Over-the-Counter (OTC)

The OTC market allows investors to trade securities directly through broker-dealers without using a stock exchange. It offers access to unlisted securities but usually involves higher risk and lower liquidity.

Key takeaways

• OTC trading occurs through a decentralised broker-dealer network.
• Securities traded include unlisted shares, bonds, derivatives, commodities and currencies.
• Companies that do not meet exchange listing requirements often raise capital through OTC markets.
• Lower transparency and liquidity can increase investment risk.
• Investors should carefully assess company information, counterparty risk and liquidity before investing in OTC securities.

The over-the-counter (OTC) market is a decentralised marketplace where financial securities are traded directly between buyers and sellers through broker-dealers instead of a recognised stock exchange.

Unlike exchange-based trading, OTC transactions do not occur on a single central platform. Instead, prices are negotiated through a network of market participants, allowing greater flexibility in how trades are structured.

OTC markets are commonly used for securities that are not listed on recognised exchanges. They also facilitate trading in customised financial instruments that may not be available through standard exchange platforms.

Securities commonly traded in the OTC market

The modern OTC market traces its origins to the National Quotation Bureau (NQB), established in 1913.

The organisation published security quotations through printed publications known as the Pink Sheets for stocks and the Yellow Sheets for bonds. These publications helped investors and broker-dealers identify available securities before electronic trading networks became widely used.

Many smaller companies initially traded through these quotation systems because they did not meet the listing requirements of recognised stock exchanges. As these companies grow and satisfy the eligibility criteria for listing, they may transition to recognised stock exchanges such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

Today, OTC trading is largely conducted through electronic broker-dealer networks, although it continues to operate outside centralised stock exchanges.

The OTC market provides companies with an alternative method of raising capital without listing their securities on a recognised stock exchange.

Rather than matching orders through a central exchange, broker-dealers facilitate transactions by quoting buying and selling prices from their own inventories. Investors trade through these broker-dealers, who act as market makers.

The OTC trading process

1. A company issues securities that are available for OTC trading.
2. Broker-dealers quote bid and ask prices.
3. Investors place buy or sell orders through authorised brokers.
4. Broker-dealers execute trades directly between market participants.
5. The transaction is settled according to the agreed terms.

Because there is no central exchange overseeing every transaction, investors rely more heavily on broker-dealers and available company disclosures.

Why do companies choose the OTC market?

Some companies prefer OTC markets because they may not satisfy the listing requirements of recognised exchanges. Others may choose OTC trading to avoid the costs and administrative requirements associated with an exchange listing.

For investors, OTC markets provide access to companies that are still growing or operate in specialised sectors. However, these opportunities should always be evaluated alongside the associated investment risks.

What risks should investors understand before trading OTC securities?

OTC markets offer investment opportunities, but they also involve risks that differ from those associated with exchange-listed securities.

Understanding these risks helps investors make more informed decisions.

OTC futures and options are privately negotiated derivative contracts between two parties. Unlike exchange-traded derivatives, these contracts can be customised to meet specific commercial or financial requirements.

The flexibility of OTC derivatives makes them useful for institutions and businesses seeking tailored risk management solutions.

Commodity OTC derivatives

Commodity OTC contracts are linked to assets such as crude oil, metals and agricultural commodities.

Businesses use these contracts to manage changes in commodity prices by agreeing on customised quantities, settlement dates and delivery conditions.

Currency OTC derivatives

Currency OTC contracts help organisations manage fluctuations in foreign exchange rates.

Exporters, importers and multinational companies commonly use these instruments to reduce the impact of currency movements on their business operations.

Interest rate OTC derivatives

Interest rate derivatives allow borrowers and lenders to manage exposure to changing interest rates.

These contracts can be tailored to match specific borrowing periods, repayment schedules and cash flow requirements.

Equity OTC derivatives

Equity OTC contracts are linked to individual company shares or stock indices.

Institutional investors often use them to manage large equity exposures or implement customised hedging strategies.

Credit OTC derivatives

Credit derivatives help participants manage credit-related risks.

These instruments are designed to protect against changes in a borrower's credit quality or the possibility of default under agreed contractual terms.

OTC stocks cannot generally be purchased directly from the issuing company. Investors typically access these securities through authorised brokers that facilitate OTC transactions.

In most cases, investors require both a Demat account and a trading account before purchasing eligible OTC securities.

Common broker options

Full-service brokers

Full-service brokers provide investment support alongside trade execution. They may also offer research, portfolio guidance and recommendations, depending on their service model.

Some full-service brokers facilitate OTC trading where permitted.

Discount brokers

Discount brokers focus mainly on executing trades at comparatively lower service costs.

Not every discount broker provides access to OTC securities, so investors should verify whether OTC trading is available before placing orders.

Investing in OTC securities requires careful evaluation because these markets operate differently from recognised stock exchanges.

Before investing, consider the following factors.

Lower investment cost

Many OTC securities trade at comparatively lower prices than exchange-listed shares. This may allow investors to purchase larger quantities with a relatively smaller investment.

Limited public information

Companies trading in OTC markets may have fewer disclosure obligations. As a result, investors should review available financial information carefully before making investment decisions.

Growth opportunities

Some OTC companies operate in emerging industries or are in the early stages of business development. If these businesses grow successfully, investors may benefit from future appreciation, although outcomes remain uncertain.

Higher investment risk

OTC securities generally carry higher risk than securities listed on recognised stock exchanges. Lower disclosure standards, limited liquidity and fewer regulatory requirements can make it more difficult to assess the financial health of an issuing company.

Investors should evaluate a company's financial position, business model and available disclosures before investing.

Lower liquidity

Liquidity refers to how easily a security can be bought or sold without significantly affecting its price.

Many OTC securities have lower trading volumes than exchange-listed stocks. This can make it difficult to buy or sell shares at your preferred price, particularly during periods of market volatility.

What are the three main OTC markets?

The OTC market is generally divided into three primary segments based on company quality, reporting standards and investor risk.

What is the grey market?

Apart from the three primary OTC segments, there is also the grey market.

The grey market generally operates without regular broker-dealer quotations and has limited publicly available financial information, making it one of the least transparent segments.

Although both markets facilitate the buying and selling of securities, they differ significantly in structure, regulation, and trading processes.

Conclusion

The over-the-counter (OTC) market allows securities to be traded directly through broker-dealers instead of recognised stock exchanges. It supports trading in unlisted shares, bonds, derivatives and other financial instruments while providing companies with an alternative way to raise capital.

Although OTC markets offer broader investment opportunities and greater contractual flexibility, they also involve lower transparency, reduced liquidity and higher investment risk. Before investing, it is important to evaluate company disclosures, understand the associated risks and conduct thorough research to make informed investment decisions.