Over-the-Counter (OTC) Markets: Trading and Securities

Over-the-Counter Markets Basics

Imagine you’re a hedge fund looking to buy 100,000 shares of Apple (AAPL). To avoid showing your hand to other traders and investors, you might conduct the transactions in an over-the-counter (OTC) market, which offers anonymity.

That’s just one use of OTC markets, which involve two parties trading either directly or through broker-dealers rather than on a centralized exchange. Securities traded on OTCs include stocks—many are also listed on U.S. exchanges—bonds, derivatives, and cryptocurrencies. Often, the derivatives are complex instruments such as credit-default swaps on mortgage-backed securities, whose trading on the OTC markets played a key role in the global financial crisis.

Financial institutions use OTC markets to trade such derivatives partly because they can tailor contracts however they like—non-standard contracts make up a large portion of the trading on OTC markets. However, the anonymity and flexibility offered by OTC markets come with a tradeoff. OTCs aren’t as closely regulated as traditional exchanges, raising increased potential risks for the parties involved.

Understanding OTC Markets

There is no “there” with OTC markets. They are decentralized, with no physical location, yet account for billions of dollars in trades each day. Essentially, an OTC market refers to any trading that doesn’t take place on a centralized exchange. Most of the trading takes place through networks of broker-dealers who connect buyers and sellers, though some well-known brokerages now offer retail customers access to those networks via their online platforms. Traders can also trade directly between themselves.

Securities that trade OTC include:

• Stocks. They typically consist of small companies without the means to trade on a national exchange, though some listed stocks can also be traded OTC.
• American Depositary Receipts (ADRs). Some of these bank-issued certificates trade on national exchanges. Others, particularly those issued without the involvement or approval of the foreign company in question, trade OTC.
• Bonds. The majority of bonds issued by companies and governments are traded OTC.
• Currencies. Currencies, such as the U.S. dollar and euro, are bought and sold OTC through a network of banks.
• Cryptocurrency. Bitcoin and Ethereum can be traded OTC, enabling the buyer and seller to negotiate directly and keep the terms of the deal private.
• Derivatives. Derivatives can also be traded OTC, and many of the more complex derivatives trade only on OTCs. This allows for privacy, more flexibility, and customization. 

How OTC Trading Works

On traditional exchanges, such as the New York Stock Exchange (NYSE), trades are conducted through a publicly visible centralized order book. Pricing data is transparent and the exchanges, acting as intermediaries, facilitate transactions between buyers and sellers with order-matching systems and the help of market makers.

OTC trading is the buying and selling of financial instruments outside of such an exchange. There are two basic types of OTC market—one, a customer market in which investors buy and sell via broker-dealers, and another, the interdealer market, in which broker-dealers quote prices and trade with each other, often to minimize risk.

In the U.S., the largest network is the OTC Markets Group. Its services include connecting broker-dealers and providing data and quote services for more than 12,000 securities.

Market Tiers

The OTC Markets Group breaks the OTC market into three tiers.

1. OTCQX is the top tier. Also called the OTCQX Best Market, this tier houses a large number of blue-chip stocks from Europe, Canada, Brazil, and Russia. To trade here, securities must “meet high financial standards, follow best practice corporate governance, demonstrate compliance with U.S. securities laws, and be current in their disclosure.”
2. OTCQB is the middle tier. Also known as the venture market, it mainly contains early-stage and developing U.S. and international companies. To be eligible, companies must be current in their reporting, undergo an annual verification and management certification process, meet a $0.01 bid test, and not be in bankruptcy.
3. OTC Pink is the lowest level. It carries no requirements that companies report financials or register with the Securities and Exchange Commission (SEC). Not all securities here are low-quality, although you will find plenty of shell companies and entities in financial distress. (Note: OTC Pink will be relaunched as OTCID Basic Market on July 1, 2025.)

Steps To Trade in the OTC Market

Trading in the OTC market is similar to buying securities on exchanges, except that orders are transacted via a dealer network rather than a centralized exchange, and more caution is generally warranted. Here are the basic steps to follow.

1.   Choose a broker

Choose a reputable one. Look for transparent fees and reliable execution. Many household names, including Charles Schwab and Fidelity, now provide access to OTC markets on their platforms.

2.   Acclimatize and research

Before jumping into a trade, familiarize yourself with the platform and research the security. Consider using OTC Markets Group to evaluate disclosure requirements and risk factors.

3.   Place an order

Placing an OTC order is similar to placing one on a regular exchange. You need to find the security you wish to buy, specify how many units you want, and then hit buy. Beware of the spreads, which can be wide, and consider starting small and placing limit and stop orders.

Pros and Cons of Trading OTC

OTC trading comes with benefits and drawbacks. Here are key points to know:

 Advantages

The OTC market gives investors access to alternative securities, including shares of smaller companies that are lesser known and may be undervalued. It can also offer greater flexibility in the terms of any transaction as well as more privacy, which is important to some investors.

OTC markets aren’t as Wild West as some people make out. There are different levels, good investments to be found, and some regulation exists to protect investors.

Disadvantages

Looser regulation means OTC markets can be riskier than national exchanges. Companies with poor finances and questionable corporate governance can issue securities here without being required to make the same disclosures as on an exchange. For every good investment, there are murky ones.

Other risks of operating outside the full supervision of a formal exchange include less price transparency, fewer buyers and sellers, which can make exiting a position harder and lead to wider spreads, greater volatility, and the possibility that the other party to the transaction defaults and can’t make good on their side of the trade.  

Regulation of OTCs

Though not governed as strictly as national exchanges, OTC markets are subject to some broad SEC regulations related to fraud, market manipulation and disclosure requirements. One of the SEC’s rules calls for broker-dealers to make sure there’s current and publicly available information about an issuer before publishing quotations for its securities. Moreover, some OTC issuers, namely those trading in QTCQX, report directly to the SEC and are subject to its disclosure requirements.

The Financial Industry Regulatory Authority (FINRA) is responsible for regulating OTC broker-dealers. Among other things, it is responsible for monitoring trading activities and handling disputes. Whenever an OTC equities transaction occurs, it must be reported to FINRA.

The Commodity Futures Trading Commission (CFTC) regulates OTC derivatives contracts and currency transactions.

The Bottom Line

The OTC market lets investors trade stocks, bonds, currencies, and other financial instruments not present on national exchanges. In these markets, there’s less regulation and fewer rules, which can be a good or bad thing.

Securities are traded directly between individuals, often with the help of a broker-dealer network such as the OTC Markets Group. OTC securities aren’t all the same. Separating the wheat from the chaff can be challenging, and given the lighter regulations in place, present risk as well as opportunity.