Understanding how OTC markets and trading work
Rebecca Cattlin September 24, 2021 7:30 PM
Over-the-counter markets are the opposite of exchange-based; they have no central location and less regulation. But the excitement of OTC trading and the opportunities that can be found in OTC markets have made them extremely popular. Find out more about what it means to trade OTC.
What does OTC mean?
OTC means over the counter; it’s a type of trading in which transactions take place directly between two market participants. Over-the-counter markets are completely decentralised, spanning a network of individual dealers and traders, rather than being held in a centralised location like a stock exchange.
The OTC market tends to be split into two:
- The customer market, where dealers trade with their clients. This would be a provider’s platform where dealers set the price and an individual’s trades are executed
- The inter-dealer market, where dealers trade amongst each other and negotiate prices
When you trade via an exchange, you’ll see a lot of different prices listed from multiple buyers and can select the one you’re interested in, but when you trade OTC via your broker, you’ll see two prices listed – a buy price and a sell price, also known as a bid and an ask.
What can I trade over the counter?
The most commonly-traded OTC markets are forex, shares, debt securities and financial instruments like CFDs that are bought directly from a dealer – usually via electronic trading platforms.
Forex is the most popular OTC market, in which currencies are exchanged via a network of banks, brokers and individuals all over the world. As forex trading isn’t reliant on an exchange being open, you can open and close positions 24 hours a day, five days a week.
See all the forex trading hours
Typically, because there are so many decentralised exchanges taking place, it’s been difficult to understand the trading volume that occurs on the forex market. This is one downside of FX being OTC; that information is less readily available compared to on-exchange assets. For example, whereas stock volume can be tracked hourly or daily, the most cited FX volume figure comes from the triennial Central Bank Survey.
Learn more about forex trading
OTC shares or ‘unlisted stocks’ are often those of smaller companies that don’t meet the market requirements of stock exchanges. It could be that their market capitalisation isn’t high enough, they can’t keep their shares above a certain price or they’re filing for bankruptcy.
Companies may also not want to pay the high fees that exchanges charge – for example the NYSE has administrative fees that can hit $250,000 a year.
This isn’t to say that high value companies don’t trade OTC – for example Allianz and Danone do – but smaller OTC stocks, such as penny stocks, are more common.
You’d find OTC shares on systems such as the OTCQX, OTCQB, and the OTC Pink marketplaces (previously the OTC Bulletin Board and Pink Sheets). Despite not being centralised exchanges, these electronic systems still show traders quotes, prices and trade volume.
OTC debt securities
Debt securities, such as bonds, are traded over the counter by investment banks. Unlike the shares of a company, bonds aren’t sold on exchanges because they can come from different issuers entirely. Each bond is different, with unique maturities, values and credit ratings.
Bonds tend to be among the least liquid of the OTC market, but it will depend on the issuer and the credit history of the firm.
OTC derivative products
Derivative products like forward contracts, swaps and CFDs can also be traded OTC. Brokers organise the supply and demand of derivatives in their organisation, setting the prices and executing trades. In other words, CFDs and other derivatives do not trade on an exchange, they are contracts made directly between you (the trader) and your provider.
Learn more about CFDs
How to start OTC trading
You can start OTC trading with City Index and get access to thousands of international markets in these easy steps:
- Open an account, or log in if you’re already a customer
- Search for the asset you want to trade in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade
Alternatively, you can practise trading in a risk-free environment with a City Index demo account.
Benefits of OTC markets
OTC markets have a range of benefits; the most commonly-cited one is that the transaction sizes are non-standardised, which means you can have greater control and flexibility over how much you trade.
As we've seen above, trading OTC also gives you access to markets that you'd otherwise be unable to trade. Trading via OTC derivatives also enables you to go long or short on markets without taking ownership of the underlying asset, creating a whole new range of opportunities.
While OTC markets gained a reputation as being illiquid, these issues have largely been resolved, making it much easier to execute trades. The advancements made in electronic quotation systems have means that the information available to traders has also increased.
Risks of OTC markets
Counterparty risk is the most frequently-cited risk of OTC markets, which is when one side of the transaction defaults on the exchange and doesn’t meet its contractual obligations. This can happen because of the unregulated nature of decentralised trading.
Financial exchanges are regulated entities – and while this can be seen as restricting the securities that can list, it also provides a significant amount of safety. All of the transactions will be standardised for quantity and quality, ensuring that you’re guaranteed to receive what you pay for. OTC prices are not made public until a trade has been completed, so there’s always the potential that your trade isn’t being executed at the most favourable price.
OTC markets also tend to be more volatile and unpredictable due to the high volume of traders and lack of regulation. While volatility does create opportunity for short-term traders, it’s important to have a risk management strategy in place as OTC markets are more likely to be subject to market manipulation.
OTC stocks in particular are considered risky because they don’t have to declare as much information to the public as listed stocks do. This means there is capacity for accounting tricks and inflated statements of success.
However, it’s always worth pointing out that the criticisms of OTC trading largely come from exchanges or advocates of exchange trading, who will always have an incentive to steer traders toward their business. Losses can occur on large exchanges, as well as OTC markets, it’s how you manage your risk that really matters.
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