Over the counter securities

What Are Over-the-Counter Securities?

Over-the-counter (OTC) securities are financial instruments traded directly between two parties, bypassing a formal centralized exchange. This method of trading occurs within a decentralized market, where transactions are facilitated through a network of broker-dealers who act as market makers. Unlike stocks listed on major exchanges like the New York Stock Exchange (NYSE) or Nasdaq, over-the-counter securities typically include those of smaller companies, emerging firms, or foreign companies that do not meet the stringent listing requirements of traditional exchanges. The trading of over-the-counter securities falls under the broader category of financial markets.

History and Origin

The concept of over-the-counter trading predates formal stock exchanges, with early transactions occurring through informal agreements between merchants and financiers. In the U.S., prior to the advent of electronic systems, over-the-counter trading was conducted through a manual system involving physical "Pink Sheets" that listed bid and ask prices, manually exchanged among market makers⁷.

A significant development occurred in 1990 when the Securities and Exchange Commission (SEC) prompted NASDAQ to establish and manage the Over The Counter Bulletin Board (OTCBB) to provide greater access to capital formation for smaller companies⁶. This marked a move towards more regulated quoting and reporting for some OTC issues. Subsequently, the OTC Markets Group (formerly Pink OTC Markets Inc.) emerged, evolving the "Pink Sheets" into tiered electronic platforms that provide varying levels of transparency for over-the-counter securities based on the information companies make available. The history of over-the-counter trading reflects a continuous effort to balance accessibility for issuers with investor protection through evolving regulatory oversight.

Key Takeaways

• Over-the-counter securities are traded directly between parties in a decentralized network, not on a traditional stock exchange.
• The OTC market provides access to a wide range of financial instruments, including equities, bonds, and derivatives, many of which would not qualify for listing on major exchanges.
• These securities often have lower liquidity and higher volatility compared to exchange-listed securities due to less public information and fewer trading participants.
• Regulatory oversight in the OTC market varies, with different tiers (like OTCQX, OTCQB, and Pink) reflecting different levels of disclosure requirements.
• Investors in over-the-counter securities should undertake extensive due diligence due to the potential for limited transparency and increased risk.

Interpreting Over-the-Counter Securities

Interpreting over-the-counter securities requires a different approach than analyzing exchange-listed securities. Since prices are negotiated directly between parties or through broker-dealers rather than being determined by a central order book, there can be wider bid-ask spreads and less real-time price discovery.

The OTC Markets Group has organized over-the-counter securities into three primary tiers:

• OTCQX Best Market: This tier represents the most transparent and highest quality segment, featuring established U.S. and international companies that meet stringent financial standards and provide regular disclosures. Many major foreign companies trade OTC in the U.S. through American Depositary Receipts.
• OTCQB Venture Market: This tier is for early-stage and developing U.S. and international companies that report their financials to the SEC or a comparable U.S. banking or insurance regulator.
• OTC Pink Open Market: This is the lowest and most speculative tier, with minimal disclosure requirements. Companies in this tier are further categorized based on the information they provide (e.g., "Current Information," "Limited Information," or "No Information").

Understanding which tier an over-the-counter security trades on is crucial for assessing the amount of publicly available information and the associated risks.

Hypothetical Example

Imagine a small biotechnology startup, "BioGen Innovators Inc.," develops a promising new drug but is still in the early stages of clinical trials. The company is too small and does not yet meet the revenue or market capitalization requirements to list its stock on a major exchange like Nasdaq.

To raise capital, BioGen Innovators Inc. decides to have its stock quoted on an OTC market, specifically the OTCQB tier, by fulfilling its reporting obligations with the SEC. An investor, Sarah, is keen on early-stage biotech companies. She contacts her broker-dealer, who uses an electronic inter-dealer quotation system like OTC Link ATS to find quotes for BioGen Innovators Inc. Sarah's broker-dealer negotiates a price directly with another broker-dealer acting as a market maker for BioGen's stock. Sarah purchases shares of BioGen Innovators Inc. directly through this OTC transaction, bypassing a central exchange.

Practical Applications

Over-the-counter securities serve several practical purposes within the broader financial landscape:

• Access for Smaller Companies: They allow smaller, emerging companies or those with fluctuating financial performance to raise capital and have their shares publicly quoted without the onerous requirements and costs of major exchanges.
• Trading Foreign Securities: Many non-U.S. companies choose to trade their shares, often as American Depositary Receipts, on OTC markets in the U.S. to gain exposure to American investors without listing on a domestic exchange.
• Bonds and Derivatives: A significant portion of the global bond market and the derivatives market (such as custom-tailored swaps and forward contracts) are traded over-the-counter, allowing for flexibility and customization not available on standardized exchanges.
• Pre-IPO Trading: Sometimes, shares of a company anticipating a future initial public offering (IPO) might trade on the OTC market before their formal exchange listing, providing an early opportunity for some investors.

Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) have continuously worked to increase FINRA's OTC transparency rules to provide more visibility into trading activities for over-the-counter equities.⁵

Limitations and Criticisms

Despite their utility, over-the-counter securities come with significant limitations and criticisms, primarily stemming from their decentralized nature and varied regulatory oversight. A major concern is the general lack of transparency compared to exchange-traded securities. Companies quoted on lower OTC tiers may provide limited or no public financial information, making it difficult for investors to conduct thorough analysis and assess risk⁴. This opacity can contribute to higher volatility and lower liquidity, as it may be challenging to find buyers or sellers, especially for larger blocks of shares.

Furthermore, over-the-counter markets can be more susceptible to fraud and market manipulation schemes due to less rigorous reporting and oversight³. The absence of a central clearinghouse for all OTC transactions also introduces counterparty risk, where one party to a trade may fail to fulfill its obligations. The SEC addresses some of these concerns through rules like SEC Rule 15c2-11, which requires broker-dealers to have a reasonable basis for believing information about an issuer is accurate before publishing quotations². However, investors must still be highly cautious and aware of the unique disadvantages of OTC trading¹.

Over-the-Counter Securities vs. Exchange-Traded Securities

Over-the-counter securities and exchange-traded securities represent two distinct approaches to trading financial instruments. The fundamental difference lies in their trading venue and regulatory structure.

While exchange-traded securities benefit from the standardization, transparency, and liquidity provided by centralized platforms, over-the-counter securities offer flexibility and access to a broader range of issuers and customized financial products. The choice between the two often depends on the investor's risk tolerance, investment objectives, and the specific characteristics of the security.

FAQs

What types of companies typically issue over-the-counter securities?

Over-the-counter securities are often issued by smaller companies, startups, or those that don't meet the financial or operational requirements for listing on major exchanges. This also includes many foreign companies seeking to access U.S. investors without a full exchange listing, often through American Depositary Receipts.

Are over-the-counter securities regulated?

Yes, over-the-counter securities are regulated, but the level of regulation varies significantly depending on the specific OTC market tier. Higher tiers, like OTCQX and OTCQB, have more stringent disclosure requirements, often aligning with SEC reporting. However, lower tiers, such as certain categories within OTC Pink, may have minimal or no reporting obligations, leading to reduced transparency for investors. Regulatory bodies like FINRA and the SEC oversee aspects of trading and broker-dealer conduct within these markets.

What are the main risks associated with investing in over-the-counter securities?

The primary risks include lower liquidity, which can make it difficult to buy or sell shares quickly without impacting the price; higher volatility due to smaller trading volumes; and limited public information about the issuing company, which complicates proper valuation and increases the potential for fraud or manipulation. Investors should conduct extensive due diligence before investing in over-the-counter securities.