Over-the-counter (OTC)

Definition

Over-the-counter (OTC) refers to the decentralised market for trading financial instruments directly between parties, without a centralised exchange or intermediary.

What is over-the-counter?

In an OTC market, buyers and sellers negotiate and execute transactions directly with each other, often using electronic trading platforms, phone calls, or other means of communication. The market includes a wide range of financial instruments, including stocks, bonds, derivatives, currencies, commodities, and other securities.

OTC transactions can be highly customised to meet the specific needs of the parties involved. This allows for more flexibility in terms of contract terms, quantities, and other aspects. They are generally subject to fewer regulatory requirements compared to centralised exchanges. This can lead to greater privacy and less transparency in OTC transactions.

Since OTC trades occur directly between parties, there is a higher level of counterparty risk. This is the risk that one party may default on their obligations, potentially leading to financial losses for the other party.

OTC markets operate around the clock and cater to a global audience, allowing for continuous trading in different time zones.

Types of OTC securities

• Foreign exchange market (Forex): This is the largest OTC market in the world, where currencies are traded.
• Fixed-income securities: Many bonds and debt instruments are traded OTC, especially those issued by corporations and governments.
• Derivatives: OTC markets are significant for trading derivatives like swaps, options, and certain types of futures contracts.

Example of over-the-counter

Let’s say Company A, a pharmaceutical company, needs to raise capital to fund its research and development projects. Instead of going through a public offering on a stock exchange, Company A decides to issue bonds directly to investors through an over-the-counter market.

In this scenario, Company A works with investment banks or brokers to facilitate the sale of its bonds directly to investors without the need for a centralised exchange. The bonds are traded over-the-counter, meaning the transactions occur directly between the company and investors or through intermediaries.

By using the over-the-counter market, Company A gains flexibility in pricing and structuring its bond offerings, as well as access to a wider pool of potential investors.