shorting the stock of a foreign acquirer. However, traders are advised to proceed with caution should this be the case.
Almost all financial advisors will state that trading in OTC stocks is a speculative undertaking. Investors should proceed with extreme caution when investing in these speculative securities. However, risk tolerance is a personal feature of investing and some investors may have the potential to include investments such as these in their portfolios. This additional risk also comes with the possibility of significant gains. However, these shares usually trade at lower values, sometimes just a tiny fraction of a penny, as this is often for a good reason.
