Definition and Examples of the Over-the-Counter Market
The over-the-counter (OTC) market refers to the sale of securities that happens outside a formal exchange. A variety of financial products can be traded over the counter, including stocks, bonds, commodities, and derivatives.
How Does the Over-the-Counter Market Work?
Companies that don’t meet the requirements to list their securities on an exchange—or those that simply don’t want to abide by those requirements—can instead list them on an OTC market. Trading on the OTC market happens on organized networks that are less formal than traditional stock exchanges. They are centered on the trading relationships and networks among dealers. OTC networks work similarly to traditional stock exchanges. Broker-dealers quote prices at which they’re willing to buy and sell securities. Investors can buy and sell these securities as they would any other stock, and the broker-dealers provide liquidity by trading from their own brokerage accounts. Here’s a typical trading process using an OTC market:
Major Over-the-Counter Markets
Most OTC trading happens at two primary networks: OTC Markets Group and Over-the-Counter Bulletin Board (OTCBB).
OTC Markets Group
OTC Markets Group is a company that operates some of the most popular OTC markets. The company operates three different markets, each of which has different listing requirements for companies. Altogether, OTC Markets Group’s markets have about 11,000 securities available to trade.
OTCQX: Known as the Best Market, OTCQX is designed for established U.S. and international companies that meet the OTC Markets Group’s highest standards. To list on OTCQX, companies must meet financial standards, use best practices for corporate governance, follow U.S. securities laws, and provide up-to-date disclosure statements. OTCQX isn’t open to penny stocks, shell companies, or companies in bankruptcy. OTCQB: OTCQB is known as the Venture Market, and is designed for U.S. and international companies in the development stage. Like OTCQX, eligible companies must provide financial statements and can’t be in bankruptcy. Companies in this tier have fewer eligibility and corporate governance requirements than OTCQX, but more than the Pink Market. Pink Market: The Pink Market is designed to provide for OTC trading for companies that don’t meet the financial standards or disclosure requirements to list in the other OTC markets. Many of the companies that list on the Pink Market include penny stocks, shell companies, and distressed, delinquent, or “dark” companies that may have ceased operations or have questionable management and market disclosure practices. Because of the limited criteria that listing companies must meet, the Pink Market is the highest-risk option for investors.
OTCBB
OTCBB, or OTC Bulletin Board, is an interdealer quotation system sponsored by FINRA, and is available to FINRA subscribing members. It shows real-time quotes for OTC securities, recent sale prices, and volume information for OTC securities. The OTCBB shows quotes for domestic and foreign stocks, as well as American depositary receipts (ADRs).
Pros and Cons of the Over-the-Counter Market
Pros Explained
Potential to be an early investor in a successful company: Many companies that list on OTC markets are too small to trade on traditional stock exchanges. As an investor, you may find a small, up-and-coming company that eventually goes on to be a successful, publicly traded company. As a result, you could see the value of your shares grow considerably.Ability to invest in companies you may not otherwise be able to: As an investor, the OTC market could give you the opportunity to own shares in a company that can’t or doesn’t want to meet the requirements to trade on a traditional exchange.Provides capital to companies that may not get it other ways: When a company is too small to list its securities on a traditional exchange, it may struggle to raise the capital it needs. The OTC market could give such companies the opportunity to raise capital and grow more quickly, which is beneficial to both the company and its investors.
Cons Explained
Companies haven’t met minimum listing requirements: The companies trading on OTC markets don’t have to meet the same requirements as those listed on traditional stock exchanges. While some OTC networks still have strict listing requirements, others have limited or no disclosure requirements and may allow distressed companies or those going through bankruptcy. These limited requirements create a greater risk for investors. Higher rates of fraud: Because there are fewer requirements to list securities on an OTC market, there are also more instances of fraud. Some brokers may buy and resell securities for many times what they are worth. Stock promoters also run campaigns to mislead individuals and get them to invest in companies for their own profit. Finally, some promoters and brokers in OTC markets already have faced disciplinary action in the securities industry. Risk of low liquidity: OTC securities may have less liquidity than those on traditional stock exchanges, meaning investors may have a hard time buying or selling a particular security when they want to. This can be especially problematic if an investor wants to sell their shares and can’t find a buyer.
What It Means for Individual Investors
If you’re considering investing in OTC securities, it’s important that you do your research and fully understand the risks you’re taking on. OTC securities are generally considered speculative investments. The OTC market can be highly volatile, and the limited requirements for companies to list on the OTC market result in greater risk for investors. Before investing in OTC markets, individual investors may want to consider how these securities will fit into their overall portfolio. In general, you should only speculate with money you can afford to lose. You may want to limit your speculative investments to a certain percentage of your portfolio; investment research firm Morningstar recommends no more than 5% or 10%.
