What Is an Over-the-Counter (OTC) 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 without a central exchange or broker. OTC markets conduct trading electronically rather than in physical locations, setting them apart from auction market systems.
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 without others being aware of the transaction price, leading to an often limited level of transparency. OTC markets are generally subjected to fewer regulations, potentially making liquidity in such markets come at a premium.
Key Takeaways
- Participants trade directly between two parties without a central exchange.
- Typically, there are no physical locations or market-makers in OTC markets.
- Bonds, derivatives, structured products, and currencies are among the most commonly traded products over-the-counter.
Delving into OTC Markets
OTC markets are crucial for trading bonds, currencies, derivatives, and structured products. They can also facilitate equity trading, as illustrated by platforms like OTCQX, OTCQB, and OTC Pink in the U.S. Broker-dealers operating in the U.S. OTC markets are regulated by the Financial Industry Regulatory Authority (FINRA).
Limited Liquidity
Sometimes, the securities traded over-the-counter lack sufficient buyers and sellers. This can lead to significant price variations based on which market-makers are involved. Moreover, a substantial position in an OTC-traded stock may pose challenges for future resale due to limited liquidity.
Risks of Over-the-Counter Markets
Despite their functionality, OTC markets carry inherent risks, including counter-party risk—the risk that one party may default before completing the transaction. The lack of transparency can amplify crises, as seen during the 2007–08 global credit crunch. In such scenarios, assets like mortgage-backed securities, often traded OTC, faced severe liquidity issues, necessitating regulatory interventions such as the use of clearinghouses for post-trade processing.
10,000
The approximate number of securities traded in over-the-counter markets.
The Meaning and Supervision of OTC Trading
Commonly, “OTC” in the pharmaceutical world refers to drugs available without a prescription. In finance, it describes markets where lower regulatory scrutiny trading occurs. Despite being less regulated than public exchanges, OTC transactions are monitored by regulatory bodies like FINRA to curb market manipulation.
Example: Navigating Over-the-Counter Markets
Consider a portfolio manager with 100,000 shares of a stock trading OTC. Intending to sell, the PM finds a lack of trading activity, facing a market with sparse buy and sell offers. This illustrates the challenges in meeting trading demands within OTC markets due to variable liquidity.
Regulatory Oversight of OTC Markets
In the U.S., the Financial Industry Regulatory Authority (FINRA) oversees and regulates OTC markets and the broker-dealers involved.
Comparing OTC and Traditional Stock Markets
Major Differences
The principal difference between OTC and public stock markets is liquidity. OTC securities generally have lower trading volumes, leading to possible slippage in large transactions. Owing to relaxed disclosure requirements, finding accurate information on OTC-traded securities can be difficult, making the market susceptible to fraud.
How to Trade on OTC Markets
Most brokerages permit retail investors to trade OTC securities, albeit with potential additional stipulations to mitigate risks. Brokerage examples facilitating OTC trading include Interactive Brokers, TradeStation, and Zacks Trade.
The Bottom Line
Over-the-counter (OTC) markets provide avenues for trading securities unavailable on major exchanges, involving broker-dealers and market-makers. Products such as bonds, derivatives, low-cap stocks, and foreign shares find their niche in OTC trading.
Related Terms: FINRA, market makers, liquidity, counter-party risk, mortgage-backed securities.
References
- U.S. Securities and Exchange Commission. “Over-the-Counter Market”.
- Federal Reserve Bank of New York. “How Does Information Affect Liquidity in Over-the-Counter Markets?”
- International Monetary Fund. “Counterparty Risk in the Over-The-Counter Derivatives Market”, Page 1.
- International Monetary Fund. “Counterparty Risk in the Over-The-Counter Derivatives Market”,
- Schwab. “OTC Markets”.
