High risk with a chance of high returns—OTC trading isn’t everyone’s cup of tea.
If you thought that you could only buy stocks from the stock market, you guessed wrong. Investors can also purchase stocks directly from the companies they wish to invest in. This is called over-the-counter (OTC) trading.
OTC stock trading is the trading of stocks bonds and financial instruments between two parties. Instead of going through stock exchanges, this kind of trading is done through OTC markets. An OTC market is a decentralized market with no physical locations and is made up of dealer networks. Curious about what OTC trading is and whether it is the right choice for you? Well, let’s find out.
How does OTC trading work?
OTC trading takes place through OTC markets where dealers of the stock quote prices at which they would buy, sell or trade certain stocks or securities. The companies trading on the OTC market are considered public but not listed on the stock market. There are various reasons leading to the lack of listing of some companies on traditional stock exchanges, like inadequate market capitalization; inability to keep stock prices above a certain level; a smaller company size; illiquid asset holdings and even the undergoing of bankruptcy filings.
Since these companies are not listed on traditional exchanges, they are not bound by the same rules and regulations as companies on the stock market. More than 12,000 stocks are traded OTC across the world. A major part of the OTC market is made up of derivatives (contracts that derive their value from underlying assets, like stocks or bonds) used for hedging purposes.
Types of OTC markets
In the United States, OTC trading is facilitated by a company called OTC Markets Group. The company provides real-time quotations called OTC Link to its participants, wherein users of the OTC market get to know the actual price of a security in real-time. The American OTC markets can be subdivided into three main categories—OTCQX, OTCQB and Pink Sheets.
Best Market OTCQX
OTCQX has the highest reporting standard and oversight of all OTC markets. OTCQX does not allow the trade of stocks worth less than US$5 (known as penny stocks). It also does not allow shell companies or companies close to bankruptcy to list their shares. Companies that are listed here must also have a sponsorship from a third-party financial advisor and report to a U.S. financial regulator, like the Securities and Exchange Committee (SEC) or the Federal Deposit Insurance Corporation (FDIC). Given the high regulatory standards, only 4% of OTC stocks are traded on this market.
This market is made up of companies that are listed on foreign stock exchanges or eventually intend to list on major U.S. stock exchanges, like NYSE or the Nasdaq. Some of the blue-chip stocks from outside the U.S., including Europe, Russia, Canada and Brazil, belong to this category. The companies traded on OTCQX also have the largest market capitalization and highest liquidity of all three markets.
Venture Market OTCQB
OTCQB consists of companies that are still in the developmental stage. It includes companies that do not meet the qualifications to be listed on the OTCQX. The companies listed on the OTCQB have to submit their financial records and also need to meet certain regulatory requirements, albeit not as strict as the ones for OTCQX. Some of these requirements include having at least 50 shareholders, with each holding 100 shares, and audited financial statements as per the Generally Accepted Accounting Principles (GAAP). Companies hoping to be traded on OTCQB must also not be undergoing bankruptcy filings.
Pink Sheets
Companies listed on Pink Sheets don’t have to meet any reporting requirements or get themselves registered with the Securities and Exchange Commission (SEC). A lot of the stocks listed on Pink Sheets are penny stocks (companies with low market capitalization and stock prices less than US$5). The companies listed on Pink Sheets tend to be volatile and risky.
Advantages of OTC trading
Companies trade on OTC markets because listing costs are lower than those of traditional stock exchanges. While a traditional stock exchange can cost a company at least US$100,000 annually, OTC listings only cost anywhere between US$5,000 and US$23,000 (depending on the market segment of choice) per year. They have also limited listing requirements and also allow the entry of foreign companies into the U.S. market. Furthermore, the transactions taking place on the OTC markets are free, which makes it financially beneficial for companies to list on them.
Investors benefit from OTC trading by getting an opportunity to invest in a company at the early stages. It also gives them access to companies from other countries. Moreover, penny stocks listed on OTC markets make it possible for investors to purchase a large share of a company and gain a major position in it.
Risks of OTC trading
One of the biggest risks of OTC trading is the lack of regulation. The lack of regulation makes it possible for market makers and even large shareholders of penny stocks to manipulate the price of the stocks. Besides the lack of regulation, what makes OTC trading risky is limited knowledge about the space. A lot of investors are not well-versed in OTC trading, and therefore you might struggle to find someone to purchase your shares. Another major concern emerging from the absence of regulation is counterparty risk. This refers to a situation where one party involved in the stock trade might default on—or fail to pay— a present or future payment required by the contract.
Moreover, the advantage of owning a large share in a company through penny stocks can also turn into a disadvantage in case the company undergoes financial hardship. The OTC markets have been the site of a lot of pump and dump schemes. One such case even came to light in April this year, when the U.S. attorney’s office for the Southern District of New York revealed the long-running market manipulation schemes that had generated US$100 million through unlawful trading.
If you want to invest in the OTC market, it is important that you do so through a trustworthy dealer. You must carefully consider which tier to invest in and how much money you are willing to invest. Make sure you understand the risks associated with OTC trading before you spend your hard-earned money on the OTC markets.
This article is meant for informational purposes only. Please make investment decisions based on your own discretion.
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Header image courtesy of Unsplash
