Over-the-Counter (OTC): Trading and Security Types Defined

What Is Over-the-Counter (OTC)?

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.

Key Takeaways

Over-the-counter (OTC) securities are traded without being listed on an exchange.
Securities that are traded over-the-counter may be facilitated by a dealer or broker specializing in OTC markets.
OTC trading helps promote equity and financial instruments that would otherwise be unavailable to investors.
Companies with OTC shares may raise capital through the sale of stock.

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Trading Over the Counter

Understanding Over-the-Counter (OTC)

Stocks that trade via OTC are commonly smaller companies that cannot meet the exchange listing requirements of formal exchanges. Many other types of securities also trade OTC.

Stocks that trade on exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted stocks.

Trade transactions can take place through OTC Markets Group's electronic matching platforms: the OTCQX; OTCQB; and the Pink Open Market, also known as OTC Pink or "Pink Sheets".

FINRA ran an OTC exchange known as the OTC Bulletin Board (OTCBB), but FINRA officially ceased operations of the OTCBB on Nov. 8, 2021.

Types of OTC Securities

Stocks

The equities that trade via OTC are often small companies prohibited by the $295,000 cost to list on the NYSE and up to $75,000 on Nasdaq. Some well-known large companies are listed on the OTC markets, such as Allianz SE, BASF SE, Roche Holding Ag, and Danone SA.

Bonds

Bonds do not trade on a formal exchange but banks market them through broker-dealer networks and they are also considered OTC securities.

Derivatives

Derivatives are private contracts arranged by a broker and can be options, forwards, futures, or other agreements whose value is based on that of an underlying asset, like a stock.

ADRs

American Depositary Receipts (ADRs), sometimes called ADSs or bank certificates that represent a specified number of shares of a foreign stock.

Foreign Currency

Foreign currencies that trade on the Forex, an over-the-counter currency exchange.

Cryptocurrency

Cryptocurrencies, like Bitcoin and Ethereum trade on the OTC market.

OTC Markets

The OTC Markets Group operates some of the most well-known networks, such as the Best Market (OTCQX), the Venture Market (OTCQB), and the Pink Open Market. Although OTC networks are not formal exchanges such as the NYSE, they still have eligibility requirements determined by the SEC.

OTCQX

The OTCQX does not list the stocks that sell for less than five dollars, known as penny stocks, shell companies, or companies going through bankruptcy. The OTCQX includes only 4% of all OTC stocks traded and requires the highest reporting standards and strictest oversight by the SEC.

It includes foreign companies that list on foreign exchanges and some U.S. companies that plan to list on the NYSE or the Nasdaq in the future.

OTCQB

The OTCQB is often called the "venture market" with a concentration of developing companies that have to report their financials to the SEC and submit to some oversight.

Pink Sheets

OTC Pink Sheets is the riskiest level of OTC trading with no requirements to report financials or register with the Securities and Exchange Commission. Some legitimate companies exist on the Pink Sheets, however, there are many shell companies and companies with no actual business operations listed here.

Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because Nasdaq is considered a stock exchange.

Pros and Cons of the OTC 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.

Pros

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.

Cons

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.

Is the OTC Market Safe?

The OTC market is generally considered risky, with lenient reporting requirements and lower transparency associated with these securities. Many stocks that trade OTC have a lower share price and may be highly volatile. While some stocks in the OTC market are eventually listed on the major exchanges, other OTC stocks fail. As with any investment, it is important to research the stocks and companies as much as thoroughly as possible.

What Is an Example of an Over-the-Counter Market?

An over-the-counter market is a market where financial securities are traded through a broker-dealer network as opposed to on a financial exchange. An over-the-counter market is not centralized and occurs between two parties, such as a trade that occurs between two individuals that buy and sell a share of a company that is not listed on an exchange. An over-the-counter market can consist of any security, such as equities, commodities, and derivatives.

How Do an Investor Buy a Security on the OTC Market?

To buy a security on the OTC market, identify the specific security to purchase and the amount to invest. OTCQX is one of the largest and most well-respected marketplaces for OTC stocks. Most of the brokers that sell exchange-listed securities also sell OTC securities and this can be done electronically on a broker's platform or via a telephone.

What Is an Over-the-Counter Derivative?

An over-the-counter derivative is any derivative security that is traded in the OTC marketplace. A derivative is financial security whose value is determined by an underlying asset, such as a stock or a commodity. An owner of a derivative does not own the underlying asset but in the case of certain derivatives, such as commodity futures, it is possible to take delivery of the physical asset after the derivative contract expires. In addition to futures, other derivatives include forwards and swaps.

What is Otcmkts?

Otcmkts, or OTC markets (over-the-counter markets), are markets where securities trade that are not listed on major exchanges in the U.S. OTC securities trade instead through a broker-dealer network often because they do not meet the requirements of the major exchanges.

The Bottom Line

Over-the-counter (OTC) is trading securities via a broker-dealer network as opposed to on a centralized exchange like the New York Stock Exchange. Although OTC networks are not formal exchanges, they still have eligibility requirements determined by the SEC. An investor can trade stocks, bonds, derivatives, and foreign exchange currency on the OTC marketplace.