OTC Markets: What They Are And How They Work

Both asset prices and contact rates between investors are endogenous and reflect investors’ heterogeneous liquidity needs. We show that intermediation arises naturally in this framework where agents choose their trading counterparties based on available prices. We also explore how the extent of intermediation depends on model primitives. Our numerical exercises what is the over the counter market contrast the model’s equilibrium implications to those of a benchmark model with random meetings and ex post bargaining. In a pump-and-dump scheme, for example, fraudsters spread false hype about a company to pump up its share prices, then offload them on unsuspecting investors.

Monetary policy, asset prices, and liquidity in over-the-counter markets

When taking linking costs into account,maximizing expected welfare involves a trade-off. On the other hand, a network that implements a high level of investment can involve a higher linking cost. One example of an over-the-counter market is the NASDAQ, which lists many of the more actively traded OTC stocks. These stocks are not traded on a traditional exchange like the New York Stock Exchange (NYSE), https://www.xcritical.com/ but rather through the NASDAQ’s electronic trading system. Some prominent international financial institutions significantly grew their earnings from their derivatives activities.

Pros and Cons of the OTC Market

Also, you can trade many OTC securities using most mainstream brokerage accounts. But OTC networks lack the rigorous financial reporting and transparency standards of major stock exchanges, so extra caution and due diligence is required from investors. Over-the-counter, or OTC, markets are decentralized financial markets where two parties trade financial instruments using a broker-dealer. Among assets traded in the over-the-counter market are unlisted stocks.

• There are a few core differences between the OTC market and formal stock exchanges.
• The OTC market allows many types of securities to trade that might not usually have enough volume to list on an exchange.
• But not everyone has access to the broker screens and not everyone in the market can trade at that price.
• Since the exchanges take in much of the legitimate investment capital, stocks listed on them have far greater liquidity.
• Alternatively, some companies may opt to remain “unlisted” on the OTC market by choice, perhaps because they don’t want to pay the listing fees or be subject to an exchange’s reporting requirements.

A strategic model of social and economic networks

Financial instruments traded over-the-counter include stocks, debt securities, and derivatives. Stocks that are traded over-the-counter usually belong to small companies that lack the resources to be listed on formal exchanges. However, sometimes even large companies’ stocks are traded over-the-counter. OTC markets offer access to emerging companies that may not meet the listing requirements of major exchanges. These smaller, growing companies can sometimes provide investors with the potential for higher returns, although this comes with higher risk. Most stocks trade on a major stock exchange, like the Nasdaq or the New York Stock Exchange.

Heterogeneous asset valuation in OTC markets and optimal inflation

The architecture of OTC markets helps explain why structured securities (which divide the risk of the underlying assets into several slices, each of which is sold separately) faced problems during the recent financial crisis. Credit derivatives, commercial paper, municipal bonds, and securitized student loans also faced problems. All were traded on OTC markets, which were liquid and functioned pretty well during normal times. But they failed to demonstrate resilience to market disturbances and became illiquid and dysfunctional at critical times. Others in the market are not privy to the trade, although some brokered markets post execution prices and the size of the trade after the fact.

Efficiency in the housing market with search frictions

Because financial statements and other disclosures are vital to investors, investors should know if their OTC security is required to file statements and should be cautious if it’s not mandated to do so. Liquidity and insufficient public information may lead to credit risk of OTC trading. “Because there’s less regulation, they’re known to be targets of market manipulation where prices can be manipulated. It involves a lot of risk because you’re buying typically less reputable securities.

The Review of Financial Studies

This structure allows investors to create a marketplace without a central location. The opposite of OTC trading is exchange trading, which takes place via a centralised exchange. The adage “know before you invest” can be hard to live up to when it comes to non-reporting companies in the unlisted market. Before investing in OTC equities, research the company as much as possible and consult with your investment professional to make sure the investment is suitable for your financial profile. FINRA also publishes aggregate information about OTC trading activity for both exchange-listed stocks and OTC equities, both for trades occurring through ATSs and outside of ATSs.

Over-the-counter market, trading in stocks and bonds that does not take place on stock exchanges. It is most significant in the United States, where requirements for listing stocks on the exchanges are quite strict. It is often called the “off-board market” and sometimes the “unlisted market,” though the latter term is misleading because some securities so traded are listed on an exchange. OTC securities comprise a wide range of financial instruments and commodities.

Where Can I Find Information About OTC Trading?

