What Is the OTC Market?

Over-The-Counter markets are popular among investors and traders. This term is mostly associated with the trading of company shares. Yet, it's possible to operate a wide range of financial instruments, including currencies, commodities, and bonds. OTC markets differ from standard exchanges. Read our guide to find out what market suits you more.

OTC Markets: Definition

If you are familiar with trading or investing, you know that most of the operations are done via a third party. Usually, this party is a broker. However, there is another system; it's the Outer-The-Counter market or in short, the OTC. As for the common OTC meaning, it's a process of trading that occurs between two market players without a broker or central exchange. It's a decentralized marketplace without a physical location. Thus, all of the operations are executed electronically.

The OTC is a decentralized two-party marketplace without a physical location. Thus, all of the operations are executed electronically. The OTC market doesn't have common market-makers. Although, the OTC is associated with stocks, this market provides trading of all standard securities, such as currencies, stocks, commodities, bonds, and derivatives.

However, this meaning is not wide enough and doesn’t include an option for a broker to be a market participant. This happens if an investor applies to a broker to present their interests on the OTC marketplace.

How Do OTC Markets Work?

Let’s define how the OTC system works. So, as you can see from the information above, there are only two parties involved in the OTC market. As a result, you might have the question: how does the market work?

The process differs from an auction market system. Dealers set prices at which they would buy or sell assets. It’s more likely prices will be monitored through the Over-the-Counter Bulletin Board (OTCBB). The process differs from an auction market system. Dealers set prices at which they would buy or sell assets.

Thus, they act as market-makers. As a result, the third party doesn't know the cost of the transaction. Usually, a broker is considered a third party. Still, if you want to finance to the OTC market, you better apply to a broker to present your interests and be only a second party of the deal. The markets are operated by the OTC Markets Group.

History

The Pink Sheets were the basis of the current OTC market. In 1904, the National Quotation Bureau (NQB) applied an inter-dealer quotation on pink papers. The NQB didn't improve the system to allow larger companies to enter the market. Thus, only small, risky firms could participate in trading. The OTC market is based on the Pink Sheets.

In 1997, the NQB was acquired by a new owner. In 2000, its name was changed to Pink Sheets. Later, Pink Sheets got the name of the OTC markets. After that, electronic products and services of the information were developed. It improved the OTC market's transparency.

As the Pink Sheets included different types of companies, a decision to divide the firms into three tiers was taken. So, traders could understand how to distinguish companies. [OTC tiers]

Tiers of the Over-The-Counter Market

There are three tiers of the OTC market, which differs with a degree of regulation.

OTCQX

The OTCQX is the most reliable tier of the OTC Market Group. It offers the trading of multinational corporations, blue-chip enterprises, and all the companies that can prove their reliability. The OTCQX is the most reliable tier of the OTC Market Group.

The market has strict requirements. A third-party financial adviser should be a sponsor for the listed enterprises. The companies must fit the US laws. As the OTCQX platform has high requirements, it helps to exclude penny stocks. It protects investors from fraud firms.

Investors should be careful as despite a high degree of regulations, the company stocks can have low quality. Although the market is strict, it's still decentralized and private. Also, the OTCQX provides the right balance of being free and safe. This marketplace includes such famous names as Nestle SA, Roche Holding AG, Bayer AG.

OTCQB

The OTCQB is also known as the "Venture Market." This market is subject to a minimum set of requirements. The OTCQB is a platform for small but developing companies from the US and all over the world. It includes the companies that don't meet the requirements of the OTCQX.

If a company wants to be listed on the OTCQB, it must pass a $0.01 bid price test and provide an annual review to confirm its legitimacy, and finance a $12,000 tax per year and a $2,500 application fee, which is paid once to enter the market.

Unlike the OTC Pink, there is a specific requirement for the available information; most of the firms report to FDIC or SEC. Still, these firms may go bankrupt. At the same time, the market doesn't have a standard amount for the company's finance. Thus, shell companies, penny stocks, and small foreign firms are listed on the market.

Fraud firms can be a challenge for investors on OTCQB. Yet, all of these requirements don’t provide a high level of transparency, the OTCQB is less risky for investors than the OTC Pink.

OTC Pink

The tier has an interesting name, which dates back to times when the prices were distributed on pink papers. Before, the whole OTC market was associated with pink sheet trading. However, later the OTC Markets Group reclassified the OTC and detached three tiers of the OTC group.

OTC Pink is the most speculative tier among others. To be listed on this market, companies don't file with the SEC. Also, firms can provide as much information as they want. Thus, this marketplace can be considered unregulated. OTC Pink is the most speculative tier among others.

The companies are classified based on the critical feature of the Pink Open Market.

