Last Updated on October 19, 2022 by Oddmund Groette
Not all securities trade on standard exchanges. In fact, not even all stocks trade on a standard exchange. Some trade on over-the-counter marketplaces. Wondering what an over-the-counter marketplace is, and how over-the-counter trading works?
Over-the-counter (OTC) trading refers to trading that is done directly between two parties, without the supervision of an exchange. This type of trading is carried out via electronic marketplaces handled by a network of market makers and dealers. The electronic marketplaces where this kind of trading takes place are known as over-the-counter markets.
In this post, we take a look at over-the-counter trading. At the end of the article, we make a backtest of the strategy.
What is the over-the-counter (OTC) market?
An over-the-counter market is an electronic marketplace where trading is done directly between two parties, without the supervision of an exchange. It is a decentralized market in which market participants trade stocks, commodities, currencies, or other instruments directly between two parties and without a central exchange or broker. In contrast to exchange markets that have physical locations, OTC markets do not have physical locations, and trading is conducted electronically.
A wide range of financial securities are traded on OTC markets, and they include financial instruments such as stocks, debt securities, and derivatives, as well as commodities. In general, stocks that are traded on the OTC market are typically those of small companies that cannot meet the requirements to be listed on formal exchanges. However, some big stocks, especially foreign stocks via American Depository Receipts (ADRs) trade on the OTC markets as well.
Unlike exchange markets that use an auction market system, in an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, and a trade can be executed between two participants without others being aware of the price at which the transaction was completed. The stock exchange, for example, has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price.
In an OTC trade, the price is not necessarily publicly disclosed. In fact, OTC markets are generally less transparent than exchanges and are also subject to fewer regulations. As a result of the way they are structured, liquidity in the OTC markets may come at a premium. Although OTC markets are regulated by the Financial Industry Regulation Authority (FINRA), the regulation is not as stringent as that of main exchanges, which makes the market more flexible but also with some serious risks.
One of the most significant is counterparty risk, which is the possibility of the other party’s defaulting before the fulfillment or expiration of a contract. Also, with its lack of transparency and weaker liquidity relative to the formal exchanges, the OTC market is home to market manipulations and some shady deals. The situation is even worse for derivative contracts, given their flexible designs. The more complicated design of the securities makes it harder to determine their fair value, so it comes with the risk of excessive speculation and unexpected events that can hurt the stability of the markets. This was what happened in 2007/2008 when a sudden lack of liquidity in mortgage-backed securities and other derivatives such as CDOs and CMOs, which were traded solely in the OTC markets, led to a global financial crisis. As a result, FINRA introduced the use of clearinghouses for post-trade processing of OTC trades.
How does over-the-counter trading work?
The OTC market works as a channel through which two counterparties can execute their trade outside of formal exchanges and without the supervision of an exchange regulator. The market is decentralized and has no physical location. All trades take place electronically and directly between the two transacting parties.
In the US, the over-the-counter market is run through networks of market makers. The main networks are managed by the OTC Markets Group and regulated by the Financial Industry Regulation Authority (FINRA). These networks provide quotation services to participating market dealers, and the trades can be executed by dealers online or even via telephone.
Unlike trading on formal exchanges, over-the-counter trades are not standardized — clearly defined range of quantity and quality of products, and prices are not always published to the public. OTC contracts are bilateral, and each party could face credit risk concerns regarding its counterparty.
The OTC market allows companies that are not listed on the major exchanges to raise money from the public by selling their stocks and other securities to them over the counter. It is the default market for some securities, like corporate bonds, and also a viable alternative for companies that don’t meet or maintain the requirements to list their shares on the major exchanges (a certain number of shareholders or monthly trading volumes).
Some companies that don’t want to pay the listing fees or be subject to an exchange’s reporting requirements may opt to remain on the OTC market by choice. In today’s world of online trading, the average investor may not know the difference between buying stocks on the OTC market and buying on the main exchange. After all, OTC stocks are assigned a unique ticker symbol and are usually available for trading via major online brokers.
Differences between the OTC Markets and Stock Exchanges
The main difference is in the decentralized nature of the OTC market. But apart from that, there are other differences. One of them is the amount of information that companies make available to investors. Exchange-listed companies are mandated to regularly provide the investing public with information about their operations via quarterly and yearly reports, company news and filings, and real-time trading data.
On the other hand, OTC-listed companies are not obligated to comply with that rule. As such, there is much less available information on OTC stocks. With less transparency and regulation, the OTC markets can be riskier for investors, and sometimes subject to fraud. For example, penny stocks are traded in the over-the-counter market and are notorious for being highly risky and subject to scams and big losses. As a result of the lack of liquidity in OTC stocks, the market is rife with pump-and-dump schemes.
Nonetheless, the OTC market is also home to many American Depository Receipts (ADRs), which allow investors to buy shares of foreign companies. The fact that ADRs are traded on the OTC market doesn’t make the companies riskier for investment purposes.
