OTC markets - What are they?

December 10, 2020 14:00 UTC
Reading time: 10 minutes

In the financial markets, we find numerous terms that can be confusing to us but that we must understand if we want to advance in the world of trading. These terms include expressions such as 'Over The Counter markets' or 'OTC markets'.

So, what exactly are they? And what about pink sheets? If you want to know more about these topics, then you're in the right place. Let's dive in.

OTC markets - What are they?

What are OTC markets?

Financial markets can be classified as organized or unorganized. Organized markets are those subject to a regulated system and in which standardized instruments are exchanged, for example, stock exchanges.

Unorganized markets are less known to the general public. They are called Over The Counter (OTC), also known as 'off-exchange' or 'over-the-counter' markets, and are non-centralized secondary markets, where transactions are formalized from bilateral agreements between participants. In other words, contracts are negotiated between two parties that establish their conditions, without the intervention of a centralized regulatory market.

On OTC markets, what are called 'pink-sheets', or 'pink-sheet stocks' are commonly available. These are small penny stocks, which are usually traded for less than five dollars a share. As such, it is also common to hear an OTC market referred to as a pink OTC market.

These markets, which do not have physical headquarters, have a greater risk of the possibility that one of the parties doesn't comply with the agreement, but they also offer greater opportunities for traders by granting greater flexibility. Furthermore, the fact that there is no centralized body does not mean that its participants don't have to submit to the supervision of regulatory institutions.

As in traditional markets, such as stock exchanges, companies go to OTC markets to raise financing and liquidity. It's an alternative for those companies that don't meet the requirements for being listed on the stock market.

DIFFERENCES: TRADITIONAL MARKETS VS OTC MARKETS

  Traditional OTC
Contracts Standard / Default Flexible / Agreed between the parties
Liquidity High Low
Transparency High (prices and public records) Low (private contracts, non-public prices)

Risk Low High
Costs High (higher taxation) Low

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Characteristics of OTC markets

Over the counter markets have registered exponential growth over the past two decades to the point that, in many cases, they exceed organized markets in volume of transactions. At first, only large funds and financial institutions participated in them, but now, thanks to the development of new technologies, anyone can access these markets through brokers or financial service providers.

As a result of the financial crisis of 2008, after the bankruptcy of Lehman Brothers, it was decided to curb these unorganized markets, increasing regulatory pressure, since they were identified as one of the causes of the crisis. The creation of a new regulation was agreed by the G20 at the Pittsburgh summit in September 2009. As a result of this agreement, the European Union Regulation No. 648/2012 (EMIR) came into force in 2012.

The main characteristics of the OTC markets are:

  • The transactions are based on contracts between the parties with a guarantee on return.
  • The operations are not carried out through a centralized platform but through electronic or telephone communications.
  • Although it's an unsupervised market, its participants are subject to surveillance. In fact, as we have already pointed out, there is more and more regulation that affects them.

How do OTC markets work?

In an OTC market, there is a counterpart, a natural person or legal entity that sets its own price ranges. This is what's called a 'market maker'. The potential buyer or seller will contact this counterparty, usually through an intermediary or broker, and if they're interested, they will buy at the sale price (Bid) or sell at the purchase price (Ask) and so on. Prices set by market makers are negotiable, unlike on an organized market.

Advantages of OTC markets

Among the advantages of Over The Counter markets, we can mention the following:

✔️ Flexibility in the contract conditions, as they're not standardized

✔️ Large amounts of money are not needed to invest in these markets

✔️ Cheaper financial instruments

✔️ Great variety of assets

✔️ Access to financing for those companies that cannot be listed on regulated markets

✔️ Longer hours, extend beyond trading sessions

Disadvantages of OTC

❌ Less transparency. Companies don't have to supply as much information

❌ Increased risk of defaults. To minimize this: diversify, don't invest more

than you can afford, hedging, etc.

❌ Lower liquidity

❌ The price does not have to be public

OTC Markets - Financial Derivatives

In OTC markets, we can find a great variety of financial instruments to invest in, since, in addition to being able to negotiate almost all of the products that already exist in the regulated markets, we can also find a wide catalogue of financial derivatives. In fact, OTC transactions account for the majority of the derivatives market because they require a smaller initial investment.

The most popular OTC derivatives are:

  • Swaps
  • Forwards
  • Forex
  • CFDs
  • More recently, cryptocurrencies

Let's look at these instruments in a little more depth:

Swaps

Swaps are contracts between two parties in which it is agreed to exchange certain amounts of money, generally referenced to interest rates, at a future date.

