What are over-the-counter (OTC) products?
Over-the-counter (OTC) is the process of trading securities through a broker network as opposed to a centralized exchange like the New York Stock Exchange.
Over-the-counter transactions may relate to shares, bonds and derivativeswhich are financial contracts that derive their value from an underlying asset such as a commodity.
Where companies do not qualify for listing on a standard market exchange such as the NYSE, their securities may be traded over-the-counter but may still be subject to some regulation by the Security and Exchange Commission.
Key points to remember
- 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 trader or broker specializing in over-the-counter markets.
- Over-the-counter trading makes it possible to promote stocks and financial instruments that would otherwise not be available to investors.
- Companies holding OTC shares can raise capital through the sale of shares.
Understanding Over-the-Counter (OTC) Products
Stocks that trade via OTC are usually small companies that cannot respond to the exchange registration requirements formal exchanges. Many other types of securities are also traded over-the-counter.
Actions that trade on stock exchanges are called listed stocks, while stocks that trade via OTC are called unlisted stocks.
Commercial transactions can take place by OTC Markets Group electronic networking platforms: the OTCQX; OTCQB; and the Pink open marketalso known as OTC Pink or “pink leaves“.
FINRA operated an OTC exchange known as the OTC Bulletin Board (OTCBB), but FINRA officially ceased operations of the OTCBB on November 8, 2021.
Types of OTC securities
Shares
Stocks that trade via OTC are often small companies banned by the cost of $295,000 to list on the NYSE and up to $75,000 on the Nasdaq. Some well-known large companies are listed on the OTC markets, such as Allianz SE, BASF SE, Roche Holding Ag and Danone SA.
Obligations
Bonds do not trade on a formal exchange, but banks market them through broker networks and they are also considered OTC securities.
Derivatives
Derivatives are private contracts entered into by a broker and can be options, forwards, futures, or other agreements whose value is based on that of an underlying asset, such as a stock.
ADR
American certificates of deposit (ADR), sometimes called ADS or bank certificates which represent a specified number of shares of a foreign stock.
Foreign currency
Foreign currencies traded on the Forexan over-the-counter exchange office.
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 like the NYSE, they still have eligibility criteria determined by the SEC.
OTCQX
The OTCQX does not list stocks that sell for less than five dollars, called penny stocks, shell companies, or bankrupt companies. OTCQX comprises only 4% of all OTC stocks traded and requires the highest reporting standards and strictest oversight by the SEC.
It includes foreign listed companies and some US companies that are considering listing on the NYSE or the Nasdaq in the future.
OTCQB
The OTCQB is often referred to as the “venture capital market” with a concentration of developing companies that must report their financials to the SEC and undergo some oversight.
pink leaves
OTC Pink Sheets is the riskiest level of OTC trading without the requirement 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 the Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered an exchange.
Advantages and disadvantages of the OTC market
Bonds, ADRs and derivatives trade in the OTC market, however, investors face greater risk when investing in more speculative OTC securities. Filing requirements between listing platforms vary and company financial data can be difficult to locate. Most financial advisors view OTC stock trading as a speculative business.
Over-the-counter stocks are generally not known for their large trading volume. Lower stock volume means there may not be a ready buyer when it comes time to trade stocks. Also, the spread between the bid price and the ask price is usually larger as these stocks can make volatile moves in any market or economic data.
The OTC market is an alternative for small businesses or those who do not want to or cannot list on standard exchanges. Listing on a standard stock exchange is a time-consuming and expensive process that is beyond the financial capabilities of many small businesses. Companies may also find that listing on the OTC market provides quick access to capital through the sale of shares.
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OTC provides access to securities not available on standard exchanges such as bonds, ADRs and derivatives.
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Fewer OTC regulations allow entry for many companies that cannot or choose not to list on other exchanges.
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Through low-cost penny stock trading, speculative investors can earn significant returns.
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Over-the-counter shares have less trading liquidity due to low volume, leading to delays in deal completion and wide bid-ask spreads.
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Less regulation leads to less publicly available information, the risk of outdated information and the possibility of fraud.
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OTC stocks are likely to make volatile moves as market and economic data releases.
Is the OTC market safe?
The OTC market is generally considered risky, with lenient reporting requirements and less transparency associated with these securities. Many OTC stocks are underpriced and can be very volatile. While some OTC market stocks eventually get listed on major exchanges, other OTC stocks fail. As with any investment, it is important to research stocks and companies 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 network of brokers and not on a financial exchange. An over-the-counter market is not centralized and occurs between two parties, like a transaction that occurs between two people who buy and sell a stock of a company that is not publicly traded. An over-the-counter market can be made up of any security, such as stocks, commodities and derivatives.
How does an investor buy a security on the OTC market?
To buy a security on the OTC market, identify the specific security to buy and the amount to invest. OTCQX is one of the largest and most respected marketplaces for OTC stocks. Most brokers who sell publicly listed securities also sell securities over-the-counter and this can be done electronically on a broker’s platform or over the phone.
What is an OTC derivative?
An OTC derivative is any derivative security traded in the over-the-counter market. A derivative is a financial security whose value is determined by an underlying asset, such as a stock or a commodity. The 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 expiry of the derivative contract. In addition to forward contracts, other derivatives include forward contracts and swaps.
The essential
Over-the-counter (OTC) involves trading securities through a network of brokers, as opposed to 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 currencies on the OTC market.