Over-the-Counter Markets: What They Are and How They Work

Suppose you manage a company looking to raise capital but don't meet the stringent requirements to list on a major stock exchange. Or you're an investor seeking to trade more exotic securities not offered on the New York Stock Exchange (NYSE) or Nasdaq. Where do you turn? Enter the over-the-counter (OTC) markets, where trading is done electronically.

OTC markets allow investors to trade stocks, bonds, derivatives, and other financial instruments directly between two parties without the supervision of a formal exchange. This freewheeling format provides prospects but also pitfalls compared with exchange-based trading. Apple Inc. (AAPL) and Microsoft Corporation (MSFT) traded OTC, as did many long-forgotten penny stocks.

In this article, we'll examine what OTC markets are, how they differ from traditional stock exchanges, and the advantages and disadvantages for investors. We'll explore the key OTC market types, the companies that tend to trade on them, and how these markets are evolving in today's electronic trading environment.

Understanding Over-the-Counter (OTC) Markets

In pharmaceuticals, OTC is a category of medications that can be bought without a doctor's or pharmacist's guidance; OTC is something similar in finance since what's sold are securities that haven't passed through the supervision of a formal exchange like the Nasdaq or NYSE.

OTC markets have a long history, dating back to the early days of stock trading in the 17th century. Before the establishment of formal exchanges, most securities were traded over the counter. As exchanges became more prevalent in the late 19th and early 20th centuries, OTC trading remained a significant part of the financial ecosystem. They have always had a reputation for where you find the dodgiest deals and enterprises, but might also find future profit-makers among them.

Since the exchanges take in much of the legitimate investment capital, stocks listed on them have far greater liquidity. OTC securities, meanwhile, often have very low liquidity, which means just a few trades can change their prices fast, leading to significant volatility. This has made the OTC markets a breeding ground for pump-and-dump schemes and other frauds that have long kept the enforcement division of the U.S. Securities and Exchange Commission (SEC) busy.

Brief History of OTC Markets

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 trading process during this era was cumbersome and inefficient. Investors had to manually contact multiple market makers by phone to compare prices and find the best deal. This made it impossible to establish a fixed stock price at any given time, impeding the ability to track price changes and overall market trends. These issues supplied obvious openings for less scrupulous market participants.

Traders also looked to the Pink Sheets, now known as OTC Markets Group, over a century ago as a paper-based system for trading unlisted securities. The term "Pink Sheets" derived from the pink-colored paper on which the bid and ask prices of these securities were printed and circulated. In the late 1990s, Pink Sheets transitioned to an electronic quotation system, eventually becoming the OTC Markets Group, which operates the OTCQX, OTCQB, and OTC Pink platforms.

Today, these platforms offer access to shares and other securities for a wide range of companies, from well-established foreign firms to small, emerging companies that don't yet meet the listing requirements of major exchanges. The shares for many major foreign companies trade OTC in the U.S. through American depositary receipts (ADRs). These securities represent ownership in the shares of a foreign company. 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.

While OTC markets offer greater flexibility and fewer barriers to entry than traditional exchanges, they also come with exceptional risks and challenges. FINRA regulates broker-dealers in the U.S. OTC markets. 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.

OTC Markets

OTC Stocks

There are several OTC markets in the U.S., including the following:

• OTCQX: The top-tier OTC market with more stringent financial and reporting requirements.
• OTCQB: Also called the "Venture Market," this tier has less stringent requirements than OTCQX but more than the Pink Open Market.
• Pink Open Market: Formerly known on Wall Street as the "Pink Sheets," this market has the least stringent requirements and includes many small, speculative companies.

OTC Foreign Company Shares

OTC markets provide access to securities not listed on major exchanges, including shares of foreign companies. This allows investors to diversify their portfolios and gain exposure to international markets and companies that may not be available through traditional exchanges.

Trading foreign shares directly on their local exchanges can be logistically challenging and expensive for individual investors. OTC markets offer a more convenient and cost-effective way to invest in foreign companies since trades are executed in U.S. dollars during U.S. trading hours, often with lower commissions than trading directly on foreign exchanges.

For foreign companies, cross-listing in OTC markets like the OTCQX can attract a broader base of U.S. investors, potentially increasing trading volume and narrowing bid-ask spreads. Some foreign companies trade OTC to avoid the stringent reporting and compliance requirements of listing on major U.S. exchanges. OTC markets, while regulated, generally have less strict listing requirements, making them attractive for companies seeking to access U.S. investors without the burden of SEC registration for an exchange listing.

OTC Derivatives

OTC derivatives are private agreements directly negotiated between the parties without the need for an exchange or other formal intermediaries. However, a broker may assist in facilitating the trade. This direct negotiation allows the terms of the OTC derivatives to be tailored to meet the specific risk and return requirements of each counterparty, providing a high level of flexibility.

While OTC derivatives offer the advantage of customization, they also carry a higher level of credit risk compared with exchange-traded derivatives. This is because there is no central clearing corporation to guarantee the performance of the contract, meaning that each party is exposed to the potential default of their counterparty.

Some common OTC derivatives include the following:

• Exotic options: Nonstandard options with complex features or payoff structures, such as barrier options or lookback options.
• Forwards: Agreements to buy or sell an asset at a preset price at a future date.
• Swaps: Contracts in which two parties agree to exchange cash flows or other assets over a specific period.
  

