What is OTC Trading and How Does it Work?

As crypto becomes more popular and before the emergence of regular crypto exchanges, traders have always embraced OTC trading. Over-The-Counter (OTC) trading is one of the oldest practices employed in the financial markets to trade digital assets, including stocks, derivatives, cryptocurrencies, bonds, etc.

Despite the high volatility of the crypto market, OTC trading allows crypto traders to trade a considerable amount of these digital assets without causing enormous changes in market price. This may have contributed to its popularity among them. However, it does come with risks.

In this article, we will closely examine what OTC trading is; does it come with any benefits? What are the risks involved? And what makes it different from exchange-traded trading?

Definition of OTC Trading

OTC trading allows financial transactions between a buyer and seller without the involvement of a third party. This implies that such platforms do not operate like regular exchanges such as the New York Stock Exchange, the London Stock Exchange, Binance, etc. OTC trading allows investors to trade on a bilateral basis; therefore, it is a decentralized market.

Often, small companies cannot trade or list their digital assets (stocks, bonds) on regulated exchanges. However, the OTC market provides them with such opportunities. Although they are not fully regulated, traders must adhere to some basic OTC rules.

Is Over-The-Counter Trading Really Decentralized?

OTC trading is a decentralized process where two parties negotiate the terms of trade directly with each other. The parties agree on the trade’s price, size, and settlement date of the underlying asset or instrument. Participants in OTC trading may include individuals, banks, hedge funds, or any other financial institutions.

The market is typically facilitated by a network of dealers or brokers who act as intermediaries between the two parties. These intermediaries provide a platform for the parties to negotiate the terms of the trade and manage the settlement process. The intermediaries also help mitigate the risk of counterparty default by ensuring both parties have sufficient collateral to cover the trade.

Currently, there are over 12,000 securities traded on the OTC market, including cryptocurrencies, stocks, bonds, derivatives, et cetera.

Types of Over-The-Counter Market

There are three types of OTC markets, as indicated by the OTC market group in charge of securities traded on the public market. However, the classification is based on the quality of the information concerned companies or securities provide.

They include the OTCQX market, the OTCQB market, and the Pink Market. However, companies are said to increase in tier as more information/report becomes available about them.

OTCQX

Most companies listed on OTCQX also appear on major exchanges abroad or may be on the verge of being listed on such exchanges as the NYSE or NASDAQ.

It is the highest tier of the over-the-counter market, and according to the Mosley fool, OTCQX accounts for just 4% of all securities listed on the OTC market.

To be considered for listing, an intending company must meet high financial standards, including minimum asset and revenue requirements, and provide ongoing disclosure to investors. Furthermore, companies listed on OTCQX are subject to regular financial reporting and are eligible for regulatory oversight.

OTCQB

OTCQB, otherwise known as the venture market, is a second-tier OTC market mainly for start-ups and developing companies that are publicly traded.

For companies to list their digital assets, their reports must be up-to-date with a minimum bid price of $0.01. Also, they can’t be a penny stock, shell corporation, or be in bankruptcy. However, less established financial track records are required compared to those on OTCQX.

Pink Market

The most speculative OTC market is the pink market, often referred to as pink sheet or open market. Companies that do not meet the financial and regulatory standards set by the Securities and Exchange Commission (SEC) use this market the most.

Because of the nature of the market, it is quite risky to trade on since investors can easily be scammed. However, legitimate companies are also registered on the pink market.

The pink market includes international companies, penny stocks, shell companies, and companies that give current, limited, or no information regarding their finances.

Grey Market

Grey isn’t indicated as an OTC market by broker-dealers and may be considered not to be part of it. The companies or securities here are not listed on any stock exchange but forced their way through to be listed.

Although the grey market is not also accessible to investors, trading is often conducted through unregistered dealers and is not subject to regulatory oversight. Therefore, it is riskier for investors; there may be limited information and a lack of transparency, which increases investment risk.

Note: The three-tier ranks are based only on information provided; it doesn’t necessarily state the authenticity of a particular company.

Benefits Of OTC Trading

The surge in the number of cryptos, stocks, bonds, or derivatives traded on the OTC market is quite interesting. Investors or companies (especially smaller ones) prefer (although risky) to trade using the over-the-counter market.

What reasons could be behind that?

Flexibility

Being a flexible market, involved parties could easily tailor their trades to meet specific needs, such as customized contract terms, pricing, and individualized settlement dates. However, this is only possible due to the relaxation of strict regulatory laws that should be enforced.

Cost-effective

Unlike regular exchanges, OTC trading can often be more cost-effective since the regulatory and operational costs associated with such regular exchanges are minimal or absent. Moreover, the absence of a centralized exchange in OTC trading can result in lower transaction costs and fewer fees.

Confidentialit

Since OTC trades do not operate like regular exchanges, they are not subject to the same level of transparency and disclosure required for exchange-traded trades. This allows for greater discretion and privacy in trading, which can be especially important for large institutional investors.

More Securities and Wider Reach

OTC Trading provides an opportunity for companies that don’t meet the requirements on formal exchanges. This, in turn, increases the number of new stocks or bonds available for investors to trade, which helps reach a wider audience of Investors.

Aren’t any Risks Involved in OTC Trading?

Although OTC provides an enticing platform for trading securities, it also comes with its risks.

Regulation

As said earlier, no strict financial regulations guide OTC markets’ operation. Therefore, it is the comfort zone of companies that do not meet specific requirements, which further exposes investors to big risks.

Counterparty

OTC markets are decentralized, and unlike regular exchanges, no central authority oversees its affairs. If one of the parties chooses to default on their obligations, the other party suffers a significant loss.

No Records

Listing on the OTC markets has no major requirements. Therefore, sufficient information about the company or its digital assets is not readily available to investors. This, of course, poses a lot of risks.

Liquidity

The liquidity on OTC markets is usually low since most of the assets listed are not traded often. This is accompanied by the difficulty of buying and selling large quantities of such digital assets and significant price volatility.

OTC Markets vs. Exchanges

Exchanges and Over-The-Counter (OTC) markets have unique characteristics and operate differently. Subsequently, this impacts how securities are traded and the types of investors who participate.

Below are a few differences between them;

Exchange refers to a trade center, a company or organization that operates a market where shares of companies listed on it are bought and sold by participants. On the other hand, OTC (over-the-counter) refers to a decentralized market where buyers and sellers converse directly with each other online.

In an OTC market, dealers are the market makers and are responsible for setting digital assets’ buying and selling prices. However, the prices of digital assets on exchanges are determined by the forces of supply and demand, with the exchange acting as a market maker.

Trading on an exchange is limited to specific trading hours, whereas OTC trading occurs around the clock, 24 hours a day, 7 days a week.

When considering transparency, the OTC market is not as open and transparent as a formal exchange, where buyers and sellers have complete visibility and records about the assets being traded.

On an exchange, only formalized companies with perfect quality and quantity are traded, whereas, in OTC markets, contracts are tailored to meet both the buyer’s and seller’s agreed needs.

In OTC markets, there is no system to prevent sudden spikes or drops in companies’ stock or bond prices due to short-term imbalances in demand and supply. However, exchanges manage these imbalances by temporarily pausing trades in a particular stock, which allows other market investors to restore balance.

Conclusion

OTC trading provides a valuable alternative to formal exchanges for certain financial products and participants. While it offers increased flexibility and privacy, the absence of a central exchange and the higher level of counterparty risk means that participants must carefully consider their risk management strategies when trading in the OTC market.

It is important to seek the advice of a financial professional before engaging in OTC trading to ensure you understand the benefits and risks involved.