Over-the-counter (OTC)

Page written by AI. Reviewed internally on May 22, 2024.

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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.

Here are some key points about the OTC market:

1. Types of instruments: The OTC market encompasses a wide range of financial instruments, including stocks, bonds, derivatives, currencies, commodities, and other securities.

2. Lack of centralised exchange: Unlike exchanges like the New York Stock Exchange (NYSE) or NASDAQ, which have physical locations and standardised procedures for trading, the OTC market operates electronically or through direct communication between parties.

3. Customisation: 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.

4. Less regulation: OTC markets are generally subject to fewer regulatory requirements compared to centralised exchanges. This can lead to greater privacy and less transparency in OTC transactions.

5. Counterparty risk: 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.

6. Market makers: In the OTC market, there are often market makers who facilitate trading by providing liquidity. These are typically financial institutions or brokers that stand ready to buy or sell a particular security at publicly quoted prices.

7. Wide range of participants: Participants in the OTC market include institutional investors, corporations, hedge funds, retail traders, and other financial entities.

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

Common examples of OTC markets include:

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.

It’s important for investors to be aware of the characteristics and risks associated with trading in OTC markets. While they offer flexibility and customisation, they also require a thorough understanding of the instruments being traded and the counterparties involved.

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.

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