What is Over The Counter Market?
Over the Counter market is a marketplace that allows non-standardized and unregulated trading in financial securities between two consenting parties. Such markets do not have any norms, rules, and regulations. There is an absence of a formal exchange or an exchange regulator who can supervise its functioning. The markets may not have a physical location at all, and may just operate online through brokers, dealers, and their networks. Virtually there are no reporting requirements.
Since there are no disclosure and regulations, all types of securities could be traded in OTC Market. And there is nothing like what can and what can not be traded. This freedom leads to the trading of a lot of unstructured and non-standardized products on such markets. These instruments can be typical derivatives and structured products, bonds, currencies, etc. Also, these types of markets are useful for trading in stocks that are not listed on a regulated stock exchange.
- What is Over The Counter Market?
- How does Over The Counter Market Functions?
- What are the Advantages of Over the Counter Market?
- What are the disadvantages of Over The Counter Market?
How does Over The Counter Market Functions?
As already said, there is neither exchange nor any regulatory body that controls such markets. Hence, dealers have a free hand in deciding what and how much they want to trade, and at what price. A buyer or a seller can enter into bilateral contracts with the dealers, or with any other willing participant. There may be an investment bank as an intermediary that may take care of the deal. They may decide their own terms and conditions for maturity time and delivery. It is not necessary for them to disclose the price at which the trade is occurring to anyone in the market. Thus, these markets give way to secrecy and minimum disclosures.
However, there is always an amount of uncertainty in the trades because of a lack of rules, regulations, and an overlooking body that can take care of complaints and grievances. There is always a “counterparty risk” in such markets. A party to the contract can deny obliging by the contract conditions at the last moment. One can default on the payments to be made. Also, the grieving party will not have any regulatory body to approach for filing a complaint in case of such misdeeds.
What are the Advantages of Over the Counter Market?
Boon for Unlisted and Small Companies
Over the Counter markets provide an opportunity for trading in stocks of companies that do not meet the minimum capital requirements of bigger exchanges. They provide a place for the trading of inexpensive “penny stocks” or other unlisted stocks. Sometimes a company cannot price its stock over a certain limit on a regulated stock exchange. This is, however, possible in an OTC market. Also, traders can trade in stocks of companies with very poor financials, or even those that are about to go bankrupt. Such trades may give avenues for high profits against high risk.
Free from Rules and Regulations
OTC markets are free from rigid rules and regulations of a formal exchange. Hence, this makes the trade very easy between two consenting parties. They can trade any quantity of a security at any price of their choice, and take delivery as per their own terms and conditions.
There are none or very limited reporting requirements to the central agencies. Such markets allow for a quick flow of information among the participants. Also, in absence of any regulator or exchange no exchange fee payment is required.
There is adequate secrecy in the deals as there are no disclosure requirements regarding pricing and other contract terms. This can be advantageous to the participants as they can further trade in that security without the new buyer knowing about the previous deal price.
OTC contracts allow for customization as per the needs and requirements of the trading parties. Quantities, pricing, delivery timelines- all can be tweaked as per the requirements of parties to the contract.
What are the disadvantages of Over The Counter Market?
Along with the advantages, come disadvantages of such markets too.
Many times trading securities in an over-the-counter market may result in a liquidity crunch. A seller may be willing to sell security but there may be an absence of suitable buyers for the same. The absence of a regulated mechanism in such markets may further aggravate liquidity risk.
For example, during the global financial crisis of 2008, sellers could not find any buyers for the complex derivatives and Collateralized Debt Obligations. These complex instruments were being traded in large volumes on the OTC market. As the housing bubble burst, buyers of such products vanished from the market, resulting in a severe liquidity crunch for the holders.
Counter Party Risk
One of the biggest disadvantages of OTC markets is the counterparty risk that parties to a contract face. As said earlier, one party may go back on his words and refuse to honor a contract. Moreover, one of the parties may refuse to follow the agreement or may face financial issues. This may lead that the payment may not happen as per the agreement. Also, a party may fail or deny to make a payment when due. Such instances can shake the confidence of participants in such markets. Also, it can lead to major financial losses for a party.
The party suffering the loss will have nowhere to file a complaint, and the erring party will not be penalized.
OTC markets can be highly volatile and unpredictable. Due to a lack of regulations, market makers can manipulate and move the price of a security as per their wish. Effective risk management techniques become essential for the participants to minimize the chances of a loss.
Lack of Transparency
Parties to a contract do not have to disclose the price at which the trade is taking place. All the deals happen virtually on one on one basis with the help of intermediaries. And there is nothing like a mandatory disclosure requirement with regard to the trade taking place. This lack of transparency in such markets may lead to an adverse or difficult situation for some of the participants. A buyer may buy a security at a much higher price than what it is actually worth and fail to sell it later.
Proper disclosures in regulated exchanges ensure pricing and other details are transparent and such situations do not occur. Also, the confidence and trust level of the participants in regulated markets are much higher than in OTC markets.