What does ‘over-the-counter’ mean in finance?
OTC is a type of trading that takes place off centralized exchanges. Instead of submitting orders on an open market like the New York Stock Exchange (NYSE) or Nasdaq, an OTC trader works with a private broker-dealer to make a trade, which is why it's common to see economists describe the meaning of "OTC" as "off-exchange" trading. For example, if you trade an asset on the OTC market, you’ll deal directly with a buyer or seller. Your broker-dealer will connect you with another trader willing to buy or sell an asset and deposit funds in your account.
OTC trading occurs in all financial markets, but it's closely associated with stocks. Small companies that don't meet the NYSE's requirements may take advantage of the less restrictive OTC markets. However, many assets on OTC markets exist, including crypto, derivatives, and foreign currencies.
Which assets are on OTC markets?
OTC trading is commonly associated with shares in small-cap businesses, but many other financial markets rely on OTC networks.
- Shares in small-cap companies: If a company doesn't have enough funds to launch on a major exchange such as the NYSE, it may consider offering shares on the OTC market. Organizations such as the OTC Markets Group have fewer barriers to entry for companies that aren't big enough to list on centralized exchanges.
- Bonds: While you can buy bond ETFs (exchange-traded funds) on centralized stock exchanges, banks have to work with broker-dealers to trade these assets, which is why all bonds go through the OTC market.
- Foreign currencies: Despite the massive size of forex, there's no central exchange for trading fiat currencies. People who use forex trading platforms are always making OTC trades.
- Derivatives: Financial products that track an underlying asset’s price (e.g., options, futures contracts, or forwards) are typically available on both OTC markets and centralized exchanges.
- American Depositary Receipts (ADRs): ADRs represent ownership rights in foreign companies. Since these businesses aren't headquartered in the U.S., it's usually easier to find ADRs on the OTC market.
- Cryptocurrencies: Although digital assets are on centralized crypto exchanges (CEXs), the crypto OTC market has grown significantly. Many OTC trading desks specialize in large peer-to-peer crypto transactions.
OTC market examples
One of the classic examples of the OTC market is the OTC Markets Group in the U.S. The company manages most of the trades in the OTC stock market. There are three major markets under the OTC Markets Group's umbrella: OTCQX, OTCQB, and Pink Markets, of which OTCQX has the most stringent Securities and Exchange Commission (SEC) reporting requirements. In contrast, Pink Markets is largely unregulated. Stocks on the OTCQB comply with some SEC requirements but aren't as closely monitored as those on the OTCQX.
While "Pink Sheets" are the riskiest of the formal U.S.-based OTC markets, there’s an even riskier market known as the "Gray OTC." As the name suggests, the information on OTC securities in the gray market is "cloudy" at best. Also, there's usually low demand for "gray" assets, which translates to lower liquidity.
How does OTC trading work for cryptocurrencies?
Unlike OTC trading for stocks, crypto OTC trading isn't focused on small-cap speculative products. While traders can exchange niche altcoins (non-Bitcoin cryptos) on the OTC market, it's more likely that large institutions or high net worth crypto investors (aka whales) will use OTC trading platforms.
Some crypto OTC trading sites offer personalized services to securely transfer large sums of cryptocurrencies such as Bitcoin, Ethereum, or Litecoin. In many cases, crypto OTC platforms only accept clients with high minimum thresholds. OTC crypto traders may also get special perks such as price negotiation privileges and transaction fee discounts. Many large CEXs such as Binance, Crypto.com, and Gemini offer OTC crypto trading to accredited clients.
Whales often prefer OTC trading because they can avoid creating extra volatility in the crypto market. Although the global crypto market cap has grown, it's relatively smaller than traditional assets such as stocks and bonds. Large inflows or outflows of a particular cryptocurrency can significantly sway the spot price on a CEX. Plus, it's easier for crypto whales to remain anonymous when making OTC trades. Blockchain analytics firms will have a tougher time tracking the movements of "whale wallets" if they use OTC markets rather than buying on exchanges.
What are the benefits of OTC trading?
Since OTC happens "off the books," some investors fear there's something shady about getting involved with these markets. However, there are a few unique advantages OTC offers market participants.
- Provides small businesses access to capital: Start-ups and small companies that can't issue shares on a centralized exchange can attract investor dollars with OTC shares. This allows more businesses to raise funds and scale their operations. While only a few OTC businesses have become Fortune 500, firms such as Apple are examples of major successes.
- Offers minimal spot market influence for large purchases: If investors want to buy or sell a significant amount of an asset, they don't have to worry about triggering high price fluctuations on the open market. Because OTC deals happen outside centralized exchanges, large trades won't drain or flood public order books.
- Gives traders confidence: Since OTC trades aren't listed on centralized ledgers, it's more challenging to trace trading activity on these markets. This provides OTC traders with greater anonymity than centralized trading platforms.
- Makes buying speculative assets easy: There's less regulatory red tape in OTC markets, especially with Pink Sheet stocks. This lack of regulation gives investors more opportunities to acquire high-risk/high-reward equities.
- Offers price negotiation features: OTC traders enjoy greater flexibility in setting their desired prices and fees. Instead of relying on the quoted bid/ask spreads on centralized exchanges, an OTC buyer can set their terms and wait for a seller willing to match their quoted price.
Are there risks to OTC trading?
OTC markets create more opportunities for companies and investors, but not without a few safety risks.
- More prone to fraud and scams: OTC markets have a strong association with scam projects, fraudsters, and shell corporations. While many legitimate OTC stocks exist, investors will likely run into suspicious businesses in less regulated Pink or Gray Sheets.
- Fewer regulations than centralized markets: OTC markets are more prone to scams due to their lack of federal oversight. Although the SEC oversees some OTC markets such as the OTCQX, OTC companies aren't held to the same standard as NYSE or Nasdaq stocks.
- Counterparty risk: Because OTC transfers take place between two entities, there's a risk one of them won’t fulfill their obligations. Unless OTC traders use a trusted escrow service, it can be costly and challenging to resolve counterparty issues.
- Liquidity concerns for speculative assets: Many assets offered in OTC markets are illiquid, which means it's difficult to find willing buyers for OTC assets such as shares in lesser-known companies. Plus, since OTC markets aren't as active as large exchanges, there's a chance the bid/ask spread will change significantly once a trader closes a deal.
How to stay safe in OTC markets
The lack of regulation in OTC trading makes it more vulnerable to scams, but experts suggest the following three strategies to be safe:
- Focus on established OTC markets: Stick to the most regulated OTC markets. For instance, those thinking about OTC stocks should focus on the OTCQX. Always carefully research the reputation of broker-dealers and exchanges offering OTC trading services.
- Steer clear of projects offering "special bonuses”: If an OTC exchange, company, or broker offers incentives to make a trade, it's likely a scam. Be skeptical of any OTC platforms that promise bonuses if you place a deposit.
- Look up info on OTC companies: Since businesses don't need to comply with as many regulations to issue OTC shares, they may not be as transparent with their finances. Try to find as much info on a company's financials, leadership, and achievements before deciding whether to invest in their OTC shares.
OTC trading is essential for many asset classes but has unique liquidity and regulatory risks. Those interested in using OTC services must recognize these markets aren't as well-regulated as centralized exchanges. It’s suggested to carefully research an OTC broker's reputation before beginning trading.
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