Understanding how OTC markets and trading work

What does over the counter (OTC) mean?

Over the counter (OTC) means a type of trading in which transactions take place directly between two market participants. Over-the-counter markets are completely decentralised, spanning a network of individual dealers and traders, rather than being held in a centralised location like a stock exchange.

The OTC market tends to be split into two:

1. The customer market, where dealers trade with their clients. This would be a provider’s platform where dealers set the price and an individual’s trades are executed
2. The inter-dealer market, where dealers trade amongst each other and negotiate prices

When you trade via an exchange, you’ll see a lot of different prices listed from multiple buyers and can select the one you’re interested in, but when you trade OTC via your broker, you’ll see two prices listed – a buy price and a sell price, also known as a bid and an ask.

What can I trade over the counter (OTC)?

The most commonly-traded OTC markets are forex, shares, debt securities and financial instruments like CFDs that are bought directly from a dealer – usually via electronic trading platforms.

OTC forex

Forex is the most popular OTC market, in which currencies are exchanged via a network of banks, brokers and individuals all over the world. As forex trading isn’t reliant on an exchange being open, you can open and close positions 24 hours a day, five days a week. 

Typically, because there are so many decentralised exchanges taking place, it’s been difficult to understand the trading volume that occurs on the forex market. This is one downside of FX being OTC; that information is less readily available compared to on-exchange assets. For example, whereas stock volume can be tracked hourly or daily, the most cited FX volume figure comes from the triennial Central Bank Survey. 

OTC shares

OTC shares or ‘unlisted stocks’ are often those of smaller companies that don’t meet the market requirements of stock exchanges. It could be that their market capitalisation isn’t high enough, they can’t keep their shares above a certain price or they’re filing for bankruptcy. There are also some grey markets in which listed shares are sold OTC.

Companies may also not want to pay the high fees that exchanges charge – for example the NYSE has administrative fees that can hit $250,000 a year.

This isn’t to say that high value companies don’t trade OTC – for example Allianz and Danone do – but smaller OTC stocks, such as penny stocks, are more common.

You’d find OTC shares on systems such as the OTCQX, OTCQB, and the OTC Pink marketplaces (previously the OTC Bulletin Board and Pink Sheets). Despite not being centralised exchanges, these electronic systems still show traders quotes, prices and trade volume.

OTC debt securities

Debt securities, such as bonds, are traded over the counter by investment banks. Unlike the shares of a company, bonds aren’t sold on exchanges because they can come from different issuers entirely. Each bond is different, with unique maturities, values and credit ratings.

Bonds tend to be among the least liquid of the OTC market, but it will depend on the issuer and the credit history of the firm.

OTC derivative products

Derivative products like forward contracts, swaps and CFDs can also be traded OTC. Brokers organise the supply and demand of derivatives in their organisation, setting the prices and executing trades. In other words, CFDs and other derivatives do not trade on an exchange, they are contracts made directly between you (the trader) and your provider.  

Benefits of OTC markets

OTC markets have a range of benefits; the most commonly-cited one is that the transaction sizes are non-standardised, which means you can have greater control and flexibility over how much you trade.

As we've seen above, trading OTC also gives you access to markets that you'd otherwise be unable to trade. Trading via OTC derivatives also enables you to go long or short on markets without taking ownership of the underlying asset, creating a whole new range of opportunities. 

While OTC markets gained a reputation as being illiquid, these issues have largely been resolved, making it much easier to execute trades. The advancements made in electronic quotation systems have means that the information available to traders has also increased.

Risks of OTC markets

Counterparty risk is the most frequently-cited risk of OTC markets, which is when one side of the transaction defaults on the exchange and doesn’t meet its contractual obligations. This can happen because of the unregulated nature of decentralised trading.

Financial exchanges are regulated entities – and while this can be seen as restricting the securities that can list, it also provides a significant amount of safety. All of the transactions will be standardised for quantity and quality, ensuring that you’re guaranteed to receive what you pay for. OTC prices are not made public until a trade has been completed, so there’s always the potential that your trade isn’t being executed at the most favourable price.

OTC markets also tend to be more volatile and unpredictable due to the high volume of traders and lack of regulation. While volatility may create potential opportunities for short-term traders, it’s important to have a risk management strategy in place as OTC markets are more likely to be subject to market manipulation. Increased volatility increases risk.

OTC stocks in particular are considered risky because they don’t have to declare as much information to the public as listed stocks do. This means there is capacity for accounting tricks and inflated statements of success.

However, it’s always worth pointing out that the criticisms of OTC trading largely come from exchanges or advocates of exchange trading, who will always have an incentive to steer traders toward their business. Losses can occur on large exchanges, as well as OTC markets, it’s how you manage your risk that really matters.

OTC trading FAQ

What are the hours for OTC trading?

The hours for OTC trading depend on the market in question. Forex, for example, is traded 24 hours a day; while most CFDs will trade according to the hours of their underlying market. It's worth doing some research to find the hours for your chosen OTC markets.

Can I buy OTC stocks in the UK?

Yes, you can buy OTC stocks in the UK. However, you'll need a stockbroker that gives access to OTC markets, as most stick to shares listed on major exchanges. OTC shares can also carry higher risk than exchange-traded ones, as they aren't subject to the same regulations.

Can you day trade OTC?

Yes, you can absolutely day trade OTC. In fact, one of the most popular asset classes among day traders – forex – is traded completely over the counter. CFDs are also frequently used by day traders, and are an OTC market.