suppose you manage a company looking to raise capital but don t meet the stringent requirements to list on a major stock exchange or you re an investor seeking to trade more exotic securities not offered on the new york stock exchange nyse or nasdaq where do you turn enter the over the counter otc markets where trading is done electronically 
otc markets allow investors to trade stocks bonds derivatives and other financial instruments directly between two parties without the supervision of a formal exchange this freewheeling format provides prospects but also pitfalls compared with exchange based trading apple inc aapl and microsoft corporation msft traded otc as did many long forgotten penny stocks 12in this article we ll examine what otc markets are how they differ from traditional stock exchanges and the advantages and disadvantages for investors we ll explore the key otc market types the companies that tend to trade on them and how these markets are evolving in today s electronic trading environment investopedia jiaqi zhouunderstanding over the counter otc marketsin pharmaceuticals otc is a category of medications that can be bought without a doctor s or pharmacist s guidance otc is something similar in finance since what s sold are securities that haven t passed through the supervision of a formal exchange like the nasdaq or nyse otc markets have a long history dating back to the early days of stock trading in the 17th century before the establishment of formal exchanges most securities were traded over the counter as exchanges became more prevalent in the late 19th and early 20th centuries otc trading remained a significant part of the financial ecosystem they have always had a reputation for where you find the dodgiest deals and enterprises but might also find future profit makers among them since the exchanges take in much of the legitimate investment capital stocks listed on them have far greater liquidity otc securities meanwhile often have very low liquidity which means just a few trades can change their prices fast leading to significant volatility this has made the otc markets a breeding ground for pump and dump schemes and other frauds that have long kept the enforcement division of the u s securities and exchange commission sec busy 2in the u s the national association of securities dealers nasd later the financial industry regulatory authority finra was established in 1939 to regulate the otc market while nasd evolved into an electronic quotation platform in 1971 and subsequently a formal exchange before then the otc stock market operated through a network of market makers who facilitated trades between investors the trading process during this era was cumbersome and inefficient investors had to manually contact multiple market makers by phone to compare prices and find the best deal this made it impossible to establish a fixed stock price at any given time impeding the ability to track price changes and overall market trends these issues supplied obvious openings for less scrupulous market participants traders also looked to the pink sheets now known as otc markets group over a century ago as a paper based system for trading unlisted securities the term pink sheets derived from the pink colored paper on which the bid and ask prices of these securities were printed and circulated in the late 1990s pink sheets transitioned to an electronic quotation system eventually becoming the otc markets group which operates the otcqx otcqb and otc pink platforms today these platforms offer access to shares and other securities for a wide range of companies from well established foreign firms to small emerging companies that don t yet meet the listing requirements of major exchanges the shares for many major foreign companies trade otc in the u s through american depositary receipts adrs these securities represent ownership in the shares of a foreign company they are issued by a u s depositary bank providing u s investors with exposure to foreign companies without the need to directly purchase shares on a foreign exchange while otc markets offer greater flexibility and fewer barriers to entry than traditional exchanges they also come with exceptional risks and challenges finra regulates broker dealers in the u s otc markets 3 nevertheless because otc traded securities are subject to less stringent reporting and disclosure requirements investors may have limited access to reliable information about the companies they are investing in below is a table distinguishing the differences between trading otc and on a regulated exchange otc marketsthere are several otc markets in the u s including the following otc markets provide access to securities not listed on major exchanges including shares of foreign companies this allows investors to diversify their portfolios and gain exposure to international markets and companies that may not be available through traditional exchanges trading foreign shares directly on their local exchanges can be logistically challenging and expensive for individual investors otc markets offer a more convenient and cost effective way to invest in foreign companies since trades are executed in u s dollars during u s trading hours often with lower commissions than trading directly on foreign exchanges for foreign companies cross listing in otc markets like the otcqx can attract a broader base of u s investors potentially increasing trading volume and narrowing bid ask spreads some foreign companies trade otc to avoid the stringent reporting and compliance requirements of listing on major u s exchanges otc markets while regulated generally have less strict listing requirements making them attractive for companies seeking to access u s investors without the burden of sec registration for an exchange listing the number of securities traded in over the counter markets 4otc derivatives are private agreements directly negotiated between the parties without the need for an exchange or other formal intermediaries however a broker