What is Over-The-Counter (OTC)?
Over-the-counter (OTC) trades are financial transactions, usually the buying and selling of company stock, that do not happen on a centralized exchange.
🤔 Understanding OTC
Over-the-counter (OTC) refers to how stocks are traded when they are not listed on a formal exchange. Such trades might happen directly with the company owners, or might be done through a broker. In the United States, listed companies are bought and sold on the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (NASDAQ). Companies not listed on the NYSE or NASDAQ can sell equity in their business over-the-counter. Other financial securities traded outside an exchange are also considered OTC — such as bonds, derivatives, currencies, and other complex instruments.
Facebook has been around since 2004. It spent its early years growing into what is now a technology giant. In 2012, the company decided to go public and sell shares of the company via the NASDAQ exchange. Although the initial public offering (IPO) didn’t happen until eight years after the company launched, that doesn’t mean you couldn’t own a piece of the company before then. If you wanted to buy into the fledgling company back in 2007, you would have needed to do it over-the-counter (OTC).
Over-the-counter (OTC) trades are like selling your car on your own…
A car dealership is like an exchange. It’s a place people go when they are looking to buy. But it costs you something to use that system. Alternatively, you could hang a “for sale” sign in the window and give it a shot on your own. You don’t get the advantage of the system designed to bring buyers and sellers together. But you also don’t have to pay a listing fee or follow the rules of the exchange.
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OTC Markets Group
The OTC Markets Group is a private company that quotes OTC equities. It was originally formed in 1913 as the National Quotation Bureau, which periodically provided brokers with lists of equity shares and bonds available for purchase. The equity lists were printed on pink paper, while the bonds were on yellow. Since then, traders knew these lists of available OTC equity as “pink sheets,” which became the name of the company in 2000.
The company changed its name to OTC Markets Group in 2010 and now provides an electronic quotation platform for the broker-dealers in its network. There are currently three quotation levels. OTCQX is the highest tier, which is reserved for established companies and has substantial financial disclosure requirements. OTCQB is designed for smaller companies, but they must not be in bankruptcy. The Pink level is now an open market with no financial disclosure or reporting requirements.
The Over-the-Counter Bulletin Board (OTCBB) is a quotation service hosted by the Financial Industry Regulatory Authority (FINRA). FINRA is a not-for-profit, non-governmental regulatory body that was authorized by the legislation that created the Securities and Exchange Commission (SEC). The OTCBB is a place for broker-dealers to make offers to buy and sell equity of companies that report to the SEC, but are not listed on the stock exchange. Companies can be listed on both the OTCBB and the OTC Markets Group.
Not all OTC securities are posted on the OTCBB or the OTC Markets Group. Many trades occur informally or without ever being published. These securities are said to trade on the “gray market.”
How do OTC markets work?
The market for over-the-counter (OTC) securities is much like any other product. An interested buyer seeks out the product and has a maximum price they are willing to pay. The owner of the product has a minimum amount they are willing to accept. If the buyer’s maximum price is above the seller’s minimum price, a transaction can occur.
The OTC quotation services continuously update what people say they are willing to pay (bid price) and what sellers are willing to accept (ask price). When there is a bid above an ask, market makers move in to coordinate the trade — They purchase the product from the seller, then turn around and sell it to the buyer.
Brokers often place a bid or ask price on behalf of their clients. Or, in some cases, the broker may also be an investment house that purchases and sells securities for themselves. In these cases, the company is called a broker-dealer.
Some broker-dealers also act as market makers, making purchases directly from sellers. Sometimes, an OTC transaction may occur without being posted by a quotation service. These so-called “gray market” transactions might happen through a broker with direct knowledge of a buyer and seller that may make a deal if they are connected. Or, an OTC transaction might happen directly between a business owner and an investor.
How do I buy OTC stocks?
The best way to buy an over-the-counter (OTC) stock is to create an account with a broker. Many, but not all, brokerage firms that allow you to trade on the stock market also let you trade OTCs.
OTCs cannot be purchased directly from the Over-the-Counter Bulletin Board (OTCBB) or the OTC Markets Group. All transactions happen through market makers rather than individual investors.
Can a stock go from OTC to NYSE?
Yes. Companies that are not listed on an exchange, like the New York Stock Exchange (NYSE), are traded OTC. Often, the company is too small to be publicly traded. Sometimes, the company can’t afford the listing fee. But some of these small companies grow into large ones. When a company gets large enough and meets the listing requirements of the exchange, it can elect to “go public.” By making an Initial Public Offering (IPO), the company can move from the OTC market to Wall Street.
While many companies that trade OTC have share prices under $1 (called penny stocks), that’s not always the case. There are a variety of other reasons the company may not be able to meet the requirements of an exchange. The most common cause might be delinquent financial reports to the Securities and Exchange Commission (SEC). Or maybe the company was recently facing bankruptcy. In these circumstances, companies can get listed on one of the stock exchanges once they fix the problem.
What is the difference between OTC and a stock exchange?
Centralized stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ, have specific listing requirements and are strictly regulated by the Securities and Exchange Commission (SEC). In contrast, over-the-counter (OTC) stocks trade between investors without strict disclosure requirements or direct government oversight. For example, to be listed on the NYSE, a U.S. company must have:
At least 1.1 million publicly traded shares 400 unique shareholders A market value of at least $40 million A share price of at least $4.00
To pass the earnings test, the company must show profits of at least $10 million over the last three fiscal years, with at least $2 million per year for the previous two years, and no net loss in any of the prior three years.
In addition to financial standards, a listed company has to meet certain governance requirements, provide audited financial records, and comply with SEC regulations.
OTC stocks do not have the same oversight and are therefore considered much riskier than publicly traded companies. Some OTC stocks do adhere to SEC regulations and are listed on the OTC Bulletin Board (OTCBB). But many are purchased and sold on the open market with no control whatsoever.
Is the OTC market safe?
Every investment comes with a certain degree of risk. Therefore, no investment is safe from the potential to lose some or all of its value. However, investors are better positioned to understand the risks they take when they have reliable information.
That is why companies listed on an exchange are required to provide a lot of details about their finances, activities, and management. This information must be audited and accurate, or else they can face criminal charges.
Securities traded on the over-the-counter market are not required to provide this level of data. Consequently, it may be much more challenging to understand the level of risk inherent in the investment. Additionally, companies trading OTC are typically at an earlier stage of the company’s lifecycle. Because they are not well established, there may be a higher chance of failure.
What are the pros and cons of the OTC marketplace?
The over-the-counter (OTC) marketplace gives you access to owning part of a company before the rest of the world knows it exists. There are pros and cons associated with that.
By getting in on the ground floor, you can take a position in a company before it grows. Then, when the company emerges as the next big thing, you will already have multiplied your investment several times over. Just imagine buying Amazon for a few pennies a share when it was just an infant of a company. As the company grew, the value of your shares would have grown alongside the other owners.
Most of the companies that trade OTC are not on an exchange for a reason. Some are companies that will never turn into anything. Some might be horrible investments with no real chance of making you any money at all. And, it might be hard to separate the wheat from the chaff. You might not get accurate information from them, or you may get no financial statement at all.
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