Over-the-Counter (OTC) Markets: Trading and Securities

What Is the Over-the-Counter (OTC) Market?

The OTC market is where securities trade via a broker-dealer network instead of on a centralized exchange like the New York Stock Exchange. Over-the-counter trading can involve stocks, bonds, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity.

When companies do not meet the requirements to list on a standard market exchange such as the NYSE, their securities can be traded OTC, but subject to some regulation by the Securities and Exchange Commission.

Understanding OTC

Stocks that trade via OTC are commonly smaller companies that cannot meet the exchange listing requirements of formal exchanges. Stocks that trade on exchanges are called listed stocks, whereas stocks that trade via OTC are called unlisted stocks. Trade transactions occur through OTC Markets Group's market tiers: the OTCQX; OTCQB; and the Pink Open Market.

Types of OTC Securities

Stocks: The equities that trade via OTC are often small companies prohibited by the $250,000 cost to list on the NYSE and up to $173,500 on the Nasdaq.

Bonds: Bonds do not trade on a formal exchange but banks market them through broker-dealer networks and they are also considered OTC securities.

Derivatives: These are private contracts arranged by a broker and can be exotic options, forwards, futures, or other agreements whose value is based on that of an underlying asset, like a stock.

American Depositary Receipts (ADRs): These are sometimes called ADSs or bank certificates that represent a specified number of shares of a foreign stock. 

Foreign currencies: Currency that trades on the Forex, an over-the-counter currency exchange.

Cryptocurrency: Digital coins like Bitcoin and Ethereum trade on the OTC market. 

OTC Markets Group

OTC Markets Group operates the OTCQX Best Market, the OTCQB Venture Market, and the Pink Open Market. Although OTC networks are not formal exchanges such as the NYSE, they still have eligibility requirements determined by the SEC.

OTCQX: The OTCQX does not list stocks that sell for less than five dollars, known as penny stocks, shell companies, or companies going through bankruptcy. The OTCQX includes only 4% of all OTC stocks traded and requires the highest reporting standards and strictest oversight by the SEC.

OTCQB: Often called the "venture market" with a concentration on developing companies that report their financials to the SEC and submit to some oversight.

Pink Open Market: Formerly known as pink sheets, this is the riskiest level of OTC trading with no requirements to report financials or register with the Securities and Exchange Commission. Some legitimate companies exist on the Pink Open Market, however, there are many shell companies and companies with no actual business operations listed here.

Pros and Cons of the OTC Market

Bonds, ADRs, and derivatives trade in the OTC marketplace, however, investors face greater risk when investing in speculative OTC securities. The filing requirements between listing platforms vary and business financials may be hard to locate. 

Stocks trading OTC are not known for their large volume of trades. Lower share volume means there may not be a ready buyer when it comes time to trade shares. Also, the spread between the bid and the asking price is usually larger as these stocks tend to be more volatile based on market or economic data.

The OTC marketplace is an alternative for small companies or those who do not want to list or cannot list on the standard exchanges. Listing on a standard exchange is an expensive and time-consuming process, and often outside the financial capabilities of many smaller companies.

The Bottom Line

The over-the-counter (OTC) market helps investors trade securities via a broker-dealer network instead of on a centralized exchange like the New York Stock Exchange. Although OTC networks are not formal exchanges, they still have eligibility requirements determined by the SEC.