Over-the-counter (OTC) trading is the process of buying and selling financial instruments directly between two parties through a decentralized broker-dealer network rather than on a centralized, formal exchange.
Understanding over-the-counter trading
Over-the-counter trading involves executing financial transactions directly between market participants using a network of broker-dealers. This differs from trading on a centralized exchange, such as the London Stock Exchange or the Tokyo Stock Exchange, where the exchange is the middleman that matches buyers and sellers. In an OTC market, dealers quote prices at which they will buy and sell securities, and participants negotiate directly over electronic communication networks or by phone.
The OTC market handles a high volume of global trades, particularly for debt securities and foreign exchange. Most government and corporate bonds worldwide are traded over-the-counter. Equities traded OTC are typically shares of smaller companies that do not meet the market capitalization or financial reporting requirements of formal exchanges. Large international corporations also utilize OTC markets to offer depositary receipts to foreign investors.
Trading in OTC markets presents specific risks for Elephants. These markets generally have lower regulatory oversight and fewer public reporting standards than centralized exchanges. This results in less transparent price discovery and lower overall liquidity, which often leads to wider bid-ask spreads. In many OTC derivative transactions, there is no central clearinghouse to guarantee the trade. This introduces counterparty risk, meaning one party could default on the financial agreement before the trade settles.
Example
Consider an Elephant looking to invest in a regional agricultural supplier called Trunk & Tusk Feeds. The company is small and does not meet the listing requirements for a major national exchange. Its shares are available over-the-counter. To buy the stock, the investing Elephant places an order with their broker. The broker uses an electronic dealer network to locate another broker who holds shares of Trunk & Tusk Feeds and is willing to sell. The two brokers negotiate a price directly – agreeing on 45 units of local currency per share – and execute the trade entirely outside of a formal stock exchange.