This article will explain what ‘OTC trading’ is and also what its relation to cryptocurrency is.
What does it mean?
Over-the-counter (OTC) trading refers to how the trading procedure of securities operates. Specifically, for companies that do not exist on a formal exchange, like the New York Stock Exchange (NYSE). Securities that experience over-the-counter exchanges are traded by way of a broker-dealer network. This is in lieu of a centralized exchange. The reason for these securities not being on a standard market exchange is that they do not meet the requirements.
Trade transactions occur through either the Over the Counter Bulletin Board (OTCBB) or the Pink Sheets listing services. The OTCBB is an electronic quotation and trading service that aids in the progression of higher liquidity. On top of that, it facilitates comparatively better information sharing. Pink Sheets is a private company that collaborates with broker-dealers in order to bring small company shares to the market.
Stocks that go about trading via OTC are usually smaller companies. Moreover, they are companies that are unable to meet exchange listing requirements of more formal exchanges. Be that as it may, there are plenty of other types of securities that also trade here. Stocks that trade on exchanges are commonly referred to as ‘listed stocks’. Stocks that trade by way of OTC, on the other hand, are ‘unlisted stocks’.
OTC securities typically trade by broker-dealers who directly bargain with each other over computer networks. Additionally, they negotiate by phone, employing the use of the OTCBB. The dealers function as market makers, using the Pink Sheets and the OTC Bulletin Board. The National Association of Securities Dealers (NSAD) provides these.
Contrary to formal exchange trading, OTC trading does not require the trading of only standardized items. An example of this is a clear-cut range of both the quantity and quality of products. In addition, prices do not always experience a public publication. OTC contracts are bilateral, and as such, each party could potentially face credit risks concerning its counterparty.
OTC securities encompass an array of both financial instruments and commodities. Some financial instruments subject to over-the-counter trades include stocks, debt securities, and derivatives. Stocks that go through over-the-counter trades are typically those belonging to small companies that are unable to be on formal exchanges. With that being said, there are some instances where even large companies’ stocks experience over-the-counter trading.
Before moving forward, let’s take a brief moment to expand on what ‘derivatives’ are. A conventional derivative is a contract between two or more parties. The value draws primarily from a settled underlying financial asset (ex. a security) or collection of assets (ex. an index). There are several underlying instruments that are commonplace, including bonds, commodities, interest rates, currencies, stocks, and market indices.
Derivatives are representative of a substantial portion of over-the-counter trading. This is especially crucial when it comes to hedging risks with the use of derivatives. There is a noticeable lack of limitations on the quantity and quality of traded items. Consequently, it allows the participating parties to adjust the specifications of the contracts in the transaction to the risk vulnerability. Ergo, these instruments could be useful in regards to working for a “perfect hedge.”
The OTC Markets Group manages and operates some of the most recognized networks. Some of these include the Best Market (OTCQX), the Venture Market (OTCQB), and the Pink Open Market. Even though OTC networks are not formal exchanges, they still have their own requirements for eligibility.
The OTCQX, for example, does not list the stocks that sell for anything that is less than five dollars; these are ‘penny stocks’. Others include shell companies or companies that are experiencing bankruptcy. The OTCQX Best Market consists of securities of companies that have the largest market caps. Moreover, these are companies that have greater liquidity than most other markets.
Through the OTC marketplaces, you are able to see the stocks of much smaller companies that are still in development. Though it depends entirely on the listing platform, these companies might submit reports to the Securities and Exchange Commission (SEC) regulators. OTCBB stocks often have a suffix of “OB” and have to catalog financial statements with the SEC.
An additional trading platform is the Pink Sheets. These particular stocks are diverse and come in a wide variety. The businesses in this specific platform do not meet the requirements of the SEC. Purchasing shares of this nature often involve less transactional costs. However, they are the cream of the crop when it comes to probable fraud and manipulating the price. These stocks usually have a suffix of “PK” and do not have to catalog financial statements with the SEC.
Nasdaq is also worth mentioning because while it operates as a dealer network, Nasdaq stocks are not technically OTC. This is primarily due to the Nasdaq being viewed as a stock exchange.
