The OTC markets, short for Over The Counter, allows for the trading of assets without the formal structure of an official exchange. This means that the trades are made in private between clients and dealers, or intra-dealer trades, without the price or terms of the trade being made public.
This arrangement is in stark contrast to an exchange where all positions and trades are usually listed and the exchange acts as a guarantor between the trading parties. Most OTC trades are done by email, phone or using proprietary trading platforms.
Any asset can be traded over the counter, but OTC markets tend to exist for the rarer and more exotic types of assets. A huge range of exotic derivatives trade in OTC markets, but some OTC markets even exist for vanilla bonds and equities.
The general theme, however, is that the less liquid and the more exotic an asset, the less suited it is to trading on an exchange, and the more likely it will be traded in an OTC market instead.
How The OTC Market Works
The OTC market was established by the Penny Stock Reform Act of 1990. Since then, the system began disseminating OTC information to market vendor terminals and web platforms which in turn was forwarded to customers.
The data and information provided to customers includes high, low, closing prices for different securities, volume, quotes and contact details for different market makers.
Issuers are required to post quotes for their respective OTC asset. Before an issuer does this, he or she must locate the market maker. The market maker will sponsor the issuer thus resulting in the security being quoted at the OTC.
Quoted securities will be assigned the OB ticker suffix. It is important to know that financial instruments quoted at the OTC do not incur any fee. This is because an OTC is not an actual stock exchange.
Lack Of Regulations
OTC market tend to face a much lighter level of regulation, as participants are expected to take on more responsibility for due diligence and protecting themselves in trades. Many OTC markets develop their own rules over time, and they are heavily influenced by the informal codes developed among the small number of professional participants.
As a result of their lack of transparency and their generally exotic and low-liquidity assets, OTC market tend to experience significant disruptions during times of market turmoil.
Assets that are already difficult to price due to their low liquidity and complexity become even more unstable since there is no public price discovery and it is difficult to determine the position and solvency of the participating counter-parties.
As such, many assets that trade in OTC markets are prone to dramatic price swings, and OTC markets can exacerbate periods of financial turmoil.
OTC markets are known to function well during normal trading hours but due to lack of transparency, they may trigger problems leading to financial difficulties. The best example happened during the 2007 -2008 global financial crisis. At the time, mortgage backed securities were traded via OTC markets.
Price quotes could not be established well which affected liquidity. As a result, several dealers began withdrawing from the market creating further issues on liquidity finally triggering the global financial crisis.
An OTC market allows the trading of stocks, commodities and bonds directly between dealers. As the opposite of a stock exchange, they lack a physical location. Since it is decentralized, dealers have the opportunity of quoting prices without other dealers being aware of the exact amount. Furthermore, trading can be done via email or proprietary electronic trading systems.