What is Over-the-Counter?
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.
OTC securities comprise a wide range of financial instruments and commodities. Financial instruments traded over-the-counter include stocks, debt securities, and derivatives. Stocks that are traded over-the-counter usually belong to small companies that lack the resources to be listed on formal exchanges. However, sometimes even large companies’ stocks are traded over-the-counter.
Derivatives represent a substantial part of over-the-counter trading, which is especially crucial in hedging risks using derivatives. The lack of limitations on the quantity and quality of traded items allows the parties involved in the trading to tailor the specifications of the contracts in the transaction to the risk exposure. Thus, these instruments could be used for a “perfect hedge.”
Pros and Cons of the Over-the-counter 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.
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.
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.
The Importance of Over-the-counter in Finance
While over-the-counter markets remain an essential element of global finance, OTC derivatives possess exceptional significance. The greater flexibility provided to market participants enables them to adjust derivative contracts to better suit their risk exposure.
Also, OTC trading increases overall liquidity in financial markets, as companies that cannot trade on the formal exchanges gain access to capital through over-the-counter markets.
However, OTC trading is exposed to numerous risks. One of the most significant is counterparty risk – the possibility of the other party’s default before the fulfillment or expiration of a contract. Moreover, the lack of transparency and weaker liquidity relative to the formal exchanges can trigger disastrous events during a financial crisis.
The flexibility of derivative contracts design can worsen the situation. The more complicated design of the securities makes it harder to determine their fair value. Thus, the risk of speculation and unexpected events can hurt the stability of the markets.
For example, notorious CDOs and synthetic CDOs that caused a significant impact on the global financial crisis in 2007-2008 were traded only in the OTC markets.