The trading process
As mentioned before, the OTC market is completely decentralized and dealer networks govern the trading. There is no involvement of the traders in the actual process directly because they can look for the assistance of middlemen. Such entities include brokers and/or OTC desks.
On the whole, ‘OTC desks’ are trading securities that are not on a formal exchange because of various reasons. Oftentimes, smaller companies cannot comply with the listing requirements of formal exchanges. What’s more, they are unable to pay the fees that the big players in the industry require. This is the key point where OTC trading comes into play.
Just like how the market attracts risks that counterparties encounter during the direct deal, so too do they attract opportunities. This is the key reason why OTC trading is becoming increasingly popular among investors with proper qualifications. Furthermore, its popularity extends to traders with experience and even commercial giants. For instance, Nestle, Bayer, Danone SA, and several other major companies are starting to trade their shares on OTCQX. If you recall, this is the “Best Market”; the finest of the three marketplaces for OTC stock trading.
Bringing crypto into the picture
Now, from here, we can dive into what OTC trading’s relation to cryptocurrency is. When taking the crypto industry into account, OTC desks are gaining popularity among those willing to sell large amounts of coins. These groups include the likes of bitcoin miners and early crypto investors. Conversely, there are many investors – like those with a high-profile – willing to purchase crypto without using major exchanges.
The OTC market is generally seen by many crypto investors as something that holds a lot of promise. One could make the argument that this is why major companies like Binance, Coinbase, and Circle are opening their own OTC desks. Even while they were in the middle of the crypto winter earlier this year. This was a period when the rates of bitcoin and major altcoins were, shall we say, less than stellar.
According to some projections, the daily volumes of crypto OTC trading are currently larger than the major exchanges. In April of 2018, Digital Assets Research and TABB Group investigators learned that the OTC market was facilitating $250 million to $30 billion in trades daily. Meanwhile, the exchanges were managing roughly $15 billion in daily trades in the midst of the same period.
Crypto amount requirement
Most of the time, the amounts are admittedly very impressive. We will start by looking into the major players; specifically, institutional traders. Cointelegraph once wrote a review about OTC services in crypto and in it, there was a brief explanation pertaining to this topic. On the desk founded by the cryptocurrency exchange, Bittrex, there is an obligation for investors to commit to trades that are worth $250,000 or more. Another exchange platform, Poloniex, has the exact same threshold for traders.
Binance, a crypto exchange from Malta, is steadfast in only carrying transactions that are larger than 20 BTC over its OTC. In the meantime, the U.S. exchange, Coinbase, only selects users of Coinbase Prime. This is a service that is tailor-made for institutional investors. These users are able to utilize the OTC trading feature.
Be that as it may, there is a more relaxing atmosphere regarding OTC trading in smaller companies. The same can be said for specialized private chat rooms. Let’s take Changelly for example. This is a noncustodial instant cryptocurrency exchange who recently launched its own OTC service. The platform establishes a limit of 10 BTC in order to start trading. There are some Telegram chats where you can conduct a deal directly with an individual wanting the same amount of crypto you are selling.
In a similar vein to the U.S. stocks exchanges, security prices will react to the market’s supply and demand. Investors want to buy and sell securities at specific prices and broker-dealers supply liquidity via trading for their own account. Other methods include either matching orders internally or publishing quotes and performing with external broker-dealers.
There are four factors that help determine how prices develop for a specific security. They are the…
- …total number of orders
- …volume (an example of this would be share size)
- …the timing of buy and sell orders
- …availability and accessibility of information
To properly understand how the trading process works, we have to go through each step carefully. It is important to note that the following example is specifically for individual investors. Nevertheless, a lot of the same principles can be applicable to institutional investors.
Step #1 – The investor selects a broker-dealer
Are you an investor who is looking to start the execution of a trade? Then you must have an account at a FINRA-registered broker-dealer. It is up to you as to which broker-dealer you select, but you absolutely need that account.
Step #2 – The investor carries out an investment decision
A crucial factor when it comes to investment decisions is that they should draw from thorough research on the company and security. For securities that specifically trade on the OTCQX, OTCQB, and Pink markets, investors can employ the use of www.otcmarkets.com. This will allow them to access the information that companies provide for the public.
This information includes trade data, company news, and financials that can all help to assist in an investment decision.
