Over-The-Counter Market (Explained: All You Need To Know)

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What Is An Over-The-Counter Market

An over-the-counter market refers to a marketplace where market participants trade securities and various financial instruments directly with one another without going through a central exchange.

In other words, an over-the-counter market is a decentralized marketplace where stocks, bonds, currencies, and other instruments are traded between dealers, brokers, and other traders.

Since the market players transact directly with one another, other market players will not necessarily have access to the transaction information such as trading volume, bid, ask, transaction price, and so on.

For example, a stockbroker can contact another stock broker and propose to buy or sell a certain financial instrument.

If there is an agreement on price and other terms of the trade, the brokers will trade the financial instrument with one another.

The details of the transaction will not be published anywhere or made available to other brokers or dealers.

In an over-the-counter market, brokers and dealers are known to be “market makers” as they look for other market participants that are willing to get into a transaction related to a specific financial product.

Keep reading as I will further break down the meaning of an over-the-counter market and tell you how it works.

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Why Is An Over-The-Counter Market Important

Over-the-counter markets are important as there are many financial instruments that can be traded such as stocks, bonds, currencies, derivatives, and other products.

In such markets, brokers and dealers are known to be “market makers” as they look for transaction opportunities and trade different types of products.

Companies looking to raise capital can potentially sell securities and financial products in the over-the-counter market by working with broker-dealers who create interest and a market for their products.

Companies and investors trading on the over-the-counter markets should be aware that the transactions are riskier than trades on a stock exchange.

Investors are exposed to greater counter-party risk and liquidity risk along with the risks inherent to the financial product purchased.

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Where Is The Over-The-Counter Market

An over-the-counter market is not located at a certain place or location in the same way central exchanges are located somewhere.

For example, the New York Stock Exchange is located in New York on Wall Street, this is one of the most recognizable exchanges in the world.

However, the over-the-counter market is a decentralized market that only exists electronically.

Brokers and dealers reach out to one another electronically, over the phone, and through other communication channels.

Since the market is decentralized (meaning that market participants do not go through a central exchange), the transactions are performed directly between the parties.

In the United States, the Financial Industry Regulatory Authority (FINRA) regulates the over-the-counter market to ensure that the market participants are held somewhat accountable.

However, the over-the-counter market is not as regulated as central markets, has less transparency, and exposes the market participants to more risk.

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Over-The-Counter Market Risks

Trading on over-the-counter markets exposes market participants to more risk.

The first important risk unique to over-the-counter markets is the counterparty risk.

The counterparty risk refers to the risks associated with your counterparty in a particular transaction.

In other words, if you enter into a trade with another party, there is a risk that the other party will default on its obligations, fail to make payment, or deliver the securities. 

Another risk that is particular to over-the-counter markets relates to the liquidity of the financial products.

It is possible that a seller of a financial product may not find a buyer to enter into a transaction.

As a result, if someone acquires a significant long position in a particular security or financial product, the investor may not be able to sell the position in the future to willing buyers.

When purchasing financial products on the over-the-counter market, it’s important to understand the market liquidity to be able to assess your liquidity risk.

Investors are also exposed to the risk of purchasing a financial product that is not priced adequately.

Since investors may not have access to sufficient or related information relating to the financial products being traded, they may not have the ability to adequately price the securities.

An investor may purchase something at a price way above its fair market price.

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Over-The-Counter Market FAQ

What are the different types of over-the-counter market tiers?

Although the over-the-counter market is riskier than central markets, the OTC Markets Group has created a tier system allowing investors to better assess the information that companies make available to investors.

Companies in the OTCQX tier are considered to provide the highest level of disclosure to investors, are current with their regulatory filings, and maintain audited financial statements.

Then you have OTCQB where early-stage and growing companies are classified as having a minimum bid of $0.01, are current with their regulatory filings, and have audited financial statements.

The Pink Market is the tier where there are no minimum financial standards and can include any type of company, domestic or foreign, shell companies, and others.

The Grey Market is the market where all other securities are classified and where there is a lack of investor interest, lack of financial information, and lack of regulatory compliance.

How does the over-the-counter market work?

The over-the-counter market is where securities that are not listed on a stock exchange are traded.

There are more than 12,000 securities traded on the over-the-counter markets, such as stocks, bonds, commodities, derivatives, ETFs, and so on.

Even though a company may not be listed on a stock exchange, it may still be able to sell its shares on the over-the-counter market to the public.

Essentially, the securities are traded via the broker-dealer network where buyers and sellers negotiate the terms of the transaction directly with one another.

Is the over-the-counter market safe?

If you’re looking to invest in the over-the-counter market, you should consider that you are looking at a riskier market than centralized markets.

There are many financial products, many companies, and different parties trading all sorts of financial products.

You may not have sufficient information on the financial products you are trading, companies are not bound by the same level of reporting requirements as companies listed on an exchange, and there may be a lot of speculation.

Investors should speak to financial advisors and carefully assess their investment options before making any purchase.

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Takeaways 

So there you have it folks!

What does an over-the-counter market mean?

In a nutshell, an over-the-counter market refers to a market where securities that are not listed on a stock exchange are traded through broker-dealers.

There are different types of financial products that can be sold on over-the-counter markets such as stocks, bonds, derivatives, structured products, currencies, or other products.

Since the financial products are not traded on a central exchange, market participants do not have access to the same level of information on the products they are trading, which exposes them to more risk.

Over-the-counter markets have a number of risks, such as lack of publicly available information, counterparty risk, liquidity risk, and the potential inability to adequately price the financial products.

If you are looking to trade on over-the-counter markets, it’s important that you speak to an investment professional who can explain to you the benefits and risks.

Now that you know the meaning of an over-the-counter market, good luck with your research!

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