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What is over-the-counter?

Over-the-counter explanation

Looking for a over-the-counter definition? Over-the-counter, also referred to as OTC and off exchange trading, is a particular type of security that isn't traded on a formal exchange, like the New York Stock Exchange or the NYSE MKT (formerly AMEX). The term over-the-counter can be used in reference to stocks that are traded by a dealer network instead of on one centralised exchange. OTC also refers to other financial instruments, such as derivatives (which are traded using a dealer network) or to debt securities.

Done between two accepting parties, OTC trading is done without the guidance or supervision of an exchange. A stock exchange promotes liquidity, gives transparency, preserves market price and alleviates credit risk regarding party default during a transaction. In an over-the-counter trade, the price doesn't have to be published publicly. In the OTC vs exchange argument, lack of transparency works for and against the over-the-counter market.

Where have you heard of over-the-counter?

Like exchange trading, over-the-counter trading takes place with financial instruments, derivatives and commodities – however, products that are traded on an exchange must be regulated and standardised. Due to this, exchanged deliverables meet a strict range of quality, quantity and identity, as decided by that particular exchange. This must happen because transparency is a necessity on exchanges. In the over-the-counter market, there are not these standards and therefore it doesn't have these limitations. In 2008, around 16% of all United States traded stocks were over-the-counter. Six years later, by 2014, this number had increased to approximately 40%.

For a lot of investors, there is little difference between OTC vs exchange trading. Advancements in electronic trading have provided higher liquidity and a better standard of information. While there are similarities, there are also prominent differences to consider when looking at OTC vs exchange trading. The main difference between the transactions channels is that on an exchange, each party is privy to the offers of all the counter parties, which isn't always the case on dealer networks.

What do you need to know about over-the-counter?

Over-the-counter trading take place on a decentralised market, with no single physical location, and participants trade through various means such as email, telephone and proprietary electronic trading systems. An exchange market and an OTC market are the two primary ways of formulating financial markets. Dealers behave as market makers in OTC markets by quoting the prices at which they'll buy and sell a currency or security.

A trade can be carried out between two parties on an OTC market without the public being given access to the price. This is why OTC markets are generally less transparent than exchanges and less regulated. Over-the-counter markets are mainly used to trade currencies, bonds and derivatives. They can also be used for the trading of equities.

OTC networks are some of the most well known in the world – for example, the OTCQX Best market and the Pink Open Market. OTC networks hold unlisted stocks that can trade on the OTC Bulletin Board or on the Pink Sheets. Nasdaq also operates as a dealer network, but is considered a stock exchange, so its stocks are not classified as OTC and it is not considered to be one of the OTC networks.

The stocks of smaller companies who can't meet exchange listing requirements are usually traded over the counter. These stocks, which are referred to as unlisted, will be traded by broker-dealers who consult directly with each other through computer networks and over the telephone. The OTC Bulletin Board is a quotation system that administers trading information to the dealers. Shares in equity that are traded on a foreign exchange are represented by American Depository Receipts. These are usually traded OTC because the underlying company doesn't want to meet the strict exchange requirements. Financial instruments like bonds never trade on exchanges, so they are also only OTC securities.

Derivatives of OTC make up a large portion of global finance, with the OCT derivatives market growing hugely from 1980 until 2000. This growth has been motivated by interest rate products, credit default swaps and foreign exchange instruments. As of December 31st2010, the derivatives market totalled approximately £453 trillion ($601 trillion). It's widely considered that the popularity and regularity of the OTC derivatives markets would have not been possible if it were not for the advancement in computer technologies that took place from 1980-2000.

Some prominent international financial institutions significantly grew their earnings from their derivatives activities. These particular institutions manage collections of portfolios of derivatives worth over £750 billion ($1 trillion) with thousands of positions. Just before the financial crisis of 2008 the OTC market was an unofficial network of reciprocal counterparty relationships. International financial institutions actively aided the ability to profit from OTC derivatives and financial markets parties reaped the benefits.

Contracts

An over-the-counter contract is a mutual contract where two parties (or their intermediaries) settle on the mechanics of a particular trade. This mainly happens from an investment bank to its clients, with forwards and swaps being prime examples of such contracts. Derivatives are often governed by an International Swaps and Derivatives Association agreement. This portion of the OTC market is sometimes referred to as “the fourth market” with critics labelling it “the dark market” because of its lax regulation and unpublished prices. OTC derivatives are particularly important for hedging risk as they can make “the perfect hedge”. Standardisation doesn't allow much room with exchange traded contracts because the contract is built to suit all instruments. With OTC derivatives, the contract can be tailored to best accommodate its risk exposure.

Stocks

In the United States, OTC trading in stock takes place by using market makers and inter-dealing quotation services such as OTC Bulletin Board (OTCBB) and OTCLink. Commonly over-the-counter stocks are not traded or listed on exchanges. Stocks that are quoted on the OTCBB must adhere to certain limited U.S Securities and Exchange Commission (SEC) reporting and regulation requirements. Some companies began by trading OTC stock and eventually upgrading to the fully regulated markets, the most famous of these companies being WalMart.

Counter Party Risks

Trading in OTC derivatives has its risks. Counterparty risk is the risk that one of the parties involved in a transaction will default before the end of the trade and will not meet all current and future payments required by the contract. There are various ways to limit this sort of risk, one of them being the control of credit exposure with diversification, hedging, collateralisation and netting.

Find out more about over-the-counter...

You can find out more about all things over-the-counter and stock market related from our glossary. Do you want to find out more about a forward and swap contracts? Or do you just want a little bit more information on hedging? We have just what you need. If you would like a more in depth look at OTC trading then why not take a look at David Murphy's book OTC Derivatives, Bilateral Trading and Central Clearing. It is incredibly in depth and will answer even the most well thought out questions.

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