What is Over-the-Counter (OTC) trading?

Written by: Evan Rouse | Financial Writer

At its core, OTC trading is a decentralised market where securities are traded directly between buyers and sellers, typically via dealers, brokers, or market makers, rather than through an exchange. Unlike exchange-based trading, where orders are matched automatically through a centralised platform, OTC trading relies heavily on negotiation and agreements between parties.

The lack of a central exchange provides flexibility and can facilitate trades in assets that may not meet the listing requirements of major exchanges. Some of the most prominent examples of OTC assets include stocks of smaller or emerging companies, bonds, derivatives and cryptocurrencies.

Key differences between OTC and exchange-based trading

While both OTC and exchange-based trading involve the exchange of financial assets, there are several critical differences between the two:

Market structure

Exchange-based markets like the NYSE and NASDAQ operate through a centralised order book where buyers and sellers match orders in real-time. OTC trading, however, occurs directly between parties (via dealers or brokers) without a centralised platform, which can lead to more flexible but less transparent trading.

Transparency

Traditional exchanges offer transparency through publicly available price information and trade volume. OTC markets, by contrast, may have less visibility into pricing, often due to fewer regulations.

Regulation

Exchange-based markets are heavily regulated by authorities such as the US Securities and Exchange Commission (SEC) and the Australian Securities and Investments Commission (ASIC). However, OTC markets are generally less regulated, with rules enforced by entities like the Financial Industry Regulatory Authority (FINRA) or self-regulated organisations.

Liquidity

Liquidity is typically higher in exchange-based trading because of the large number of participants, whereas OTC markets may experience lower liquidity, especially for smaller, less frequently traded assets.

Trading hours

Traditional exchanges operate during set hours, often with extended hours for pre-market and after-market trading. OTC markets, however, may operate more flexibly and are not restricted to specific hours.

How does OTC trading work?

The mechanics of OTC trading involve several key players, including brokers, dealers and market makers. These entities facilitate the buying and selling of securities in a less structured environment than exchange-based trading.

Brokers and dealers

Brokers act as intermediaries, matching buyers and sellers in the OTC market. They do not take ownership of the securities themselves but instead help execute trades on behalf of their clients.
Dealers, on the other hand, maintain inventories of securities and are often the ones who quote prices for specific assets. They take on some level of risk by holding assets and may trade directly with buyers and sellers.

Market makers

Market makers play a crucial role in OTC trading by providing liquidity and ensuring that there is always a buyer or seller available for a particular asset. They do this by standing ready to buy or sell at quoted prices. Market makers are particularly important for less liquid or harder-to-price securities.

Negotiation process

OTC trades are often negotiated on a case-by-case basis, with prices determined through negotiation between buyers and sellers, as opposed to the automated matching system used in traditional exchanges. While this can result in more flexibility, it also means that pricing can be less transparent and may vary between transactions.

Technology and platforms

Modern OTC trading often takes place through electronic networks that facilitate communication between buyers and sellers. Platforms like the OTC Markets Group provide organised marketplaces where transactions can be conducted, though these platforms are still less centralised compared to traditional exchanges.

What are the advantages of OTC trading?

There are several advantages to OTC trading. A primary one is that you get access to unlisted securities, such as penny stocks, foreign securities and derivatives, offering the flexibility to trade unique or specialised assets that are not listed on traditional exchanges. There's also potential for higher returns, thanks to the speculative nature of OTC securities. Therefore, if you're willing to take on more risk, you may be able to achieve significant returns from high-growth companies or underpriced assets. Moreover, derivatives like CFDs enable you to gain access to assets that would otherwise be untradeable, such as whole indices. This is because instead of taking ownership of the asset, you’re just speculating on the price of it.

What are the risks of OTC trading?

While OTC trading offers certain advantages, it also comes with substantial risks. A key downside is that OTC markets are often less transparent than traditional exchanges. The absence of a centralised exchange means that price discovery can be more difficult, and you may struggle to understand the fair value of certain assets.

Moreover, OTC markets are often subject to higher volatility and liquidity risks. With fewer participants and lower trading volumes and liquidity, even small transactions can lead to significant price swings. This can increase your likelihood of loss, making it crucial to ensure you have a robust risk-management plan.

Finally, the less-regulated environment of OTC markets can increase the potential for fraud and market manipulation. Conducting thorough research and due diligence is essential to help protect yourself from these risks. If you're trading products like Contracts for Difference (CFDs), it's especially important to choose a responsible, well-regulated provider that offers transparent pricing and robust risk-management tools — these can help mitigate some of the inherent risks in OTC trading.

Types of securities traded OTC

A wide range of securities can be traded in the OTC market. Some of the most common types include:

1. Penny stocks and small-cap companies: Many companies that are too small or too risky to be listed on major exchanges opt for OTC trading. These companies, particularly penny stocks, are typically high-risk, low-price assets often traded in the OTC market.
2. Foreign securities: American Depositary Receipts (ADRs) allow investors to buy foreign securities in the US market, often through OTC platforms. These receipts represent shares in foreign companies and trade in a similar manner to domestic stocks.
3. Bonds, forex and derivatives: The OTC market is also home to a range of fixed-income instruments, including bonds, as well as currencies (forex) and complex derivatives.
4. Cryptocurrencies: With the rise of digital assets, OTC trading has become an essential venue for buying and selling cryptocurrencies. Due to their high volatility and relatively small market capitalisation, cryptocurrencies often trade OTC to avoid the price swings that can occur on public exchanges.
5. Contracts for difference (CFDs): CFDs are derivative instruments that allow trading on the price movements of underlying assets without owning them. They are commonly traded OTC between brokers and clients. CFD providers cover a wide range of asset classes, including stocks, commodities, indices and forex.

Key players in OTC trading

The OTC trading market involves several key players who ensure the efficient operation of the market, provide liquidity and help maintain regulatory standards. These include platforms like OTC Markets Group, self-regulatory organisations such as FINRA and institutional investors like hedge funds.

OTC Markets Group: The OTC Markets Group operates various platforms, such as OTCQX, OTCQB, and Pink Sheets, which categorize companies based on financial transparency and investor protections.

FINRA: The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organization that oversees the activities of brokers and dealers in the OTC market, helping to enforce fair practices and protect investors.

Institutional investors and hedge funds: Large institutional investors and hedge funds play a significant role in OTC markets, using these venues to access unique investment opportunities, particularly in the bond and derivative markets.

Regulation and compliance in OTC trading

Regulation in OTC trading is crucial for ensuring market integrity and protecting investors, especially due to the decentralised, less transparent nature of these markets. For example, in the US., the Securities Act of 1933 requires securities to be registered with the SEC before they can be publicly sold, though exceptions apply for OTC-traded securities. In Australia, the Australian Securities and Investments Commission (ASIC) is responsible for overseeing OTC trading. Brokers offering OTC products must hold an Australian Financial Services Licence (AFSL) and comply with ASIC’s strict conduct and disclosure obligations.

The Financial Industry Regulatory Authority (FINRA) oversees brokers and dealers in OTC markets, enforcing rules to promote fairness, transparency and ethical behaviour. This helps reduce fraud and ensures proper conduct among market participants.

Globally, regulatory approaches vary. In the UK, the Financial Conduct Authority (FCA) regulates OTC trading. In Australia, it’s the Australian Securities and Investments Commission (ASIC). In Asia, however, regulations differ from country to country. As OTC markets grow, regulators worldwide are adapting their frameworks to address emerging risks, such as the trading of complex financial instruments like derivatives and cryptocurrencies. This ongoing regulatory evolution seeks to balance flexibility with investor protection.