What Are the OTC Markets and How Do They Work?
Over 11,000 securities trade on the U.S. OTC markets, and over $600 billion worth of transactions occur every year.
Compare that to some 7,000 companies trading on the major US stock exchanges NYSE and Nasdaq and it's obvious that OTC stocks can provide some variety otherwise missing from “big board” investment options.
But what are the OTC markets, and how do they differ from exchanges like the Nasdaq?
Read on to find out more about what the OTC markets are and how they work.
What Does OTC Trading Mean?
OTC stands for over-the-counter. Most people are familiar with this term related to pharmaceutical drugs and medicines. If you get an OTC medication, it's one you can buy without going through the formal prescription process and involving a physician and pharmacist.
In the financial world, the meaning is somewhat similar. OTC stocks and bonds are those that you can buy or sell outside of the major exchanges like the Nasdaq and New York Stock Exchange (NYSE).
Traditionally, over-the-counter meant you were literally buying or selling stock without the agency of a formalized exchange. Two people were simply engaging in a transaction together.
In the United States, OTC trading can mean private selling between two parties (usually via a broker-dealer), but “OTC markets” more commonly refers to trading on separate public markets that are designed specifically for OTC trades and involve the intervention of brokers.
What Are Some OTC Markets?
Older investors may be familiar with the OTC Bulletin Boards (OTCBB), which was an electronic quotation service provided by the Financial Industry Regulatory Authority (FINRA) until 2021. For years, the OTCBB was where you went to trade OTC equities not listed on exchanges, and it worked very much like an electronic “bulletin board” where you “posted” your desired trade in hopes another party would take the other side.
But much has changed in the last decade, and OTC trading in the U.S. now takes place almost exclusively on three markets owned by the OTC Markets Group. In fact, in 2021, FINRA officially closed down the OTCBB due to most OTC trading occurring on the OTC Markets Group’s platforms.
OTC Markets Group Inc. (traded publicly as OTCM itself on the OCTQX) operates the OTCQX Best Market, the OTCQB Venture Market, and the Pink Open Market.
- Pink Open Market (known as the Pink Sheets). This market is also called the OTC Pink or OTC Pink Sheets. There are no SEC reporting or registration requirements here, which makes it a bit of a Wild West environment when it comes to investing. Investors can find legitimate penny stocks and new companies on the Pink Sheets, but scam and shell companies are also known to make appearances here. Investors adventuring into this market should arm themselves with research and know what they own (or want to own).
- OTCQB Venture. This market does include some increased reporting requirements and oversight, making misinformation less likely. It's typically made up of companies that are developing and seeking venture capital investments and seed money for growth opportunities.
- OTCQX Best. Only around 4% of OTC stocks trade on the OTCQX, as it is more selective and requires higher levels of oversight and reporting. This market is often considered a steppingstone to major markets like the NYSE or Nasdaq.
These markets represent a wide range of securities including:
- ADRs and foreign ordinaries
- SEC reporting companies
- Community banks
- Small and micro-cap companies
- Large and mid-cap companies
In contrast to securities listed on the large U.S. stock exchanges, securities on the OTCQX, OTCQB and Pink markets may make public disclosure available through a variety of reporting standards, not just through the Securities and Exchange Commission, and these standards increase in rigor from the Pink Sheets up to the OCTQX Best. The standards include OTCQX International Requirements, Alternative Reporting Standards, Regulation A Reporting, SEC Reporting or Pink Basic Guidelines.
OTC Markets Vs Exchanges: How They work
The OTC markets work like a metaphorical market square. In a market square, merchants set up booths to sell goods. They let people know what the price is — what they're willing to sell at — and consumers shopping in the square haggle, letting the vendors know what they're willing to buy at.
A key difference between the NYSE, Nasdaq, and OTC markets is that these larger markets are exchanges. What’s the difference?
On an exchange, the exchange itself pairs trades electronically. With OTC markets, broker-dealers or market-makers fulfill this role through a decentralized network.
This is one reason, for example, that popular discount brokerages like Robinhood restrict trading to established exchanges like NYSE and Nasdaq: less leg-work.
On an OTC market, broker-dealers and market-makers act as their own intermediaries, and in the case of the OTC markets group, trades posted through your broker-dealer are either filled internally (one broker-dealer client to another of the same firm) or sent to OTC Link® ATS. In that case, a second broker-dealer can step in to fill the other side of a posted trade.
Once this data is published electronically to the market, the deal is executed at the best possible price. Here's a simplified example:
- A broker has a client that wants to sell OTC stock in a certain company.
- The broker posts an ask of a certain price. For the purpose of an easy example, let's say $10 per share.
- Other brokers with clients who want to buy OTC stock in that company may have posted a bid. Perhaps bids range between $7 and $9.
- The broker and his or her client can decide to sell at $9 per share, as that's the best possible price in the market at the time, or wait for a $10 buyer.
This is a simplified example, and this action typically happens seamlessly in OTC stocks that have enough volume.
Transactions also typically go through clearing houses, part of every market or a third-party established by the market to perform clearing activities. Clearing houses validate transactions before they're finalized to ensure that everyone involved is holding up their side of the “agreement” or obligation in the transaction.
Potential Pros of OTC Trading
One of the biggest advantages of OTC trading is that it offers options for companies that can't or don't want to be listed on major exchanges. Typically, new issues in these markets cost much less than new issues in major markets.
If companies are transfer-agent verified, buyers can have more peace of mind in up-to-date share data. That's because they know a transfer agent was hired to keep track of and manage records related to investors and shares.
A reason many investors like engaging in OTC stock trading is that many of the companies trading in these markets are startups or new players in various industries. They haven't risen to the size that might allow them to go public on the major exchanges, but they're ready to trade publicly in OTC markets. That gives investors a chance to get in “on the ground floor” with companies that may be poised to make moves in their industry — an important consideration, especially for investors looking for more ESG opportunities.
Companies or individuals that hold OTC stock can also take advantage of OTC stock loans. These are loans that are secured by OTC holdings, and they can be an easy way to bolster your own cash flow.
Potential Cons of OTC Trading
One of the biggest downsides of OTC trading is reduced regulation. OTC Markets Group has made major efforts to improve disclosure requirements for companies and investors, but these securities don't abide by the same regulations that companies on major exchanges do. It's important to consider the market and what regulations and oversight are present, because all OTC markets are different in this regard.
OTC markets sometimes have such little oversight that they are known to be hotbeds for fraud. That’s why it's important to understand which market your stock is traded on.
OTC securities tend to have lower trading volumes than securities on the major exchanges, which can lead to more volatility that drives prices up or down rapidly. This can create risk for buyers and sellers and results in wide bid/ask spreads.
Further, less liquidity means that stock owners with large positions may have a hard time selling without materially affecting the market for their security.
That’s where a stock loan can be beneficial in the right market. We help large position-holders access cash collateralized by their stock ownership, and we operate in markets globally, including OTC.
Click here to learn more about our non-recourse stock loans on OTC markets.
To summarize, the OTC markets in the U.S. generally refers to the markets run by OTC Markets Group, and it no longer includes the OTC Bulletin Boards. OTC markets differ from exchanges in that they rely on a decentralized network of broker-dealers to execute transactions rather than a single, central trading system. The OTC markets can offer great variety for savvy investors, you just need to understand what you own and proper disclosure.