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision.

While OTC markets offer greater flexibility and fewer barriers to entry than traditional exchanges, they also come with exceptional risks and challenges. Nevertheless, because OTC-traded securities are subject to less stringent reporting and disclosure requirements, investors may have limited access to reliable information about the companies they are investing in. Below is a table distinguishing the differences between trading OTC and on a regulated exchange. For example, many hugely profitable global companies that are listed on foreign exchanges trade OTC in the U.S. to avoid the additional regulatory requirements of trading on a major U.S. stock exchange.

But this compensation does not influence the information we publish, or the reviews that you see on this site. We do not include the universe of companies or financial offers that may be available to you. OTC markets used to have two key players, the Pink Sheets and the FINRA-operated Over The Counter Bulletin Board (OTCBB). However, FINRA officially ceased operations of the OTCBB on Nov 8, 2021. Now, the main player in OTC markets is OTC Markets Group (formerly known as Pink Sheets), an American financial market providing price and liquidity information for over 10,000 OTC securities.

How securities are traded plays a critical role in price determination and stability. When it comes to equities trading, movements of share prices on major stock exchanges like the New York Stock Exchange and Nasdaq tend to dominate headlines. But every day, millions of equity trades are made off the stock exchanges in what’s known as over-the-counter (OTC) trading. The major regulatory reform underway in the United States, European Union, and other developed financial markets are directly addressing these issues. In others, post-trade clearing of OTC trades is moving to clearinghouses (also known as central clearing counterparties). The role of the dealer in OTC markets is not, however, being explicitly addressed except through possibly higher capital requirements.

Less transparency and regulation means that the OTC market can be riskier for investors, and sometimes subject to fraud. What’s more, the quoted prices may not be as readily available—with less liquidity, these stocks are prone to big swings in prices. In the U.S., the National Association of Securities Dealers (NASD), later the Financial Industry Regulatory Authority (FINRA), was established in 1939 to regulate the OTC market. While NASD evolved into an electronic quotation platform in 1971 and subsequently a formal exchange, before then, the OTC stock market operated through a network of “market makers” who facilitated trades between investors. The investing information provided on this page is for educational purposes only.

Schedules of fees for buying and selling securities are not fixed, and dealers derive their profits from the markup of their selling price over the price they had paid. The investor may buy directly from dealers who are willing to sell stocks or bonds that they own or with a broker who will search the market for the best price. Contrary to trading on formal exchanges, over-the-counter trading does not require the trading of only standardized items (e.g., clearly defined range of quantity and quality of products). OTC contracts are bilateral, and each party could face credit risk concerns regarding its counterparty. Although exchange-listed stocks can be traded OTC on the third market, it is rarely the case.

In the United States, listed companies are bought and sold on the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (NASDAQ). Companies not listed on the NYSE or NASDAQ can sell equity in their business over-the-counter. Other financial securities traded outside an exchange are also considered OTC — such as bonds, derivatives, currencies, and other complex instruments. Some OTC markets, and especially their interdealer market segments, have interdealer brokers that help market participants get a deeper view of the market. The dealers send quotes to the broker who, in effect, broadcasts the information by telephone. Brokers often provide trading platforms such as dark pools to give their clients (the dealers) the ability to instantaneously post quotes to every other dealer in the broker’s network.

Electronic quotation and trading have enhanced the OTC market; however, OTC markets are still characterised by a number of risks that may be less prevalent in formal exchanges. It consists of stocks that do not need to meet market capitalisation requirements. OTC markets could also involve companies that cannot keep their stock above a certain price per share, or who are in bankruptcy filings.

They are issued by a U.S. depositary bank, providing U.S. investors with exposure to foreign companies without the need to directly purchase shares on a foreign exchange. Debt securities and other financial instruments, such as derivatives, are traded over the counter. Particular instruments such as bonds do not trade on a formal exchange – these also trade OTC by investment banks.

You rely on Marketplace to break down the world’s events and tell you how it affects you in a fact-based, approachable way. “I think these probably would deter many mom-and-pop businesses,” Weill said, who added that a small company’s best means of raising money would probably be through its bank. Hometown’s share price rose from $1.25 in 2019 to more than $13 at the beginning of this year. Although it’s easy to buy OTC stocks, the tougher question to answer is whether you should buy OTC stocks. The value of shares and ETFs bought through a share dealing account can fall as well as rise, which could mean getting back less than you originally put in.