What is the size of the OTC market?
In the US, there are more than 12,000 securities traded on the OTC market. OTC securities come from a wide range of financial assets, including stocks, exchange-traded funds (ETFs), bonds, commodities, and derivatives.
Typically, stocks that are traded over the counter belong to small companies that lack the resources to be listed on the main exchanges. But it is also possible to have large companies’ stocks trading on OTC markets, especially those of foreign companies that trade as ADRs.
Derivatives are another major asset class that trades in the OTC market, and they are often used in hedging risks. Given the flexibility in the quantity and quality of traded items in the OTC market, the parties involved in the trading can tailor the specifications of the contracts in a transaction to their needs.
How the OTC is useful to the financial market
The OTC markets remain an essential element of global finance, as it allows certain players to conduct their dealings in private. It helps small companies that cannot trade on formal exchanges gain access to capital, and as such, it increases overall liquidity in financial markets.
Furthermore, OTC derivatives offer exceptional characteristics that allow the transacting parties to adjust their contracts to better suit their risk exposure.
Is it good to trade in OTC markets?
The OTC market is home to penny stocks, and these OTC stocks have an average negative annual return of 24%. As a matter of fact, over 90% of penny stocks fail, and here’s why:
The OTC market has a more lenient reporting requirement, so there is less transparency associated with those securities. With less publicly available information about the financials of the related company, it is difficult to value the stocks. And, since OTC stocks have low share prices and little liquidity, they’re ripe for speculation and huge volatility. While these stocks could experience rapid and outsized gains, they’re also prone to frauds, such as so-called “pump and dump” schemes. Pump and dump is a market manipulation where a group of people hypes a penny stock to inflate the price and draw in more investors before selling it and sending the price plummeting.
Some stocks in the OTC market may move up to become listed on the major exchanges, but this only happens on rare occasions. But the odds of that happening are less than 1%, so the prospect of long-term investment in penny OTC stocks is very slim. Most OTC stocks simply spike up and down, and many eventually fail. Those who trade OTC stocks do so on a short-term basis.
Having said that, OTC stocks and other OTC securities are readily available for trading with many online brokerages, but they may be subject to higher fees or some restrictions. Some brokers limit trading of OTC securities during the period surrounding the stock market open and market close, while others require investors to place limit orders — which indicate the exact price executing the trade. Given the highly speculative and higher risk involved in OTC securities, it’s important to invest only an amount of money you can afford to lose.
As with any investment decision, it’s important to fully consider the pros and cons before trading. If you must trade, ensure you research the stocks and companies as much as possible, thoroughly vetting the available information. But most short-term trading is based on technical analysis.
Is crypto an over-the-counter market?
Not exactly. While cryptocurrencies offer an avenue for the peer-to-peer exchange of value through a decentralized network, the trading of cryptocurrencies as an asset class is just like that of any other asset — it can be on an exchange or over the counter.
Most crypto trading happens on exchanges, with the details of the transaction being public on the exchange order books. Examples of such exchanges include Binance, Coinbase, Kraken, Crypto.com, Kucoin, and so on.
Apart from trades on the exchanges, there is also over-the-counter trading. OTC trading of crypto revolves around massive off-market deals, often facilitated by the exchanges themselves. In fact, most crypto exchanges have an OTC desk to serve big clients who want off-market deals, such as when companies like MicroStrategy make multimillion-dollar purchases using OTC desks run by the likes of Coinbase or Kraken.
Other aspects of OTC trading include peer-to-peer platforms like LocalBitcoins, which has been helping individuals trade BTC both in-person and via bank transfer since 2013.
Over-the-counter market examples
OTC Markets Group (OTC: OTCM) is the name of a company that operates the largest electronic marketplace for OTC securities. It categorizes securities by tier based on the quality and quantity of information the companies report. Such designations don’t speak to the investment merits of a particular company; they show how much information is available. The main categories are as follows:
- Best market (OTCQX): This OTC market includes well-established, reputable companies that meet high financial standards and other stringent reporting requirements. Only 4% of all OTC stocks listed are traded on this exchange, and they generally consist of foreign companies that list on major exchanges abroad, as well as some U.S. companies that plan to eventually list on the NYSE or the Nasdaq.
- Venture market (OTCQB): This is for young companies that are still developing and growing. The eligibility requirements for this market are more lenient than for the best market. Companies here have to report their financials and submit to some oversight.
- Pink Sheets: Companies here are by far the riskiest of the OTC markets. They provide the least amount of information and fail to meet the reporting requirements set forth by the Securities and Exchange Commission (SEC). Also known as the open market, this category is home to most penny stocks, shell companies, and companies that are in some sort of financial distress. These securities are most subject to fraud and manipulations.
- Gray Market: Though not an official OTC stock market, it is worth mentioning. The gray market is an unofficial market where securities that are unlisted by choice or by force trade.
Over-The-Counter trading strategy backtest
A backtest of the strategy with trading rules and settings is coming shortly.