The most common interest rate-linked swap generally consists of exchanging fixed-rate interest payments for variable-rate interest payments.

Derivative swap contracts must include at least the following parameters: the start and end date; basis on which the exchange is agreed (foreign exchange, credits); reference currency; what are we going to refer to; frequency of payments.

⚠️Don't confuse swap contracts with currency swap or Forex swap, a commission paid by the client to the online broker for open positions from one day to the next.

Forwards

Forward contracts are financial derivatives, mostly OTC, that represent a contract between two parties to buy or sell a certain underlying asset at a specific price at a future date. They can be used as a hedge or for speculation.

The market for forward contracts has grown exponentially because many large companies have used it to hedge interest rate and currency risks. However, since the details of forward contracts are determined by the buyer and seller and are not made public, the size of this market is difficult to estimate.

FOREX

The Forex market is the one in which currencies are traded. This is the largest financial market in the world, since more than 6 trillion dollars are traded daily between governments, banks, corporations and speculators.

Currencies are traded as pairs, and the movement of currency pairs measures the value of one currency against another. For example, the EURUSD currency pair measures the value of the euro against the US dollar.

If this pair rises, it means that the euro is appreciating, and vice versa. When trading Forex, traders can make a profit or loss on these currency movements. This market is open 24 hours a day, five days a week, and is only closed on weekends. It opens on Sunday night at 11:00 p.m. and closes on Friday at 10:00 p.m. (CET).

Contracts for Difference (CFD)

Contracts for Difference (CFDs) are derivative products whose price is based on that of an underlying asset, which can be stocks, indices, futures, commodities, currencies or cryptocurrencies. When we trade these contracts, we do not own the underlying asset but rather speculate on its price, both up and down.

How does it work? When we buy a CFD, what we do is establish that the price of the asset will rise or fall and if the market goes in our favour, we will earn the difference between the price when opening the operation and when we close it. If the market goes against us, we will lose that difference.

CFDs have some advantages, for example, that they do not have an expiration date so they can be closed whenever you want. In addition, they allow leverage so it doesn't take large amounts of money to open an order. This tool allows you to multiply your profits but you have to use it with great care and with good risk management because it can also multiply your losses.

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Cryptocurrencies

The cryptocurrency market is decentralized and is carried out between individuals or through specialized companies, so it also works as an OTC market. All validated cryptocurrency transactions are recorded in what is called a blockchain.

The amount of cryptocurrencies in the world is increasing with new technological advances. Today, there are more than 5,000 cryptocurrencies according to CoinMarketCap. The most popular are Bitcoin, Bitcoin Cash, Dash, EOS, Ethereum, Monero or Ripple. We can invest in cryptocurrencies by buying them directly or through a broker through CFDs.

OTC Markets - How to reduce risks and trade with a guarantee

As we have pointed out above, among the disadvantages of the OTC markets are the possible breaches of any of the parties that sign the contract due to the lack of a supervisory body. That is why it is essential that if we operate through a broker we know how to choose well to avoid scams.

These are the criteria that we must take into account:

▶ ️ The best brokers have good regulation. There is no zero risk, but an account with a regulated broker will minimize risk and prevent possible wrongdoing and scams.

▶ ️ Security of funds. It is better if the broker has segregated bank accounts, in Europe. In this way, clients will have their funds available at all times and cannot be used by the broker itself for any other purpose.

▶ ️ Ability to choose leverage. To properly manage your position, it's highly important that you can choose the leverage with which you want to operate.

▶ ️ Quality of order execution and slippage. Having low spreads is good, having orders executed at the Ask price is even better.

▶ ️ Customer service. Having a broker with customer service in your language and with its physical headquarters in your country is very reassuring, since you can go in person to clarify your doubts or problems.

▶ ️ Training. You should bear in mind that a Forex broker is not authorized to give investment advice, but it can offer training in trading.

Admiral Markets meets all these requirements as it has one of the strictest regulations in Europe, that of the Financial Conduct Authority (FCA) of the United Kingdom. It also has a "Negative Balance Protection Policy" to protect you against negative account balance. If you want to start trading you can open a real trading account by clicking on the following banner:

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer or solicitation for any transaction in financial instruments. Please note that such business analysis is not a reliable indicator for any current or future performance as circumstances may change over time. Before making any investment decision, you should seek the advice of independent financial advisers to ensure that you understand the risks.

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