While the New York Stock Exchange (NYSE) and the Nasdaq get all the press, over-the-counter or OTC markets worldwide list more than 11,000 securities for investors to trade.
OTC markets offer the chance to find hidden gems, but also the opportunity to get stuck in a scam stock that you can’t sell before it becomes worthless. But for investors willing to do the legwork, the OTC markets offer opportunities beyond the major exchanges.
Here’s what the OTC markets are, what you can trade there, and why companies trade over-the-counter.
What are the OTC markets?
The OTC, or over-the-counter, markets are a series of broker-dealer networks that facilitate the exchange of various types of financial securities. They differ in a number of important ways from the stock exchanges that most investors and the wider public are familiar with.
Investors are familiar with trading on an exchange such as the NYSE or Nasdaq, with regular financial reports and relatively liquid stocks that can be bought and sold. On an exchange, market makers – that is, large trading firms – help keep liquidity high so that investors and traders can get in and out of stocks. Exchanges also have certain standards (for example financial) that a company must meet in order to keep its shares listed on the exchange.
The OTC markets, in contrast, consist of broker-dealers at investment banks and other institutions that make calls to other brokers when a trader places an order. These brokers look for buyers or sellers willing to take the other side of the trade, but they may not find any. Therefore, securities on OTC markets tend to be much less liquid than those on exchanges. Because of this structure, shares may not trade for months and there may be large differences between the buyer’s bid price and the seller’s ask price (i.e. wide bid-ask spreads).
But OTC markets offer the opportunity to list large and small – even tiny – stocks and other securities with different requirements and, in some cases, no requirements at all.
The OTC markets consist of several submarkets with different characteristics and requirements:
- OTC Link – OTC Link processes equities, some corporate bonds and foreign securities. It has three submarkets, with different listing requirements:
- OTCQB: This marketplace contains securities of companies that are up to date in their financial reporting with the SEC or an appropriate regulator.
- OTCQX: This marketplace contains securities of companies that are current in their reporting to the SEC or the applicable regulator, or, if not required to report to the SEC, current in their filings with OTC Link. They must have audited financial statements and meet certain eligibility requirements.
- OTC Pink: OTC Pink, also known as the pink sheets, is more like the Wild West, with no financial standards and no requirement that companies report to the SEC.
Because financial statements and other disclosures are critical to investors, investors should be aware of whether their OTC safeguards are required to file statements and should exercise caution if they are not required to do so.
Which investments can you trade OTC?
You can trade a surprising number of securities on the OTC market, including:
- Equities: Many listed companies trade over-the-counter rather than through a major exchange.
- ADRs: ADR, or American Depositary Receipt, is a fancy term for foreign companies whose shares can be traded over-the-counter (or on the major exchanges) in the US. Many reputable companies trade over-the-counter as ADRs, including BMW and Nestle.
- Bonds: Corporate bonds are typically traded over-the-counter.
- Derivatives: Derivatives such as options or swaptions can also be traded over-the-counter, which is typical of non-standard contracts.
- Penny Stocks: The OTC market is also a popular place for suspect penny stocks, many of which offer low share prices and even lower liquidity.
The OTC market allows many types of securities to be traded that generally do not have sufficient volume to be listed on an exchange. This feature gives investors access to more securities.
Why do companies trade OTC?
Companies may trade over-the-counter for a variety of reasons, so investors should understand the disadvantages and risks associated with OTC trading.
Some important reasons to list on the OTC markets are:
- Lower listing requirements than a major exchange. The major stock exchanges impose higher listing requirements that some companies cannot or do not want to meet. These include a certain number of shares outstanding, a minimum market capitalization, a minimum share price, a certain level of financial strength and financial reporting.
- Cheaper than a major fair. Trading on a major exchange can easily cost a company more than $100,000 per year, and for small businesses, that fee can eat up a significant portion of their profits. The OTC market is cheaper.
- Easier for foreign companies. Some foreign companies cannot or do not want to list on a major stock exchange because of the additional costs and requirements. Fewer of them are therefore needed to list on the OTC markets, while still being able to reach American investors.
- It may not be required to file with the SEC. Some OTC markets, such as the pink sheets, do not require filing financial reports with the SEC, meaning investors should be wary.
These are some of the main reasons why a company applies to list its shares over the counter.
In short
The OTC market may contain many attractive stocks, but it certainly also contains shares of many less attractive companies that may be difficult to sell once you acquire them. Investors who engage in over-the-counter trades should carefully understand the risks associated with trading there and the stocks that call it home. Unfortunately, buyers can be wary of OTC markets.
