When we think of trading, what comes to mind are order books, volume, trade size, and other trade parameters. They stay the industry standard when we are trading. However, there is a lesser-known market called the OTC market or Over The Counter market.

We all know how trading works on the traditional exchange; OTC markets, however, operate on a totally different principle and framework. Let us look into the intricacies of the OTC market and analyze how it works.

What Is An OTC Market

When trades are conducted between private parties or broker-dealer networks over a loosely regulated trading environment, it is called an OTC market.

Financial institutions are one of the major users of the OTC market, as it provides them with higher levels of customization of orders. For example, often complex derivatives such as credit-default swaps require high levels of customization. A traditional exchange operating on an order book cannot provide the flexibility for such customization.

How Does OTC Markets Work?

An OTC marketplace is inherently decentralized. Despite the lack of a physical location and centralized control, they trade in billions of dollars per day.

The flow of communication in an OTC market often takes place between three entities: buyers, sellers, and broker-dealers. It is the broker-dealers who connect the buyers and sellers. However, this is sometimes bypassed when traders conduct transactions directly between each other.

There are different types of assets available to trade through OTC markets. Stocks, Bonds, Currencies, Cryptocurrencies, etc., are some of them.

Cryptocurrency OTC primarily exists for Bitcoin and Ethereum, where traders can communicate directly and keep the terms of the trade private.

Types of OTC Markets

There are two main types of OTC markets.

1. Customer Market: Here, investors are connected through broker-dealers who assist and finalize trades.
2. Interdealer Market: Here, in an effort to minimize risks, broker-dealers trade with each other. The availability of the counterparty’s information and their reputation as traders reduces the risk factor.

Tiers of OTC Markets

OTC markets are mainly divided into three tiers.

1. OTCQX Best Market: Here, traders get to access the majority of the blue-chip stocks. The big players in the market dominate OTCQX. Staying active in OTCQX demands a lot of dedication as it comprises high-quality, high-volume traders. All traders of this tier must comply with US securities laws.
2. OTCQB: This is the middle tier, where early-stage and developing companies in and outside the US participate. This tier is also titled Venture market. To be able to list and trade in this tier, there are specific rules the companies must follow. For example, a company interested in partaking in the OTCQB tier must not be bankrupt.
3. OTCID Basic Market: Formerly known as OTC Pink, this is the lowest among the three tiers. Even though many shell companies and companies that are financially struggling are found here, one may find hidden gems as well, which may perform quite well.

Advantages and Disadvantages of OTC Markets

Conclusion

OTC markets are a great way to trade with the advantage of anonymity. Since an OTC market is highly customizable, the chances of placing profitable trades increase.

While OTC markets come with great advantages, some trade-offs almost balance them out. The key takeaway from this is that OTC markets are not for everyone; trading on the OTC market requires expertise and market knowledge. It also requires the tenacity to navigate the backgrounds of your counterparty.

FAQs

Yes. If individuals have a trustworthy broker-dealer who can link them with potentially well-performing assets, they can trade on OTC markets.

Counterparty risk corresponds to the risk posed by the one with whom you are making a trade. If they default on their trade terms, there aren’t many options for correction.

Yes, the OTC market has several instruments, including options and derivatives.

In traditional exchanges, the strategies applied are visible to everyone, but anonymity in the OTC market prevents being copied and influenced by large traders.

OTC markets operate without an order book; hence, transactions are not publicly available and, thus, maintain anonymity