What Is the Over-the-Counter (OTC) Market?
The OTC market is where securities trade via a broker-dealer network instead of 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 subject to some regulation by the Securities and Exchange Commission.
Key Takeaways
- Over-the-counter (OTC) market securities are traded without being listed on an exchange.
- Securities trade OTC through a dealer or broker specializing in OTC markets.
- OTC trading helps small investors enter the market.
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Understanding OTC
Stocks that trade via OTC are commonly smaller companies that cannot meet the exchange listing requirements of formal exchanges. Stocks that trade on exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted stocks. Trade transactions occur throughOTC Markets Group'smarket tiers: theOTCQX;OTCQB; and thePink Open Market.
Types of OTC Securities
Stocks: The equities that trade via OTC are often small companies prohibited by the $250,000 cost to list on the NYSE and up to $173,500 on the Nasdaq.
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: These are private contracts arranged by a broker and can be exotic options, forwards, futures, or other agreements whose value is based on that of an underlying asset, like a stock.
American Depositary Receipts (ADRs): These are sometimes called ADSs or bank certificates that represent a specified number of shares of a foreign stock.
Foreign currencies: Currency that trades on the Forex, an over-the-counter currency exchange.
Cryptocurrency: Digital coins like Bitcoin and Ethereum trade on the OTC market.
OTC Markets Group
OTC Markets Group operates the OTCQX Best Market, the OTCQB Venture Market, 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 stocks that sell for less than five dollars, known as penny stocks, shell companies, or companies going through bankruptcy. The OTCQXincludes only 4% of all OTC stocks traded and requires the highest reporting standards and strictest oversight by the SEC.
OTCQB: Often called the "venture market" with a concentration on developing companies that report their financials to the SEC and submit to some oversight.
Pink Open Market: Formerly known as pink sheets, this 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 Open Market, 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 speculative OTC securities. The filing requirements between listing platforms vary and business financials may be hard to locate.
Stocks trading OTC are not 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 and the asking price is usually larger as these stocks tend to be more volatile based on 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 often outside the financial capabilities of many smaller companies.
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 due to 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.
How Does an Investor Buy a Security on the OTC Market?
To buy a security on the OTC market, investors identify the specific security to purchase and the amount to invest. OTCQX is one of the marketplaces for OTC stocks. Most brokers that sell exchange-listed securities also sell OTC securities electronically on a online platform or via a telephone.
What Is an Over-the-Counter Derivative?
An over-the-counter derivative is any derivative security traded in the OTC marketplace. A derivative is a 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, in derivatives such as commodity futures, it is possible to take delivery of the physical asset after the derivative contract expires.
The Bottom Line
The over-the-counter (OTC) market helps investors trade securities via a broker-dealer network instead of 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.
