What is OTC trading?

What is OTC trading?

OTC or over-the-counter trading is the process of exchanging financial instruments outside of a central exchange, directly between two parties. OTC trading can be conducted across a wide range of products, including stocks, bonds, derivatives and currencies. This process is popular among companies that aren’t compatible with the strict criteria of established exchanges such as the New York Stock Exchange or Nasdaq.

How does OTC trading work?

An important difference between OTC trading and public exchange trading is the difference in transparency. For centralised exchange trades, all information like prices and volumes are publicly accessible. As OTC trades are facilitated via broker-dealers via telephone, email or specialised private electronic trading systems, the details are only shared between the involved parties.

OTC trades can be made on a variety of financial products. Stocks traded OTC are often those that are unable to meet exchange listing standards, instead traded on OTC markets such as those provided by the OTC Market Group. Examples of these platforms in the US include OTCQX, OTCQB and the Pink Open Market, each with varying degrees of regulation and transparency.

OTCQX

 Known commonly as the “Best Market”, this includes companies which are compliant with higher standards of finance and are up to date with disclosures.

OTCQB

Referred to as the “Venture Market”, OTCQB is made up of earlier-stage companies, which through a US regulator are subject to annual verification and certification.

Pink Open Market (Pink Sheets)

This category spans a wide range of companies, often with very limited financial information, or considered ‘speculative entities’. As regulatory requirements are minimal, this is the riskiest category for investors. The Pink Sheets, (as this market is often called) originated in 1904 when the National Quotation Bureau (NQB) printed an inter-dealer quotation service on pink paper.

Bonds are another commonly traded OTC item, particularly corporate bonds. Trading this way allows for more customisable terms and more direct negotiation. Derivatives like options, forwards and swaps are often traded OTC, again with more flexibility in contract negotiation when hedging or speculating. Forex market OTC trading allows for around-the-clock trading, whereas cryptocurrency OTC trading is utilised particularly for large transactions that may impact overall market price, particularly in lower liquidity situations.

Advantages of OTC trading

OTC trading provides investors with a number of advantages over centralised exchanges.

Accessibility

OTC trading gives opportunities to those companies that are unable to get listed on major central exchanges.

Flexibility

The flexibility of the OTC market allows for easier negotiation of terms, leading to more personalised deals to benefit both parties.

Extended trading hours

Often operating beyond the typical market hours, trading can be more convenient for those participating globally.

Anonymity

Many OTC deals are conducted anonymously. This can be advantageous for parties involved in large transactions, who may prefer not to disclose their identities.

Risks of OTC Trading

These benefits do not come without risks, however. Some downsides include:

Misinformation

The lack of transparency with OTC trading can sometimes lead to situations where obtaining reliable information is difficult, due to more liberal reporting requirements.

Liquidity Difficulties

Lower trading volumes on OTC markets can generate liquidity problems, especially with larger transactions.

Higher Volatility

The combination of the above two factors may lead to greater price volatility in OTC securities.

Fraudulent Activity

OTC markets are not as heavily regulated as formal exchanges. This can expose traders to fraudulent activity or other forms of financial misconduct.

Default Risk

Operating directly peer-to-peer opens up potential for counterparty risk, if one party defaults on the agreement, losses may be incurred.

How can I trade OTC?

For those looking to trade OTC, many brokerage firms offer access to OTC markets. Due diligence is required to make informed trading decisions, especially since provided information can often be limited with OTC-listed companies. Seek professional guidance, and make use of reputable resources before making investments. 

In the UK, the Financial Conduct Authority (FCA) regulates OTC markets in order to protect investors, and maintain legal market practices. Since Brexit, the UK has adjusted its regulatory framework in order to address new challenges of its financial markets in accordance with international standards. For UK investors, look for FCA-authorised brokers.

The Future of OTC Trading

In recent years, electronic trading platforms and other tools have developed solutions to the liquidity issues that affect OTC trading, creating processes for matching buyers and sellers and speeding up the negotiation and settlement times. Automated systems allow for enhanced liquidity, as well as reducing transaction costs. While greater efficiency is an obvious benefit, the technological developments have also brought about greater cybersecurity risks, which need to be managed.

As environmental, social, and governance (ESG) factors become increasingly relevant to businesses throughout the globe, investors are showing greater interest in green bonds and sustainable derivatives, many of which are traded OTC. As we have learned, the flexibility available in OTC deals allows bespoke financial instruments to be created in order to meet sustainability goals. For example in the UK, firms are issuing green derivatives to align with carbon reduction targets.

OTC also has very different practices and regulations depending on your region - as Europe, for example, has introduced much more rigorous reporting requirements through the Markets in Financial Instruments Directive II (MiFID II), transparency has increased. Emerging markets, by contrast, have fewer regulatory frameworks to protect investors. It is therefore key to fully understand the regulatory environment of your region before engaging with OTC trading. 

Conclusion

OTC trading is a crucial element of the global financial system, allowing a diverse range of financial instruments to be traded outside of centralised exchanges. By nature of its decentralisation, OTC trading allows investors to access niche markets, more customisable deals, as well as extended trading hours. However, these benefits are balanced by potential risks in the reduced transparency, contrasting regulatory practices and liquidity risks.

In order to counter these risks, it is important for investors to understand the details of OTC trading, by conducting due diligence and sticking to reliable brokers for conducting transactions. At a time when financial technology is moving at a rapid pace, OTC trading is likely to see regulatory changes, but remain a key part of global finance, bridging the gap between mainstream and broader markets. 

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Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder.