Over the Counter (OTC) is a trading platform where securities between two counterparties are traded through informal exchanges and with no interference of an exchange regulator. Trading is done in over-the-counter trading market, having no physical existence and is done through a network of dealers. It doesn’t require any defined range of quantity and quality of trading products. In fact, trading prices are not revealed to the public. Hence, it is completely a subject to credit risk in terms of investment and its counterparty.
Background of OTC Trading:
The OTC market initially began in 1904 as Pink Sheets after the National Quotation Bureau got the inter-dealer quotation service printed on the pink papers. Even when the electronic trading platform was introduced, NQB had no interest in going for most sophisticated methods of electronic quotation. As a result, the Pink Sheets continued its services for smaller, shakier, and usually liquid companies through an informal trading platform.
In 1990, the U.S. Securities and Exchange Commission had asked the National Association of Securities Dealers Automated Quotations (NASDAQ) to create separate Over the Counter Bulletin Board (OTCBB) in order to provide better access to capital formation for the smaller companies. However, there were no quantitative standards set up to trade on the OTCBB platform and thus, the companies must file to the U.S.S.E.C in accordance with their rules.
Tiers of the OTC Market:
Earlier, the over the counter trade market was considered highly suspicious due to fear of shell companies, feeling of uneasiness, lack of transparency, and low liquidity. However, later on Cromwell Coulson acquired the National Quotation Bureau in 1997 and transformed the market into an industry leader by introducing number of innovative changes. Among these changes, he also introduced the three tier system of organization for the stocks and securities quoted by the OTC. The OTC Market Group organizes securities into three tiers – OTCQX, OTCQB, and OTC Pink, subject to the degree of disclosure provided and the listing fees an issuer is entitled to pay.
• OTCQX – The OTCQX International is a disclosure tier for the over-the-counter trading of stocks. It has over 300 issuers with $1.7 trillion market capitalization and over $29.5 billion of annual revenue. Stocks traded in the OTCQX need to be more stringent qualified compared to the other tiers’ criteria. This is a cost-effective alternative to New York Securities Exchange (NYSE) for publicly traded companies.
• OTCQB – The OTCQB reports to the Securities Exchange Commission. There are no specific qualitative standards, though the finances of the companies must be audited to report to the SEC. However, it is advised to treat the stocks and securities as speculative, so that one can perform with due diligence.
• Pink Open Market – The Pink open market is the most speculative tier of all the over-the-counter trading stocks. There is no specific standards or disclosure requirements and thus, provides the brokers a transparent trading platform and best execution in any form of security. In this tier, a wide spectrum of companies are traded including international companies limiting their disclosure in the U.S., penny stocks and shells.
Types of Securities traded at OTC platform:
Over the Counter comprises a wide of range of securities, financial instruments and commodities such as stocks, debt securities and derivatives. Usually, stocks traded at the OTC platform belong to smaller companies, which lack of resources to be listed on formal security exchange boards.
Derivatives belong to a substantial part of the OTC trading, which is crucial in hedging risks. Due to lack of standards on the quantity and quality of the trading instruments, the parties involved customize the specifications of the contracts as per their risk exposure.
Risks associated with OTC Market:
Company transparency – One of the risk factor associated with over the counter trade market is that they have a less stringent reporting standard to follow. As a result, companies tend to remain far opaque than the companies trading on formal security exchange markets. Due to less exposure to the market, it is much more difficult to identify an appropriate price of the securities. This puts traders or investors at risk of making wrong investment decisions. OTC lacks companies’ transparency, and thus, sometimes could mislead the investors with false or incomplete information and shady business dealings.
Low market capitalization – Due to lower market value of the companies, securities traded in the OTC market are more vulnerable to risks of manipulation and pump and dump frauds. On the other hand, companies trading on formal security exchange boards have larger market capitalization and thus, the investors are significantly able to impact the trading prices merely by investing.
Light volume and wide spreads – It may be noted that the stocks traded with OTC NASDAQ can expect trading in high volume with low competitiveness compared to the stocks listed on exchange boards. This makes it difficult to get good prices and in fact, it could be difficult to exit as the move can result in huge losses.