What is OTC Market – Its Working, Types, Risks and Is it Safe to Buy
The term share market is naturally associated with large stock exchanges. When you think of buying or selling commodities, equities, or debts, you think of exchanges like the BSE (Bombay Stock Exchange), NSE (National Stock Exchange), and Nasdaq, among many others. These aren’t the only places where you can trade, though. OTC Markets are a viable alternative to stock exchanges. This begs the question, what exactly is an OTC stock market, and why does it not have the same market pull as stock exchanges?
Let’s demystify the scantly understood world of the OTC Market. Read on!
What is the OTC Market?
OTC stands for Over-the-Counter. This term finds its way into the market’s name because this is its most significant feature. All trades are completed directly between the buyer and the seller in an over-the-counter fashion.
Naturally, one must wonder why does this market exist?
This is where the second quirk of the OTC market comes to the fore. It’s a haven for unlisted stocks. These companies can’t or choose not to go through the process of getting listed on a major stock exchange. Perhaps they don’t want to pay the listing fee, or maybe they don’t meet the minimum share price required to feature.
Whatever the reason, these companies are often small, have low-profit margins and are priced relatively low. As a result, their volumes are likewise lower than most stocks you would find on exchanges.
How do OTC Markets Work?
For the average investor, over-the-counter trading will look no different than regular trading. The glaring difference is that the purchase is not made from an exchange. Instead, it is directly bought from the ‘owner’ of that particular stock.
An intermediary broker facilitates the transaction between the two parties.
In India, the market operates through brokers, market makers, custodians, and transfer agents of the OTC Exchange of India. Here are the roles played by each individual mentioned above.
- Broker – The broker completes over-the-counter trading on behalf of the buyer and the seller.
- Market Maker – The market maker ensures the availability of OTC stocks at reasonable prices.
- Custodian – Custodians fulfil administrative duties like validation and storage of documents and transaction clearing.
- Transfer Agents – Ensures accuracy of transfer amounts and share allotment.
Since there is no location where these trades are made, the OTC exchange exists exclusively in the digital world.
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List of Investments that Trade on OTC Markets
Commonly, over-the-counter stocks include shares of small-cap companies. These stocks are often called penny stocks since they seldom sell above a minimum price.
Besides these stocks, you can find several other securities on OTC markets.
- Foreign Currency – Vast sums of money in foreign currency are traded on the Forex market.
- Cryptocurrencies – Bitcoin, Ethereum, or Tether, these coins and many more can be traded on this market.
- Listed Debt – These bonds are made available through public or private placement.
- Listed Mutual Funds – These are units of mutual funds that are listed on the OTCEI.
- Permitted Securities – These are blue chip securities listed on stock exchanges yet made available on the OTCEI.
Types of OTC Securities
The Over-the-Counter market functions in 3 different tiers as designated by the OTC Markets Group. This agency classifies stocks into these categories based on the amount of financial information that is available about the parent company.
OTC stocks list can be full of unlisted entities that can function with fewer restrictions. The Markets Group categorizes companies higher than others if they offer more information about themselves despite this caveat.
The different tiers are:
- The Best Market: Only established companies that function with the highest financial standards can be found in this OTC market.
- The Venture Market: This market is for growing companies that are young and show promise. The eligibility criteria for the Venture Market are slightly more lenient than the Best Market. A company running on fumes or in the clutches of bankruptcy may never feature in this market.
- The Pink Market: Commonly referred to as the Pink Sheets, this market is home to companies with little information available about them. With the inherent lack of transparency and the unregulated nature of the OTC market, this market is considered the riskiest of all investment ventures.
Is it Safe to Buy OTC Stocks?
- The OTC market is significantly riskier than stock exchanges. Once again, this is due to the lack of transparency regarding financial information and lenient reporting standards that are associated with OTC stocks.
- It all comes down to the market research you can do before investing any money. This is especially true of OTC trading due to the speculative nature of penny stocks.
- Remember that not all companies listed on an OTC stock exchange are shill companies. Many of them will eventually get listed on proper stock exchanges in time. As risky as it is, OTC markets give the street-smart investor the first bite of the next big industry giant.
Risks of Trading OTC Stocks
OTC trading is ideal for those investors who can comprehend and consolidate the risk-reward factors associated with it. Some potential red flags to keep an eye out for are:
- A capital you are comfortable losing: The high volatility of the open market and the speculative nature that is associated with it means your capital investment amount is in a state of permanent risk. Therefore, when walking down this path, you should start with an amount that you are comfortable losing.
- Pump and Dump: Pump and Dump schemes are scams where a penny stock is hyped enough to get investors on board. As soon as the price hikes, the scamster/s sell off shares in bulk resulting in a crippling price fall. Unlike stock exchanges, such scams are plausible within the OTC market. A keen eye should always be cast upon a deal that almost looks too good to be true.
- No fixed prices: Unlike the stock exchange, OTC trades do not have fixed prices. The transaction is between the buyer and the seller, and the prices, as such, are determined by the seller. Since there is no regulation to ensure fair, equal prices within the market, the same stock can be bought simultaneously by two individuals for two different prices.
- As speculative as it gets: Small cap trading on stock exchanges is considered a high-risk venture. In an OTC market, you invest in stocks that are not even listed on stock exchanges. Companies with so few shareholders and very little liquidity result in an investment strategy that inches ever closer to being nothing more than a coin toss.
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OTC Market and Stock Exchanges – What is the Difference?
To understand how OTC markets are different, let’s first understand its counterpart – the Stock Exchange. To put it simply, a stock exchange is a location where stocks, commodities and bonds are traded. Companies are listed, prices are regulated, and trades are done by brokers who meet strict membership standards in a very transparent manner.
The OTC market fundamentally differs from stock exchanges in all but one of the factors mentioned above.
Trading OTC is done through a similarly-qualified broker. Other than that, the OTC market is not an actual ‘place’. All transactions are digital. The companies on the market are not listed and prices are not regulated at all.
The missing transparency and lack of a regulatory body are why OTC markets exude a shady aura to investors.
Final Word
OTC markets deal with securities that are not listed on the stock exchanges. It may seem volatile and unpredictable but investors, who are well-versed with how the market functions, can easily sail through it, without significant losses. It is always advised to make sure your investment is in safe hands and you have ample information about particular security before investing.
FAQs
Ans: OTC Markets may be speculative and volatile, but remember, it’s a good breeding ground for infant, promising companies with a very high financial ceiling. Besides, many industry leaders started their journey as penny stocks. Even greats like Ford and Apple had to start somewhere right!
Ans: It is significantly cheaper. Stocks listed on over-the-counter stock exchanges are often very low priced. Don’t forget to do a diligent market study before the low prices entice you into dipping your toes into this murky pool.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
