A guide to understanding what the OTC (Over The Counter) market is and how it works: how to trade?
Among the various options for trading there is also the OTC (Over The Counter) market: what is it and how does it work?
When exchanging cryptocurrencies, currencies, some derivative instruments we are referring to an OTC market.
In simple terms, this expression refers to a type of financial market in which transactions take place directly between two parties, without going through a centralized stock exchange. In other words, exchanges take place in a decentralized way.
The only principle that determines the prices in OTC markets is the meeting between supply and demand, regardless of the prices on the underlying assets themselves. The OTC market is therefore much more liquid than regulated ones, with advantages and risks.
If you are a finance enthusiast and are looking for as much information as possible to invest safely, knowing what is the OTC market is important.
What is OTC (Over the Counter)? Meaning and definition
The term OTC (Over The Counter) literally means “outside the counter” and refers to a market in which financial instruments are exchanged directly between two parties, without going through a centralized stock exchange.
The etymology Over the Counter seems to date back to the expression adopted in pharmacies for over-the-counter products (counter, counter), for which a doctor’s prescription is not required and whose prices are not controlled.
The acronym OTC can refer both to the market itself and to the instrument listed within the Over the Counter market, such as a share, a cross or a stock.
The differences between OTC and regulated markets
In an OTC market, trading takes place in a decentralized manner through a network of brokers, dealers or specialized platforms.
This way of trading summarizes all the differences with regulated markets. In general, it can be summarized that the regulated market is ideal for those seeking security, transparency and liquidity, while the OTC is suitable for those who need flexibility in contracts or instruments not available on official exchanges.
The characteristics, and therefore the differences between the two markets are the following:
Structure
Decentralized OTC market (trading between two parties without a central platform); centralized regulated market (trading takes place on official exchanges)
Regulation
Less regulated OTC market, with variable regulations depending on the country; regulated market subject to rules, with stringent rules to protect investors and stability
Transparency
OTC market with less transparency, prices and volumes may not be publicly available; regulated market with high transparency, with legal obligations and price publication
Liquidity
OTC market with variable liquidity, depends on the counterparty and the product traded; regulated market with generally high liquidity, since there is a market with many participants
Risks
OTC market with high counterparty risk, because the transactions are private and without third-party guarantees; regulated market with lower risk, because the transactions are guaranteed by a clearing house
Flexibility
OTC market with high contract flexibility, contracts can be customized between the parties; regulated market with standardized contracts, with precise rules for each instrument
Examples of instruments
OTC market: OTC shares, derivatives, unlisted bonds, cryptocurrencies; regulated market: listed shares (NYSE, NASDAQ, Borsa Italiana), futures, options on official exchanges
How does an Over the Counter market work?
The OTC market is mainly used for the sale of bonds, currencies, derivatives and structured assets but also for trading stocks.
OTCs are typically divided into two parts: the customer market - where dealers trade with their customers, such as companies and institutions - and the interdealer market, where dealers trade among themselves. The price that a dealer offers to a customer may very well differ from the price offered to another dealer, and the bid-ask spread may be wider in the first case.
In short, investors, banks or financial institutions agree directly to buy or sell financial instruments.
Transactions can take place via telephone, email or private electronic platforms.
Unlike regulated exchanges, prices and terms of trade are freely negotiated between the parties. This allows for greater flexibility, but with less transparency.
In the OTC market, transactions occur without an intermediary, increasing the risk that one of the parties will not fulfill the agreement.
Which instruments can be traded on OTC markets?
OTC markets, through the methods indicated above, are the spaces designed to trade these financial instruments:
- Shares: securities not listed on official stock exchanges (e.g. OTC Markets Group, Pink Sheets);
- [Forex (Foreign Exchange): currency market is entirely OTC;
- Derivatives: Swaps, options and customized forward contracts;
- Bonds and government bonds: some securities not listed on regulated markets;
- Cryptocurrencies: Trading large volumes without impacting market prices
The advantages of Over the Counter markets
Trading in OTC markets involves a series of advantages, mainly linked to their greater flexibility and the possibility of access to customized tools.
They can be classified as follows:
- Greater flexibility in trading;
- Access to financial instruments not available on regulated markets;
- Potentially lower transaction costs
Cons and risks of OTC
The exchange between two participants in an OTC market can take place without others being aware of the price at which the transaction was concluded.
In general, it can be deduced that OTC markets are less transparent than traditional markets and are also subject to less regulation.
While OTCs work well in normal times, their lack of transparency can cause a vicious cycle during times of financial stress, such as the 2008 global crisis. Mortgage securities and other derivatives, which were traded exclusively on OTC markets, were not reliably valued because liquidity dried up completely in the absence of buyers.
This led to many dealers ceasing to act as market-makers, exacerbating the liquidity problem and causing a global credit crunch.
Regulatory initiatives taken in the wake of the crisis to address this issue included the creation of clearing houses for post-trader processing of OTC trades.
How to Trade OTC Markets
How to Trade Over The Counter Markets? Here are some important tips.
Since the OTC market does not have a centralized platform, it is necessary to operate through:
- Brokers specialized in OTC (e.g. Interactive Brokers, TD Ameritrade, eToro for OTC stocks)
- Dealers who act as direct counterparties
- OTC cryptocurrency platforms (e.g. Binance OTC, Kraken OTC)
- Banks and financial institutions (for derivatives and Forex)
Furthermore, being less transparent, the OTC market requires in-depth analysis. Studying balance sheets, news and financial data of OTC companies or assets, using charts and indicators to predict price movements, making sure the counterparty is reliable are all advisable actions.
How is the trading operation performed at this point? With direct negotiation, the trader contacts the counterparty (broker or dealer) and agrees on price and quantity.
If, on the other hand, OTC electronic platforms are used, brokers provide software to execute OTC orders with more liquidity. Finally, with custom orders, as in Forex, you create tailor-made contracts.
Original article published on Money.it Italy. Original title: Mercato OTC (Over the Counter), cos’è e come funziona nel trading