Companies with current information. These enterprises comply with the International Reporting Standard or Alternative Reporting Standard. Filings of the companies become public through the OTC Disclosure & News Service.
Firms with limited information. This category may include companies with accounting issues, those that suffer bankruptcy and financial distress.
Firms without information. These companies don't give any disclosure.

The only requirement is to receive quotes from a broker-dealer, which should be registered with the Financial Industry Regulatory Authority. If you choose this tier, be ready for a high degree of risk. Only experienced investors can succeed trading on the OTC Pink marketplace, avoiding scams and frauds.

OTC Markets Pros and Cons

The Over-The-Counter market has more disadvantages. Check them all.

OTC Markets: Pros

Fewer regulations. It's an advantage for companies, not for traders. If the company doesn't comply with the world stock exchanges' high requirements, it can be listed on the OTC market.
Privacy. It's an advantage for market parties as their transactions are decentralized and aren't controlled as on traditional markets.
Openness. The market can be considered more open than other regulated markets.
High returns. High rewards finance high risks. It doesn't mean that an investor will become rich immediately. Still, the opportunity for higher income exists.
A wide range of traded instruments. The OTC markets allow trading bonds, derivatives that are not operated on standard exchanges.

OTC Markets: Cons

A lack of regulations. The OTC market is decentralized and less reliable than a typical marketplace.
A lack of liquidity. As the OTC market is not the primary market, it can suffer little liquidity as there are not enough buyers and sellers.
Unstable asset value. Due to the low liquidity, the price of the securities may suffer high volatility.
Counterparty risk. Despite standard market risks that the OTC experiences, there is another one, called counterparty risk. As the OTC has weak regulation, there is a chance that parties won't complete the trade or won't make the required payments.
Lack of transparency. This factor causes an inability to control trades. It may lead to more significant problems such as worsening of the crisis conditions. In the 2007 crisis, the lack of liquidity resulted in the lack of mortgage-backed securities such asCDOs and CMOs and derivatives buyers.
High risks. Due to the factors mentioned above, you can see the market is a subject of high risk. Limited regulations and the possibility of fraud companies are the primary reasons.
No barometer. When entering a common financial market, you know that the price is quite fair. It's based on the demand/supply factor and regulated by a third party. In the case of the OTC, fairness is questionable.

What Financial Instruments Can I Trade on OTC Markets

Although the OTC market is mostly associated with stocks, you can trade different securities.

Commodities. Although the volume of commodity trading has been declining in recent years, traders and investors continue to operate these types of securities. The OTC market allows us to trade commodities as well.
Currencies. Many Forex brokers provide their clients with OTC trading. Thus, clients trade currencies. In the case of the OTC market, a broker serves as one of the two parties.
Stocks. OTC stocks mostly relate to small companies that don't meet the requirements of stock exchanges. At the same time, not only small firms are listed on the OTC. Well-known names can also enter the OTC.
Debt. Bonds can be traded on the OTC market too. If you are experienced enough in the bond market, you can try debt OTC trading.
Derivatives. Derivatives are mostly used to hedge risks. As the market allows trading a wide range of securities, it gives an option to adapt the contract specifications to the risk exposure.

OTC or Standard Exchange?

Although the Over-The-Counter market allows investors to get a higher income, the high level of risk is the main pitfall you should consider. Standard markets, such as Forex and stock, are the best options. The trading is done via brokers, regulated by world organizations; they guarantee the safety of trader funds and the execution of placed orders.

Conclusion

To conclude, the OTC markets are risky. They are recommended only for experienced traders or newbies who apply to brokers. The markets have many advantages, such as a vast number of financial instruments and privacy. At the same time, investors should be careful as cons prevail over pros.

That's why if you don't feel confident, trade on standard markets. Libertex provides a wide range of assets for trading and guarantees the security of your funds. For example, you can try CFD assets that include stocks, metals, and oil.

Why to trade with Libertex?

access to a demo account free of charge
technical assistance to the operator 5 days a week, from 8 a.m. till 8 p.m. (Central European Standard Time)
leverage of up to 1:600 for professional Ñlients
operate on a platform for any device: Libertex and Metatrader

FAQ

The OTC is not a simple market; that's why it's worth summing up significant points of the OTC trading.

OTC or Over-The-Counter market is a marketplace where operations are executed between two parties, serving as market-makers.

Where Can I Buy OTC Stocks?

Although, the Over-The-Counter is a platform for trading between two parties, the OTC investments are available via a full-service or discount broker.

Is the OTC Market Safe?

The OTC market has a low degree of transparency and regulations. Thus, it's not a safe platform, especially for newbies.

What Is the Difference Between OTC and NYSE?

NYSE is a centralized market, including many market participants. OTC is a broker-dealer network. The NYSE has high requirements and a significant level of regulations, while the OTC has weak regulations.