Over-the-Counter (OTC) is a type of trading practice where the two parties directly trade with each other. These parties can trade their stocks without the intervention of any stock exchange platforms such as NYSE or NASDAQ. The OTC market is a distributed network of dealers. There is no physical location where the deal is completed but is done through electronic platforms. Over-the-Counter stocks are sometimes also termed penny stocks as the trading is usually less than $1.
Understanding the OTC Trading
In OTC trading, a wide range of financial instruments such as stocks, derivatives, debt securities, etc. can be traded. Normally the OTC market is for companies having a small market cap and that lack requirements to list on stock exchanges. Unlike the stock exchange, the price per stock is not visible to the public each day. The price is only published on certain days and based on that price, the dealers will trade at either discount or premium.
Here, the buyer and the seller will quote their respective prices at which they want to buy or sell their stocks. These prices might also be different from the OTC market. Suppose that you want to sell any securities that only trade on the OTC market. The first thing you need to do is to find out the market that is currently trading those stocks. For this, you might need to contact multiple over-the-counter market makers. Once you have found out where the trading is performed, you can now know the last traded price for that stock. Finally, you can now place the price you want to sell your stocks. It could be at a premium or at a discount.
Bid Price vs Offer Price
In the OTC market, the dealer will act as a “market maker” and can bid price or offer prices for the securities. The bid price is the price the buyer is willing to pay to purchase the stocks of any company. Whereas, the offer price is the price the seller is willing to accept to sell their stocks of that company. If these both prices match, the trading will be performed. In the OTC market, the difference between these two is high so either the buyer or the seller or both need to adjust their prices to make the trade happen.
OTC Market Tiered System
Over the years, the OTC market has evolved so much and has more than 10,000 global companies that trade on the OTC market. The main aspect of managing these OTC markets in tiers is to help investors have a better understanding of the companies and their associated risks. The system is divided into 3 tiers:
OTCQX
It is a top-tier market with minimal risk. The company that wants to trade in OTCQX must meet the financial standards and also follow the highest reporting standards. They need to disclose their best practices and sponsors to the public to make the company transparent. There are more than 400 companies that trade on OTCQX.
OTCQB
The middle tier is the OTCQB tier. This tier will have companies that are in their early stage and may not follow the strict regulations of the OTCQX tier. Also called the venture market, the OTCQB market has more than 900 companies currently trading. The requirement to be eligible for OTCQB is that the company’s financial report needs to be certified and the company must have a bid price of $0.01.
Pink Open Market
Most of the companies that are bankrupt or have not been regulated by the SEC or any exchanges trade in the Pink Open Market. There are no reporting requirements which makes them less transparent to the public as a result are riskier to invest in.
Risks in the OTC market
Over-the-counter trading is not for every investor. Only those who have an understanding of what they are doing with their money should invest in the OTC market. Here are the top 4 risks that are normally associated with Over-the-Counter trading:
Lack of Information:
One of the main issues with the OTC market is that there is very little information about the trading companies. Although these companies are regulated by the SEC, the financial reports like 10K and 10Q, 8k, S1, S4, etc. are not submitted periodically. This makes the public have less understanding of the financial state of that company which makes them riskier to invest in.
Limited Liquidity:
This is a market situation, in which the buyers and sellers of a particular stock are not present. In this situation, if someone is trying to sell or purchase any stocks from the OTC platform, he/she won’t be able to do so. Most of the time, the stocks in the OTC market are often thinly traded. That is, the gap between the selling price and the buying price is high which makes trading very difficult and slow. Also, as there are multiple market makers trading the stock, the price of the stock might also vary.
Low Market Cap:
Due to the low market cap, they are more vulnerable to rumors and other unknown factors. This results in two outcomes; either you lose a lot or you gain a lot. If you have less experience in trading in OTC platforms then there is a higher probability of losing your invested money.
Counterparty Risk:
Also known as a counterparty credit risk, is a risk where the counterparty is not able to make current or future payments as per the contract. It can be minimized using one of the popular techniques called collateralization. The buying party will deposit a specific property (i.e. cash) to a lender before proceeding with the trade.
Over the Counter vs Auction Market
The OTC market and auction market are totally opposite of each other. In the OTC market, the deal is done between two parties at a time and is done between two dealers. Whereas the auction market is a platform where multiple investors will buy and sell their stocks at a time. The price is also continuously visible to the investors so that they can make up their minds when to purchase or sell their stocks. Auction markets are regulated by the SEC which makes those stocks transparent to the investors. NYSE is the biggest auction market platform and has more than 2800 public companies listed on it. These companies are from various sectors such as mutual funds, ETFs, SPACs, etc.