Over-the-Counter-Markets: What They Are and How They Work

What Is an Over-the-Counter Market?

An over-the-counter (OTC) market is a decentralized market in which market participants trade stocks, commodities, currencies, or other instruments directly between two parties and without a central exchange or broker. Over-the-counter markets do not have physical locations; instead, trading is conducted electronically. This is very different from an auction market system.

In an OTC market, dealers act as market-makers by quoting prices at which they will buy and sell a security, currency, or other financial products. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was completed. In general, OTC markets are typically less transparent than exchanges and are also subject to fewer regulations. Because of this, liquidity in the OTC market may come at a premium.

Understanding Over-the-Counter Markets

OTC markets are primarily used to trade bonds, currencies, derivatives, and structured products. They can also be used to trade equities, with examples such as the OTCQX, OTCQB, and OTC Pink marketplaces (previously the OTC Bulletin Board and Pink Sheets) in the U.S. Broker-dealers that operate in the U.S. OTC markets are regulated by the Financial Industry Regulatory Authority (FINRA).

Limited Liquidity

Sometimes the securities being traded over-the-counter lack buyers and sellers. As a result, the value of a security may vary widely depending on which market markers trade the stock. Additionally, it makes it potentially dangerous if a buyer acquires a significant position in a stock that trades over-the-counter should they decide to sell it at some point in the future. The lack of liquidity could make it difficult to sell in the future. 

Risks of Over-the-Counter Markets

While OTC markets function well during normal times, there is an additional risk, called a counter-party risk, that one party in the transaction will default prior to the completion of the trade or will not make the current and future payments required of them by the contract. Lack of transparency can also cause a vicious cycle to develop during times of financial stress, as was the case during the 2007–08 global credit crisis.

Mortgage-backed securities and other derivatives such as CDOs and CMOs, which were traded solely in the OTC markets, could not be priced reliably as liquidity totally dried up in the absence of buyers. This resulted in an increasing number of dealers withdrawing from their market-making functions, exacerbating the liquidity problem and causing a worldwide credit crunch. Among the regulatory initiatives undertaken in the aftermath of the crisis to resolve this issue was the use of clearinghouses for post-trade processing of OTC trades.

A Real-World Example

A portfolio manager owns about 100,000 shares of a stock that trades on the over-the-counter market. The PM decides it is time to sell the security and instructs the traders to find the market for the stock. After calling three market makers, the traders come back with bad news. The stock has not traded for 30 days, and the last sale was $15.75, and the current market is $9 bid and $27 offered, with only 1,500 shares to buy and 7,500 for sale. At this point, the PM needs to decide if they want to try to sell the stock and find a buyer at lower prices or place a limit order at the stock’s last sale with the hope of getting lucky.