Updated Mar 31, 2022

What is over-the-counter (OTC)?

What is over-the-counter?

Trading that takes place over-the-counter (OTC) or off-exchange is done directly between two parties without the involvement of an exchange. It differs from exchange trading, which takes place on exchanges. A stock exchange provides the advantages of facilitating liquidity, transparency, and maintaining market prices. The price of an OTC trade is not always publicly revealed.

Assets, financial instruments (including stocks), and derivatives of such goods are traded on the over-the-counter market (OTC). The exchange's products must be well-standardised. This means that exchanged deliverables must fall within a specific quantity, quality, and identity range that is set by the exchange and is consistent across all transactions of that commodity. This is required for trading to be transparent. This restriction does not apply to the OTC market. They may, for example, agree on an uncommon quantity. OTC market contracts are bilateral (i.e., the contract is only between two parties), and each side may be concerned about the other's credit risk. In several asset classes, such as interest rates, foreign exchange, equities, and commodities, the OTC derivative market is prominent.

Over-the-counter in stocks

In the United States, market makers use inter-dealer quote services such as OTC Link (a service offered by OTC Markets Group) and the OTC Bulletin Board to conduct over-the-counter stock trading (OTCBB, operated by FINRA). For their OTCBB securities, the OTCBB licenses OTC Link's services. Although equities that are listed on one exchange can be traded OTC on a third market, this is uncommon. OTC equities are typically not listed on exchanges or traded on them, and vice versa. The Securities and Exchange Commission (SEC) requires OTCBB-listed stocks to meet some limited reporting requirements. Other OTC equities, notably the OTCQX stocks, are subject to more strict financial and reporting requirements by the SEC (traded through the OTC Market Group Inc). Pink Sheets securities and "grey market" stocks, for example, have no reporting requirements.

Some corporations, including Wal-Mart, began trading as OTC stocks before later being upgraded to a fully regulated market. Wal-Mart Stores Inc. was formed in 1969. Wal-Mart began trading as over-the-counter (OTC) stocks in 1972, with stores in five states: Arkansas, Kansas, Louisiana, Oklahoma, and Missouri. Walmart has made over 100 crores in sales by 1972, making it the fastest corporation in history to do it. Wal-Mart was first listed on the New York Stock Exchange (NYSE) in 1972, with the ticker WMT.

Dan Burrows said in Kiplinger in 2017 that American OTC marketplaces are riddled with penny stock fraud and other hazards, and that investors should avoid them "except for major, established international firms." He points out that reputable corporations from outside the United States may sell stock over-the-counter to gain access to American markets without incurring the cost of maintaining two sets of audited paperwork to be listed on different stock exchanges (one in their homeland or to international standards, and one for American standards).

The significance of over-the-counter derivatives in modern banking

OTC derivatives are an important element of the global financial industry. From 1980 to 2000, the OTC derivatives markets increased at an exponential rate. Interest rate products, foreign currency instruments, and credit default swaps have all contributed to this growth. The notional outstanding of OTC derivatives markets increased throughout time, reaching around US$601 trillion at the end of 2010.

The surge in OTC derivatives trades would have been unthinkable "without the tremendous breakthroughs in information and computer technologies" that happened between 1980 and 2000, according to a 2000 article by Schinasi et al. published by the International Monetary Fund in 2001. During that time, the share of earnings from derivatives activities at big internationally active financial institutions expanded significantly. These institutions handle derivatives portfolios with tens of thousands of positions and a global turnover of over a billion rupees. Before the 2008 financial crisis, the OTC market was a loose network of bilateral counter-party relationships and dynamic, time-varying credit exposures whose size and distribution was linked to major asset markets.

Financial markets participants benefited as international financial institutions cultivated the ability to profit from OTC derivatives activity.

The authors agreed in 2000 that the growth of OTC transactions "made possible, in many aspects, the modernization of commercial and investment banking, as well as the globalization of finance." However, an IMF team led by Mathieson and Schinasi warned in September that "episodes of turbulence" in the late 1990s "exposed the dangers presented to market stability that originated in features of OTC derivatives products and markets."

The NYMEX has developed a clearing system for several regularly traded OTC energy derivatives, allowing counterparties to mutually agree to transfer trades to ClearPort, the exchange's clearinghouse, removing credit and performance risk from the initial OTC transaction counterparts.

Conclusion

OTC trading makes stock and financial instruments available to investors who would otherwise be unable to access them. Companies that trade on the OTC market can raise money by selling stock.