OTC Foreign Exchange (Forex) Trading

The foreign exchange (forex) market is the largest and most liquid financial market globally. Unlike stocks or commodities, forex trading occurs only over-the-counter (OTC). This decentralized nature allows for greater flexibility in transaction sizes. However, it also exposes traders to counterparty risk, as transactions rely on the other party's creditworthiness.

Major markets are open 24 hours a day, five days a week, and a majority of the trading occurs in financial centers like Frankfurt, Hong Kong, London, New York, Paris, Sydney, Tokyo, and Zurich. This means the forex market begins in Tokyo and Hong Kong when U.S. trading ends. The forex market is volatile, with price quotes changing constantly. Like other OTC markets, due diligence is needed to avoid fraud endemic to parts of this trading world.

Advantages and Disadvantages of OTC Markets

Advantages

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.

OTC markets may also offer more flexibility in trading than traditional exchanges. Transactions can, in some cases, be customized to meet the specific needs of the parties involved, such as the size of the trade or the settlement terms. This flexibility can be particularly worthwhile for institutional investors or those trading large blocks of securities.

In addition, companies traded OTC have fewer regulatory and reporting requirements, which can make it easier and less expensive when raising capital.

Disadvantages

Unlike major exchanges that have strict listing requirements, OTC markets have minimal standards for companies to meet. Regulated exchanges require a minimum market capitalization, financial stability, and corporate governance standards. In contrast, OTC markets have fewer requirements, making trading easier for financially unsound or even fraudulent companies. Here are the major disadvantages:

• Counterparty risk: This is a hazard that one party in the transaction will default before completing the trade.
• Fraud: OTC markets are infamous for pump-and-dump schemes. These involve artificially inflating the price of a stock through false or misleading statements, often via social media or online outlets, and then selling the stock at a higher price before it crashes.
• Illiquidity: Many stocks traded OTC lack buyers and sellers, so getting out of your position can be challenging when needed.
• Lack of transparency: Unlike companies listed on major exchanges, those traded OTC are not required to disclose the same level of financial and operational information to the public.
• Wide spreads: OTC stocks are prone to both wide bid-ask spreads and high volatility. The value of an OTC security may swing wildly depending on which market markers trade the stock. 

Examples of Trading in Over-the-Counter Markets

Let's start with an example from a company's point of view. Suppose Green Penny Innovations, a promising renewable energy startup, is not yet publicly listed on a major stock exchange. However, institutional investors and high-net-worth individuals are interested in acquiring company shares. Mega Investments, a prominent investment firm, contacts brokers specializing in OTC securities. They inquire about the availability of Green Penny shares and receive quotes from different market makers. One market maker, OTC Securities Group, offers to sell 50,000 shares at $0.85 per share. Another market maker, Global Trading Solutions, offers to sell a smaller block of 10,000 shares at $0.90 per share.

After evaluating the quotes and considering the company's prospects, MegaFund buys 30,000 shares from OTC Securities Group at $0.85 per share. The trade is executed directly between MegaFund and OTC Securities Group through a private negotiation. No public announcement is made about the transaction, and the price isn't displayed on any exchange.

Several days later, another investor, TechVision Ventures, contacts a different broker and expresses interest in buying Green Penny shares. The broker reaches out to various market makers and discovers that the price has increased due to growing investor interest. TechVision eventually purchases 20,000 shares at $0.95 per share from another market maker.

Customer Example

Suppose you're an investor seeking high returns on your investments, so you're willing to dip into the OTC markets if you can find the right stock. You come across an opportunity called "CoinDeal," which promises exceptionally high returns on the premise that one or more technology companies under the "ViRSE" banner are about to be acquired by a group of wealthy investors. You look to be in early on what promises like a big deal, just like other storied early investors.

The promoter of CoinDeal assures you that even if the returns from CoinDeal do not materialize, he'll repay your investment with 7% annual interest over three years. The promoter points to an exclusive and lucrative contract with AT&T to distribute government-funded phones to support this promise. He also says he has an app ready for the Better Business Bureau to distribute that will yield substantial revenue.

Enticed by these promises, you and thousands of other investors invest in CoinDeal. However, when the promised sale doesn't close, you discover that the promoter, Michael Glaspie, 72, of Florida, has transferred investor funds to other accounts—he'd been buying cryptocurrency, among other things—despite his assurances he wouldn't. The case is, of course, one of many OTC frauds targeting retail investors. Glaspie pleaded guilty in 2023 to defrauding more than 10,000 victims of over $55 million through his "CoinDeal" investment scheme.

OTC Due Diligence

This case highlights the importance of due diligence and the risks associated with OTC investments. When considering an OTC investment, you should do the following:

1. Thoroughly research the investment and the individuals involved.
2. Be cautious of promises of high returns with little or no risk.
3. Verify the legitimacy of any claimed contracts or agreements.
4. Understand the lack of regulatory oversight in the OTC market.
5. Diversify investments to minimize potential losses.

The Bottom Line

The over-the-counter (OTC) market is a decentralized market where stocks, bonds, derivatives, currencies, and so on are traded directly between counterparties. While the OTC market offers prospects for investors to access a wide range of securities and for smaller companies to raise capital—many storied firms have passed through the OTC market—it also comes with risks. The OTC market's lack of regulatory oversight and transparency makes it more susceptible to fraud, manipulation, and other unethical practices.

For investors considering OTC securities, it is crucial to conduct thorough due diligence, understand the hazards involved, and decide on investments with an eye toward your investment goals and risk tolerance. Seeking the guidance of a qualified financial professional can also help you navigate the complexities of these markets.