OTC Market/ Over-the-counter market is an important alternative to the organized stock exchange and is measured in terms of the total volume of trading. It is a telephone- and computer-linked network of dealers who trade over the telephone.
Key Points:
Over-the-counter markets are those in which participants trade directly between two parties, without the use of a central exchange or other third party.
OTC markets do not have physical locations or market-makers.
Some of the products most commonly traded over-the-counter include bonds, derivatives, structured products, and currencies.
Transactions in the OTC market are usually done between two financial institutions or between a financial institution and one of its clients like corporate houses; and fund managers.
In past times securities were traded over the counter of banks or in the offices of security dealers. Today over-the-counter trades occur in brokers’ offices, dealers’ offices, homes, over the phone, electrically, and any place or even any transport whole over the country and in foreign countries.
OTC Market/Over-the-Counter Market
The over-the-counter (OTC) market includes trading in all securities not listed on one of the exchanges. It also includes trading in listed stocks referred to as the third market.
Though an unlisted securities trading market, OTC is one of the most modern and efficient securities markets in the world. OTC market is not physically located market in any one place.
This over-the-counter market is called the secondary market of the secondary market. It consists of a number of broker-dealers throughout the country who are linked together through an e-mail or electronic and telecommunications network.
Any security can be traded on the OTC market as long as a registered dealer is willing to make a market in the security. The OTC market competes with investment bankers and organized exchanges as OTC dealers can operate as both a primary and a secondary. market.
Risk-free securities, government, and corporate bonds, common stocks, etc. are traded in the over-the-counter markets.
Corporate bonds are preferably traded in the OTC market because organized exchanges prefer to trade stocks of corporations instead of their bonds as the commissions of common stock are higher. The OTC broker-dealers are organized as sole proprietorships, some as partnerships, and many as corporations.
Related: What is Capital Market?
OTC Market Category
However, the broker-dealers in the OTC market can be categorized as follows:
OTC house- An OTC house is specialized in OTC issues and rarely belongs to an exchange.
Investment banking house- An investment banking house is specialized in IPOs and may diversify by acting as the dealer in both listed and OTC securities.
Commercial bank- A commercial bank may be an OTC dealer or broker when it trades securities.
Stock exchange member house- It can work as an OTC broker or dealer having a separate department specifically formed to carry on trading in the OTC market.
Bond House- A bond house may deal in government and autonomous bond issues trading in OTC.
Risks of Over-the-Counter Markets
While OTC markets function well during normal times, there is an additional risk; called a counter-party risk, that one party in the transaction will default prior to the completion of the trade or will not make the current and future payments required of them by the contract.
Lack of transparency can also cause a vicious cycle to develop during times of financial stress, as was the case during the 2007–08 global credit crisis.
Mortgage-backed securities and other derivatives such as CDOs and CMOs, which were traded solely in the OTC markets, could not be priced reliably as liquidity totally dried up in the absence of buyers.
This resulted in an increasing number of dealers withdrawing from their market-making functions, exacerbating the liquidity problem and causing a worldwide credit crunch.
Among the regulatory initiatives undertaken in the aftermath of the crisis to resolve this issue was the use of clearinghouses for post-trade processing of OTC trades.
Example
A portfolio manager owns about 100,000 shares of a stock that trades on the over-the-counter market.
The PM decides it is time to sell the security and instructs the traders to find the market for the stock. After calling three market makers, the traders come back with bad news.
The stock has not traded for 30 days, and the last sale was $15.75, and the current market is $9 bid and $27 offered, with only 1,500 shares to buy and 7,500 for sale.
At this point, the PM needs to decide if they want to try to sell the stock and find a buyer at lower prices or place a limit order at the stock’s last sale with the hope of getting lucky.
