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What is OTC? (Over-the-Counter) | Definition | Beginner’s Guide

What is OTC? | Over-the-Counter Definition | Beginner's Guide
Anastasia
Menshikova
Updated: 08 Jun, 2022
6 mins read

In this guide, you’ll learn what OTC (Over-the-Counter) is and what are the types of OTC Markets, as well as the advantages and disadvantages of trading on this market.

OTC definition

OTC (Over-the-Counter) is the process of stock trading directly between a dealer and a broker (a.k.a. off-exchange trading) without the involvement of third parties (e.g., exchange regulator). 

Dealers act as market makers by announcing the price for selling and buying stocks. It means that sellers and buyers negotiate 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 stocks, debt securities, and derivatives that usually are not traded over traditional stock exchanges. 

Companies that are presented on OTC Markets might be:

  • Small (or microcap) companies that do not meet the requirements of securities exchanges like NASDAQ and NYSE;
  • International companies that want to be introduced to the U.S. market of investors;
  • Penny Stock companies.

Watch the video: OTC Trading and Broker-Dealers Explained in 1 minute

OTC Markets tiers

Companies presented on OTC Markets Group are distinguished into four tiers according to the available information. These tiers are created for the investors to provide data about businesses and the amount of published information. ​​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 kind of provider between international companies and U.S. investors: it allows to present information without strict global company should be listed on a qualified international stock exchange and submit an introductory letter from an approved OTCQX Sponsor. 

Notably, Penny Stocks, shell companies, and businesses in bankruptcy are never traded on the OTCQX.

OTCQB

The OTCQB Venture Market also offers clear information about early-stage or growth international and U.S. companies that do not yet meet the requirements of the OTCQX. To be listed on the OTCQB, companies should provide annual reports and undergo annual verification; their stocks should be sold at a minimum $0.01 bid, and the company may not be in bankruptcy. 

Pink Market (“Pink Sheets”)

Pink Market (Open Market) usually does not require firms to meet any minimum financial criteria, and it can contain a wide variety of different sorts of corporations, including diverse multinational organizations, penny stocks, shell companies, and businesses that may not have any actual financial information.

Note: You can learn what companies are required to submit in order to be listed for trading within the “Pink Sheets” here [PDF] (Pink Basic Disclosure Guidelines).

Grey Market

The Grey Market is an unofficial market for securities that do not meet the requirements of other tiers. Usually, there is no or little information about the business itself, or financial reports. Securities traded on the Grey Market are the ones that are removed from official trading on securities exchanges or have not started it yet.

Why is OTC an important instrument? 

OTC is a viable instrument for both investors and companies because:

  1. OTC Markets give opportunities to foreign companies to be presented outside their domestic market and this may lead to increased U.S. ownership, liquidity enhancement, and value creation, especially, related to the companies listed on OTCQX
  1. OTC Markets allow investors to trade the shares of international companies and bonds and non-standard derivatives. 
  1. the low level of regulations and limitations on OTC Markets provides more flexibility to participants which can regulate derivative contracts to better ensemble their risk exposure.

Risks of OTC trading

It is important to understand that despite attractive fundamentals behind the OTC trading, there are risks involved due to:

  • Lack of information;
  • Low or absence of listing standards;
  • Business and financial risks.

Pros and Cons of OTC

Pros

  • Foreign companies investments: Many global companies opt to be traded on OTC Markets (for example, the OTCQX) because it provides them with the opportunity to be presented to the U.S. market of investors. Before these companies could only be listed on the NASDAQ or NYSE but this process was connected with a high cost and strict requirements. 
  • High return: Stocks traded on OTC Markets might have high volatility, so it may lead to a higher profit in a short period. 

Cons

  • Less liquidity: When trading OTC stocks, it is possible to encounter situations where it is impossible to sell the stocks due to a lack of buyers. In these instances, investors may find themselves ‘left holding the bag,’ which refers to being stuck with a certain number of stocks or having to sell the stocks at a lower price than expected.
  • Less transparent: Despite the fact that companies traded on OTCQX and OTCQB go through initial and ongoing requirements, it may be difficult to get complete information on these firms. Therefore, trading on OTC Markets may entail some risks.
  • Counterparty risk: Due to the fact that trading on OTC Markets is conducted via a dealer-broker network, it may lead to significant risks, for example, counterparty risk. Counterparty risk is the situation when the counterparty in a derivatives transaction may fail to meet the obligation before the expiration of the trade and therefore will not make the current and future payments required by the contract.

Conclusion

The issue of trading on OTC Markets is not clearly defined, as it might be connected with some financial and business risks; however, it can be a good opportunity to invest in startup companies or in international businesses.

Moreover, on OTC Markets, it is possible to find investment products that are not presented on securities exchanges (e.g., bonds, derivatives, cryptocurrencies, etc.).

Finally, OTC Markets include several types of trading instruments that vary depending on the companies presented and the requirements for listing on OTCQX, OTCBX, Pink Sheets Market. 

FAQs about OTC Markets

How can I buy stocks on OTC Markets?

If you want to trade on OTC Market, you can acquire stocks by using Otcmarkets.com, the core OTC trading platform.

What can I buy on OTC Markets?

Apart from stocks of the companies, investors may trade:

  • Derivatives (contracts between two parties that control the payments that are to be made between these parties)
  • American Depositary Receipts (ADRs) that represent the shares of non-US companies and which pay dividends in U.S. dollars
  • Foreign currencies
  • Cryptocurrencies

What foreign companies sell their stocks on OTC Markets?

Some of the most famous international companies are:

  • Nestlé S.A. (OTCMKTS:NESN.SW)
  • Sony Group Corporation (OTCMKTS:6758.T)
  • Bayer Aktiengesellschaft (OTCMKTS: BAYRY)

Is it risky to buy OTC Stocks?

OTC trading has a mixed reputation; on the one hand, there is a lack of information about companies, stock prices are not transparent, and OTC Markets can be a breeding ground for fraud and scams; on the other hand, some stocks are not traded on formal exchanges and are therefore available for trading on OTC Markets (e.g., foreign firms). As a result, it is vital to emphasize that in order to reduce risks, the investor should find a reputable broker-dealer for negotiating the trades.

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Anastasia Menshikova
Author

Anastasia Menshikova is an experienced content creator specializing in business, economics, IT and accounting. Her previous teaching expertise allows her to present complex ideas in an easy and accessible manner.

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