What is an over-the-counter (OTC) market?
An over-the-counter market (OTC) is one without a fixed location, unlike the London Stock Exchange (LSE) which occupies a grand building in central London. Dealers control the OTC market, as it’s they who set the price they’re willing to buy and sell for. Trades aren’t made over a physical counter, instead, traders buy and sell by phone, email or even instant messaging services.
Where have you heard of over-the-counter markets?
OTC markets played a big part in the 2007-2008 financial crisis. The home loan-backed securities, CDOs and CMOs that became so well-known during the period were all traded on OTC markets. Essentially, the number one issue was that it was impossible to price these assets accurately as buyers and dealers started abandoning OTC markets.
What you need to know about over-the-counter markets...
There are two basic ways of organising financial trading: exchanges and over-the-counter markets. The latter are essentially bi-lateral, with participants dealing with one another rather than through an exchange. There is no physical location and traders communicate through telephone, e-mail and proprietary trading systems.
Bonds, currencies and stock are traded on OTC markets, as are money market instruments.
There are two types of OTC trading. One type involves dealers trading with other dealers, the other dealers trading with their customers. The price a dealer will set for another dealer can be very different from the one they set for a customer.
OTC markets are less organised than traditional exchanges, but that informality means that traders can make deals very quickly.
Investors in an OTC market can trade without the trade or the price they paid being published. Since the 2007-2008 financial crisis, however, countries have tightened regulations around OTC markets and tried to get more investors using traditional exchanges.