may assist in facilitating the trade this direct negotiation allows the terms of the otc derivatives to be tailored to meet the specific risk and return requirements of each counterparty providing a high level of flexibility while otc derivatives offer the advantage of customization they also carry a higher level of credit risk compared with exchange traded derivatives this is because there is no central clearing corporation to guarantee the performance of the contract meaning that each party is exposed to the potential default of their counterparty some common otc derivatives include the following the foreign exchange forex market is the largest and most liquid financial market globally 7 unlike stocks or commodities forex trading occurs only over the counter otc this decentralized nature allows for greater flexibility in transaction sizes however it also exposes traders to counterparty risk as transactions rely on the other party s creditworthiness major markets are open 24 hours a day five days a week and a majority of the trading occurs in financial centers like frankfurt hong kong london new york paris sydney tokyo and zurich this means the forex market begins in tokyo and hong kong when u s trading ends the forex market is volatile with price quotes changing constantly like other otc markets due diligence is needed to avoid fraud endemic to parts of this trading world 8advantages and disadvantages of otc marketsaccess to emerging or smaller companiespotential for higher returnsless stringent requirements for companies to be able to listflexibility in trade termsless regulation and oversighthigher risk volatilityless liquidityless transparency and reliable public informationsusceptibility to market manipulationotc markets offer access to emerging companies that may not meet the listing requirements of major exchanges these smaller growing companies can sometimes provide investors with the potential for higher returns although this comes with higher risk otc markets may also offer more flexibility in trading than traditional exchanges transactions can in some cases be customized to meet the specific needs of the parties involved such as the size of the trade or the settlement terms this flexibility can be particularly worthwhile for institutional investors or those trading large blocks of securities in addition companies traded otc have fewer regulatory and reporting requirements which can make it easier and less expensive when raising capital unlike major exchanges that have strict listing requirements otc markets have minimal standards for companies to meet regulated exchanges require a minimum market capitalization financial stability and corporate governance standards in contrast otc markets have fewer requirements making trading easier for financially unsound or even fraudulent companies 2 here are the major disadvantages investing in otc markets carries significant risks that investors should be aware of before trading there these markets often lack the regulations transparency and liquidity of exchanges examples of trading in over the counter marketslet s start with an example from a company s point of view suppose green penny innovations a promising renewable energy startup is not yet publicly listed on a major stock exchange however institutional investors and high net worth individuals are interested in acquiring company shares mega investments a prominent investment firm contacts brokers specializing in otc securities they inquire about the availability of green penny shares and receive quotes from different market makers one market maker otc securities group offers to sell 50 000 shares at 0 85 per share another market maker global trading solutions offers to sell a smaller block of 10 000 shares at 0 90 per share after evaluating the quotes and considering the company s prospects megafund buys 30 000 shares from otc securities group at 0 85 per share the trade is executed directly between megafund and otc securities group through a private negotiation no public announcement is made about the transaction and the price isn t displayed on any exchange several days later another investor techvision ventures contacts a different broker and expresses interest in buying green penny shares the broker reaches out to various market makers and discovers that the price has increased due to growing investor interest techvision eventually purchases 20 000 shares at 0 95 per share from another market maker suppose you re an investor seeking high returns on your investments so you re willing to dip into the otc markets if you can find the right stock you come across an opportunity called coindeal which promises exceptionally high returns on the premise that one or more technology companies under the virse banner are about to be acquired by a group of wealthy investors you look to be in early on what promises like a big deal just like other storied early investors the promoter of coindeal assures you that even if the returns from coindeal do not materialize he ll repay your investment with 7 annual interest over three years the promoter points to an exclusive and lucrative contract with at t to distribute government funded phones to support this promise he also says he has an app ready for the better business bureau to distribute that will yield substantial revenue enticed by these promises you and thousands of other investors invest in coindeal however when the promised sale doesn t close you discover that the promoter michael glaspie 72 of florida has transferred investor funds to other accounts he d been buying cryptocurrency among other things despite his assurances he wouldn t the case is of course one of many otc frauds targeting retail investors glaspie pleaded guilty in 2023 to defrauding more than 10 000 victims of over 55 million through his coindeal investment scheme 13this case highlights the importance of due diligence and the risks associated with otc investments when considering an otc investment you should do the following 