What Does Over The Counter (OTC) Stand For in Trading?
Securities purchases through an Over-the-Counter (OTC) system offers investors the opportunity to take advantage of more flexible, yet secure transactions and maintain anonymity. By bypassing centralized exchanges, OTC trading enables individuals to access a wide range of products not available in traditional markets. Let’s explore how this form of the decentralized broker-dealer network works and investigate the benefits it presents.
What is Over-the-Counter?
Trading securities without needing a centralized exchange is possible with over-the-counter (OTC) trading. This type of brokerage allows investors to buy and sell stocks, bonds, and financial contracts derived from various commodities directly through broker-dealer networks.
Companies unable to satisfy the criteria of a traditional stock exchange, such as NYSE, can have their securities traded with the over-the-counter model. However, all OTC transactions must adhere to relevant regulations established by the SEC for security trading activities.
Stocks transacted on exchanges come under the category of ‘listed stocks,’ while those traded via OTC are classified as ‘unlisted stocks.’
An increasing number of securities are now traded over the counter, such as those from smaller companies that don’t have the compliance requirements for listing on an exchange. This is creating more investment opportunities for investors and better conditions for brokers.
Types of Assets Traded Over-the-Counter
OTC offers a variety of security systems tailored to the specific needs and demands of businesses.
- Stock
While the NYSE and Nasdaq have large entry costs, trading equities with the over-the-counter model provides an avenue for small companies that incur lower expenses. Many of the world’s most influential corporations are also traded on OTC markets.
- Derivatives
Derivatives offer investors the ability to diversify portfolios and hedge risk by securing agreements such as options, forwards, and futures.
- Bonds
Banks provide access to bond investments through their broker-dealer networks, offering investors the opportunity to trade in securities not listed on a formal exchange but still able to be bought and sold as OTC products.
- American Depositary Receipts
ADRs, or American Depositary Receipts, are a viable way for individuals to invest in foreign securities without needing an overseas trading account. Banks issue these certificates as proof of stock ownership and guarantee that each share is backed by its equivalent quantity held abroad.
- Foreign exchange
Forex brokerages, while trading foreign currencies, are also traded OTC.
- Crypto
Cryptocurrencies offer a unique investment opportunity to capitalize on the potential of digital assets like Bitcoin and Ethereum — accessible through an OTC market.
Ups and Downs of the OTC Market
Investing in bonds, American Depository Receipts, and features through the over-the-counter marketplace can pose greater risks than trading on a listed platform due to looser filing requirements. As such, financial advisors highly recommend exercising caution when selecting more speculative OTC securities, as their business disclosures may be harder to find.
Due to their relatively low volume, over-the-counter trades are less liquid than other stock trading methods. This may lead to difficulty when attempting transactions, as buyers could be unavailable during this time. Moreover, the variance between the bid and ask prices is typically greater with OTC trades – any sort of news-related or market movement can cause massive price swings.
Upsides:
- OTC brings a wide variety of securities to investors, including uncommon offerings like corporate bonds and American Depository Receipts (ADRs), as well as derivatives
- Regulation on over-the-counter markets is lower, enabling a wider range of companies to enter this market without the requirement to list their shares on primary exchanges.
Downsides:
- The trading liquidity of such investments can be low, which may cause substantial bid-ask spreads.
- An unregulated environment can reduce access to reliable public information and create an elevated risk of outdated or fraudulent data.
- OTC stocks can be highly affected by unpredictable movement depending on the release of the relevant market or economic data.
Final Thoughts
OTC trading provides an alternative to traditional exchanges when buying and selling securities. It boasts eligibility requirements for investors, including stocks, bonds, derivatives, Forex and crypto — providing a wide array of options suited to any investor’s needs.