Over-the-counter(OTC)

Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without any supervision of an exchange. It is contrasted with exchange trading, which occurs via these facilities. An exchange has the benefit of facilitating liquidity, mitigates all credit risk concerning the default of one party in the transaction, provides transparency, and maintains the current market price. In an OTC trade, the price is not necessarily made public information.

OTC trading, as well as exchange trading, occurs with commodities, financial instruments (including stocks), and derivatives of such. Products traded on the exchange must be well standardized. This means that exchanged deliverables match a narrow range of quantity, and identity which is defined by the exchange and identical to all transactions of that product. This is necessary for there to be transparency in trading. The OTC market does not have this limitation. They may agree on an unusual quantity, for example. In OTC market contracts are bilateral (i.e. contract between only two parties), each party could have credit risk concerns with respect to the other party. OTC derivative market is significant in some asset classes: interest rate, foreign exchange, equities, and commodities.

In the U.S., over-the-counter trading in stock is carried out by market makers using inter-dealer quotation services such OTC Link (a service offered by OTC Markets Group) and the OTC Bulletin Board (OTCBB, operated by FINRA). The OTCBB licenses the services of OTC Link for their OTCBB securities. Although exchange-listed stocks can be traded OTC on the third market, it is rarely the case. Usually OTC stocks are not listed nor traded on exchanges, and vice versa. Although stock quoted on the OTCBB must comply with U.S. Securities and Exchange Commission(SEC) reporting requirements, other OTC stocks have alternative disclosure guidelines(for example, OTCQX stocks through OTC Market Group Inc), and others have no reporting requirement, for example Pink Sheets securities.

An OCT contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivative, these agreements are usually governed by an International Swaps and Derivatives Association agreement. This segment of the OTC market is occasionally referred to as the “Fourth Market”.

OTC derivatives can lead to significant risks. Especially counterparty risk has gained particular emphasis due to the credit crisis in 2007. Counterparty risk is the risk that a counterparty in a derivatives transaction will default prior to expiration of the trade and will not make the current and future payments required by the contract. There are many ways to limit counterparty risk. One of them focuses on controlling credit exposure with diversification, netting, collateralization and hedging.

The International Swaps and Derivatives Association suggested five main ways to address the credit risk arising from a derivatives transaction, as follows:

Avoiding the risk by not entering into transactions in the first place;

Being financially strong enough and having enough capital set aside to accept the risk of non-payment.

Making the risk as small as possible through the use of close-out netting.

Having another entity reimburse losses, similar to the insurance, financial guarantee and credit derivatives markets.

Obtaining the right of resourse to some asset of value that can be sold or the value of which can be applied in the event of default on the transaction.

The advantages of OTC derivatives over exchange-traded ones are mainly the lower fees and taxes, and greater freedom of negotiation and customization of a transaction, as it involves only a seller and a buyer and no standardization authority.