In this guide, you will learn what is OTC (Over-the-Counter) and what are the types of OTC markets, as well as the advantages and disadvantages of trading in this market.
OTC DEFINITION
OTC (Over-the-Counter) is the process of trading stocks directly between a trader and a broker (also known as off-exchange trading) without the involvement of a third party (e.g. exchange regulator).
Dealers act as market makers by announcing the selling and buying price of shares.
It means that sellers and buyers trade through special inter-dealer quotation services managed by OTC Markets Group, but not through formal exchanges such as the New York Stock Exchange (NYSE).
On the OTC, it is possible to find equities, debt securities and derivatives that are not generally traded on traditional stock exchanges.
Companies listed on the OTC markets can be:
Small (or micro-cap) companies that do not meet the requirements of stock exchanges such as NASDAQ and NYSE;
International companies that want to enter the US investor market;
Penny stock companies.
OTC MARKETS TIERS
The companies presented in the OTC Markets Group are distinguished into four tiers according to the information available. These tiers are created for investors to provide data on the companies and the amount of information published. The tiers also give no indication of the investment merits of the company and should not be construed as a recommendation.
OTCQX
The OTCQX Best Market offers transparent and efficient trading of established, investor-focused U.S. and global companies. OTCQX is a type of provider between international companies and US investors: it allows for the submission of information without strict global competition that must be listed on a qualified international stock exchange and submit an introductory letter from an approved OTCQX sponsor.
In particular, penny stocks, shell companies and bankrupt companies are never traded on the OTCQX.
OTCQB
The otcqb venture market also provides clear information on international and US early-stage or growth-stage companies that are not yet OTCQX-qualified. To be listed on the OTCQB, companies must file annual reports and undergo annual verification; their shares must sell at a minimum bid of $0.01, and the company cannot be in bankruptcy.
Pink Market (“Pink Sheets”)
The Pink Market generally does not require companies to meet any minimum financial criteria, and may contain a wide variety of different types of corporations, including various multinational organisations, penny stocks, shell companies, and companies that may not have any real financial information.
Grey Market
The Grey Market is an unofficial market for securities that do not meet the requirements of other levels. Generally, there is little or no information about the business itself, or financial reporting. Securities traded on the Grey Market are those that are either removed from official trading on stock exchanges or have not yet been initiated.
WHY IS OTC AN IMPORTANT INSTRUMENT?
OTC is a viable instrument for both investors and companies because:
OTC markets provide opportunities for foreign companies to trade outside their home market and this can lead to increased ownership in the US, improved liquidity and value creation, especially in relation to OTCQX-listed companies.
OTC markets allow investors to trade the shares of international companies and bonds and non-standard derivatives.
The low level of regulations and limitations in OTC markets provides more flexibility to participants who can regulate derivative contracts to better combine their risk exposure.
RISKS OF OTC TRADING
It is important to understand that despite the attractive fundamentals behind OTC trading, there are risks involved due to:
Lack of information;
Low or non-existent inclusion rules;
Business and financial risks.
PROS AND CONS OF OTC
Pros
Investments by foreign companies: Many global companies choose to list on OTC markets (e.g. OTCQX) because it gives them the opportunity to present themselves to the US market of investors. Previously these companies could only list on the NASDAQ or NYSE, but this process was associated with high cost and stringent requirements.
High return: Stocks traded on the OTC markets can have high volatility, so it can lead to a higher profit in a short period of time.
Cons
Less liquidity: When trading OTC shares, it is possible to encounter situations where it is impossible to sell the shares due to a lack of buyers. In these cases, investors may find themselves “holding the bag”, which refers to being stuck with a certain number of shares or having to sell the shares at a lower price than expected.
Less transparent: Despite the fact that companies listed on OTCQX and OTCQB go through initial and ongoing requirements, it can be difficult to obtain complete information about these companies. Therefore, trading on the OTC markets may entail some risks.
Counterparty risk: Due to the fact that trading in the OTC markets is done through a network of broker-dealers, it can lead to significant risks, for example, counterparty risk. Counterparty risk is the situation where the counterparty to a derivative transaction may fail to fulfil the obligation before the maturity of the transaction and therefore will not make the current and future payments required by the contract.
CONCLUSION
The issue of trading in OTC markets is not clearly defined, as it might be related to some financial and commercial risks; however, it can be a good opportunity to invest in start-ups or international businesses.
Moreover, on OTC markets, it is possible to find investment products that are not presented on stock exchanges (e.g. bonds, derivatives, cryptocurrencies, etc.).
