Explore the Potential of the 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 over-the-counter, but are still subject to some regulation by the Securities and Exchange Commission.
Key Insights
- Trading Access: Over-the-counter (OTC) market securities are traded without being listed on an exchange.
- Broker-Dealer Network: Securities trade OTC through a dealer or broker specializing in OTC markets.
- Market Entry: OTC trading helps small investors enter the market.
Understanding OTC Markets
Stocks that trade via OTC are commonly smaller companies that cannot meet the exchange listing requirements of formal exchanges. Trade transactions occur through different market tiers of OTC Markets Group: OTCQX, OTCQB, and the Pink Open Market.
Types of OTC Securities
Stocks: The equities that trade via OTC are often small companies unable to bear the high listing cost of larger exchanges.
Bonds: Bonds do not trade on a formal exchange but are marketed through broker-dealer networks.
Derivatives: These are private contracts arranged by a broker and can be exotic options, forwards, futures, or other agreements whose value is based on an underlying asset.
American Depositary Receipts (ADRs): Bank certificates representing a specified number of shares in a foreign company’s stock.
Foreign currencies: Currency that trades on Forex, an over-the-counter currency exchange.
Cryptocurrency: Digital coins like Bitcoin and Ethereum trade on the OTC market.
OTC Markets Group Insights
OTC Markets Group operates the OTCQX Best Market, the OTCQB Venture Market, and the Pink Open Market. Despite being informal compared to exchanges like the NYSE, they have specific eligibility requirements set by the SEC.
OTCQX: This market excludes stocks selling for less than five dollars, shell companies, or those in bankruptcy, requiring the highest reporting standards and SEC oversight.
OTCQB: Known as the “venture market”, it’s focused on developing companies that report their financials to the SEC.
Pink Open Market: Formerly known as pink sheets, this level has the riskiest trading with no requirement to report financials or register with the SEC.
Pros and Cons of the OTC Market
Pros:
- Access to securities not available on standard exchanges like bonds, ADRs, and derivatives.
- Fewer regulations allow more companies to enter the market.
- Potential for significant returns from low-cost, speculative penny stocks.
Cons:
- OTC stocks have less trade liquidity, leading to delays and wide bid-ask spreads.
- Less regulation and public information, with higher fraud potential.
- Stocks can make volatile moves based on market and economic data releases.
Is the OTC Market Safe?
The OTC market is considered riskier due to lenient reporting requirements and lower transparency. Stocks often have lower share prices and higher volatility, with some eventually reaching major exchanges, while others may fail.
How to Invest in the OTC Market
To buy a security on the OTC market, investors should identify the security and the investment amount. OTCQX is one viable marketplace. Most brokers that deal with exchange-listed securities also engage with OTC securities, available electronically via an online platform or by telephone.
Understanding Over-the-Counter Derivatives
An over-the-counter derivative is any traded security whose value is based on an underlying asset. Unlike the ownership of the actual asset, derivatives allow for the potential delivery of a physical asset after contract expiration.
Conclusion
The over-the-counter (OTC) market enables trading of securities not listed on centralized exchanges, guided by compliance with SEC requirements despite its decentralized nature.
Related Terms: Securities Exchange Commission, OTC Markets Group, Broker-Dealer Network, Derivative Contracts, NYSE, Nasdaq.
References
- OTC Markets. “About”.
- Nasdaq. “Rules”.
- NYSE. “Listing Fees”, Page 1.
