What Is Over-the-Counter (OTC)?
Over-the-counter (OTC) refers to the process of how securities are traded via a broker-dealer network as opposed to on a centralized exchange. Over-the-counter trading can involve equities, debt instruments, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity.
In some cases, securities might not meet the requirements to have a listing on a standard market exchange such as the New York Stock Exchange (NYSE). Instead, these securities can be traded over-the-counter.
However, over-the-counter trading can include equities that are listed on exchanges and stocks that are not listed. Stocks that are not listed on an exchange, and trade via OTC, are typically called over-the-counter equity securities, or OTC equities.
Trading Over the Counter
- Over-the-counter (OTC) refers to the process of how securities are traded for companies not listed on a formal exchange.
- Securities that are traded over-the-counter are traded via a dealer network as opposed to on a centralized exchange.
- 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.
Understanding Over-the-Counter (OTC)
Stocks that trade via OTC are typically smaller companies that cannot meet exchange listing requirements of formal exchanges. However, many other types of securities also trade here. 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 the Over the Counter Bulletin Board (OTCBB) or the Pink Sheets listing services. The OTCBB is an electronic quotation and trading service that facilitates higher liquidity and better information sharing. A Pink Sheet company is a private company that works with broker-dealers to bring small company shares to the market.
OTC securities trade by broker-dealers who negotiate directly with one another over computer networks and by phone using the OTCBB. The dealers act as market makers using the Pink Sheets and the OTC Bulletin Board, which is provided by the Financial Industry Regulatory Authority (FINRA), which is an agency that writes and enforces the rules governing brokers and broker-dealers.
Types of OTC Securities
The equities that trade via OTC are not only small companies. Some well-known large companies are listed on the OTC markets. For instance, the OTCQX trades shares of foreign companies such as Nestle SA, Bayer A.G., Allianz SE, BASF SE, Roche Holding Ag, and Danone SA.
American depository receipts (ADRs), which represent shares in a stock that trade on a foreign exchange, are often traded OTC. Shares trade in this manner because the underlying company does not wish to or cannot meet the stringent exchange requirements. Also, the $500,000 cost to list on the NYSE—up to $75,000 on Nasdaq—creates a barrier for many companies.
Instruments such as bonds do not trade on a formal exchange as banks issue these debt instruments and market them through broker-dealer networks. These are also considered OTC securities. Banks save the cost of the exchange listing fees by matching buys and sells from clients internally or from another brokerage firm. Other financial instruments, such as derivatives, also trade through the dealer network.
Over-the-Counter (OTC) Networks
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. For example, 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 Best Market includes securities of companies with the largest market caps and greater liquidity than the other markets.
Through the OTC marketplaces, you can find the stocks of companies that are small and developing. Depending on the listing platform, these companies may also submit reports to the Securities and Exchange Commission (SEC) regulators. OTCBB stocks will usually have a suffix of "OB" and must file financial statements with the SEC.
Another trading platform is the Pink Sheets, and these stocks come in a wide variety. These businesses do not meet the requirements of the SEC. While buying shares of this nature may involve less transactional costs, they are prime for price manipulation and fraud. These stocks will usually have a suffix of "PK" and are not required to file financial statements with the SEC.
Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange.
Pros and Cons of the OTC Marketplace
As mentioned earlier, bonds, ADRs, and derivatives also trade in the OTC marketplace. However, investors should take great care when investing in more speculative OTC securities. The filing requirements between listing platforms vary, and some necessary information, such as business financials, may be hard to locate.
Most financial advisors consider trading in OTC shares as a speculative undertaking. For this reason, investors must consider their investment risk tolerance and if OTC stocks have a place in their portfolios. However, with the added risk of OTC shares comes the possibility of significant returns. Since these shares trade at lower values, and usually, for less transactional costs, they provide an avenue for share price appreciation.
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 sell your shares. Also, the spread between the bid-price and the ask-price is usually larger. 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 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.
Real-World Examples of OTC Securities
OTC Markets Group is the operator of the financial markets for OTCQX. "OTCMarkets.com" lists the most actively traded companies and information on the advances and decliners.
On a given day, the total dollar volume can exceed $1.2 billion, with over 6 billion shares trading hands. Companies include the Chinese multimedia company Tencent Holdings LTD (TCEHY), the food and beverage giant Nestle SA (NSRGY), and the healthcare company Bayer A.G. (BAYRY).