Over the Counter Market (OTC)

The over-the-counter market, popularly known as the OTC market, trades securities not listed on the major exchanges. In an OTC market, dealers quote prices for purchasing and selling a currency, security, and other financial products, thereby acting as market-makers.
Here, a trade can be very well executed between two participants where none is familiar with the transaction price. Generally, exchanges are more transparent than an OTC market. Besides, it is also subject to much fewer regulations, thereby bringing liquidity at a premium.
This article will give you informative insights into the basics of the over-the-counter market. Please keep reading until the end of the article to know more. Let’s begin.
 

What is the Over-the-counter-market?

If you are wondering ‘what is the OTC market?,’ we have some quick answers for you.
An over-the-counter or OTC market is a decentralised financial market. Here, two different parties trade financial instruments with the help of a broker-dealer. Besides, unlisted stocks are the most prominent assets that are traded in the over-the-counter market.
Whenever a company is unlisted, it automatically becomes public. Therefore, they stand an opportunity to sell stocks. However, this scenario is not applicable to security exchanges like Nasdaq or the New York Stock Exchange.
An OTC market is pragmatically a lower-tier marketplace for significantly smaller companies that seldom trade. Even though it sounds risky, some investors get to see the potential upside. And they might end up getting first dibs on the otherwise hidden gems.
 

How Does the OTC Market Work?

Companies that don’t necessarily meet the requirements of listing their securities on an exchange can always choose an OTC market. Even though OTC securities are not listed with the major exchanges, companies can still sell their stocks to the public over the counter.
You should note that trading on the OTC market typically happens on organised networks. These networks are less formal than the traditional stock exchanges. They remain centred on trading networks and relationships among leaders.
Nevertheless, OTC networks function just like traditional stock exchanges. And the broker-dealers quote their desirable prices for buying and selling securities.
On the other hand, investors can easily purchase and sell these securities like other stocks. And while the broker-dealers trade from their own brokerage accounts, they provide extensive liquidity by trading.
In a nutshell, the OTC market is regarded as the default exchange for some securities, such as corporate bonds. Besides, it is an excellent alternative for companies that are incapable of maintaining the necessary requirements for listing their shares on major exchanges.
At the same time, certain companies might choose to remain unlisted on the OTC market. It’s mainly because they are either worried about paying the listing fees or are subject to the reporting requirements of an exchange.
 

Risks of Over-the-Counter Markets

Some of the potential risks associated with the OTC market in India are:

●    Counterparty Risk

In OTC markets, traders are significantly exposed to the risk of default by their counterparties. As there isn’t any centralised clearinghouse, traders must rely on the creditworthiness of their counterparties. This allows them to honour their obligations.

●    Lack of Transparency

The OTC market is generally less transparent than the exchange-traded market. This happens because there is no presence of centralised platforms where market participants can access information regarding trades, volumes, and prices.

●    Regulatory Risk

An OTC market is less regulated compared to the exchange-traded markets. And this is very likely to make them more vulnerable towards manipulative and fraudulent practices.

●    Price Volatility

As there is a lack of liquidity and transparency in OTC markets, it eventually paves the way for higher price volatility. This might happen because of a limited number of market participants and zero public information regarding the market.

●    Liquidity Risk

Certain OTC markets might have limited liquidity and come with a significantly low trading volume. Therefore, it becomes quite difficult for traders to purchase or sell positions at their desirable prices.
However, you should note that OTC markets also have potential benefits. Some of the most commendable ones include lower transaction costs and greater flexibility. Etc. Investors are highly recommended to become aware of the potential risks before engaging in these markets.
 

Differences Between the OTC Market and Stock Exchanges

Here's a table of differences between OTC (over-the-counter) markets and stock exchanges:

What are the 3 OTC Markets?

The three distinctive OTC markets are:

●    The Venture Market (OTCQB)

The venture market is typically for young companies still growing and developing. Please note that the eligibility requirements for this market are way more lenient than the best market.

●    The Best Market (OTCQX)

This OTC market includes reputable and well-established companies that meet high financial standards. Besides, it also comes with other stringent reporting requirements.

●    The Pink Market

Most commonly referred to as the pink sheets, the pink market is the riskiest among all OTC markets. This open market is home to most of the penny stocks, shell companies, and those who are in some financial distress. As a result, these securities are subject to extensive fraud and pose significant risks to investors.
Another OTC market - the grey market - is quite hard to access. Here, the securities are not even quoted by the broker-dealers since there is no regulatory compliance and much available financial information.
 

Is the OTC Market Safe?

Considering the lower transparency and lenient reporting requirements associated with the securities, the OTC market is quite risky. While over-the-counter stocks have a significantly lower share price, they are more vulnerable towards speculation.
Nevertheless, certain stocks in the OTC market might eventually move upwards and become listed on major exchanges. Therefore, the prospect of long-term investment gains is very likely to appeal to potential investors. In contrast, other companies with OTC stocks remain on the downtrend.
So, before making any investment decisions, it’s ideal to consider the pros and cons of investing in unlisted securities. Besides, determining the three OTC markets of a stock can guide you with a company’s relative investment risks.
 

Risks of OTC Stocks

OTC stocks have less liquidity than those listed on exchanges. The exchange stocks usually have a significantly lower trading volume and bigger spreads between the bid and ask prices. Therefore, OTC stocks are subject to more volatility.
Besides, the publicly available information regarding the financials of the related company is also quite less. Thus, it is imperative for investors to remain comfortable with the speculative nature of investing in this market.
Since OTC stocks are highly speculative, investment in OTC securities comes with a higher risk backdrop. Thus, investing in something you can afford to lose is ideal.
 

The Importance of OTC in Finance

Even though the OTC market remains a crucial element of global finance, OTC derivatives possess exceptional significance. The remarkable flexibility offered to market participants allows them to adjust derivative contracts that suit the best risk exposure.
On the other hand, OTC trading elevates the overall liquidity in financial markets. It's because companies incapable of trading on formal exchanges can access capital through over-the-counter markets.
 

Conclusion

You should clearly remember that trading in the OTC market is clearly not meant for everyone. Even though it might seem unpredictable and volatile, well-versed investors can easily sail through. However, it is always recommended to double-check and ensure that your investments are in safe hands.