Step #3 – The investor outlines the order
Investors distinguish the order that they want the broker-dealer to deal with. There are two key types of order, which are ‘Limit Order’ and ‘Market Order’.
- Limit Order is an order type to buy or sell an asset. Specifically, either at, below or above a specific price. It allows investors to indicate the exact price that they are open to accepting for a buy or sell order. These orders have a design that offers more price protection. However, they may not go through execution if the price of the security fails to reach the price stated in the order
- Market Order is an investor’s request to buy or sell a security at whatever the best available price in the market currently is. These requests are usually made through a broker or brokerage service. They command the broker-dealer to immediately carry out either a buy or sell order at the current ‘market price’. This, in other words, is the best bid or offer.
Investors have to ask themselves an important question: which is more important? Price (Limit Order) or timing/immediacy (Market Order)?
Step #4 – The broker-dealer handles the order
As soon as a broker-dealer receives an order, it will typically go through the following steps:
- Internally execute the trade. The first step broker-dealers take is determining if the order can go through internal execution. These can occur supposing they can ‘match’ (exact same prices for a buy and sell order) Limit Orders. Alternatively, if they are able to provide liquidity against their own account. Should they trade for their own account, then they must give investors the best available quoted price or better at that time.
- Externally trade marketable order. Let’s assume that the broker-dealer is unable to – or chooses not to – execute the trade internally. In this particular case, they will make an attempt to execute the trade with a different broker-dealer.
- Construct/Edit quote on OTC Link ATS. If the order ends up not being marketable, the broker-dealer may have to adjust its existing quote. Doing so will reflect either a new price or a new size.
Step #5 – The broker-dealer reports, clears, and eventually settles the trade
At this point, the broker-dealer will accept an offer to trade through OTC Link® ATS. Alternatively, they will accept to do it by way of other means of communication. Should this happen, then they are responsible for reporting, clearing, and settling the trade. A key part of this process is the confirmation of the trade with the investor.
Still, the trade will not officially be complete until after the final settlement. This is basically the delivery of funds at the hands of the buyer. Moreover, the delivery of securities by the seller.
Advantages & Disadvantages
Bonds, ADRs (American depositary receipts), and derivatives are tradable in the OTC marketplace. Regardless, it would be smart for investors to be cautious when investing in more hypothetical OTC securities. The general filing requirements between listing platforms may vary On top of that, some necessary information – like business financials – may be difficult to locate.
A majority of financial advisors view trading in OTC shares as being a risky undertaking due to it being speculative. It is because of this that investors have to think about their investment risk tolerance. Moreover, they must consider if OTC stocks are suitable for their portfolio and if they have a place in it. However, accompanying the additional risks of OTC shares is the potential of substantial returns. Seeing as how these shares trade at lower values – sometimes for less transactional costs – they offer an outlet for share price appreciation.
Stocks that trade OTC are not customarily known for their large trading volume. Lower share volume means that there might not be a ready buyer when the time comes to sell your shares. Furthermore, the spread between the bid-price and the ask-price is typically much larger. It’s possible for these stocks to make erratic moves on any market or economic data.
The OTC marketplace is essentially an alternative for small companies. It is also relevant for those who do not wish to list on the standard exchanges. To be listed on a standard exchange is a process that is both costly and tedious. Moreover, it is beyond the financial capabilities of a majority of smaller companies. It is not uncommon for companies to lean more towards listing in the OTC market. This is because they find that it provides quicker access to capital by way of the sale of shares.
Pros & Cons of OTC Trading
To wrap up this guide to OTC trading, here are the pros of the OTC marketplace:
- OTC provides users with direct access to securities not available on standard exchanges. These include ADRs, bonds, and derivatives.
- There are less regulations on the OTC. This effectively allows the entry of many companies who can not – or do not want to – list on other exchanges.
- By trading low-cost, penny stock, speculative investors are able to garner significant returns.
Here are the cons of the OTC marketplace:
- OTC stocks possess less trade liquidity because of the low volume. Consequently, this results in trade finalization delays and wide bid-ask spreads.
- With fewer regulations, it leads to fewer pieces of accessible public information. Not only that but there is also a higher chance of obsolete information and potential fraud.
- OTC stocks have a tendency to carry out volatile moves upon the release of both market and economic data.