In the financial markets we do not find many terms that can be confusing 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'.
What is OTC?
Financial markets can be classified between organized and unorganized. Organized markets are those subject to a regulated system and in which standardized instruments are exchanged, for example, stock markets.
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 based on bilateral agreements between the participants. In other words, contracts are negotiated between two parties that base their conditions, without the intervention of a centralized regulatory market.
These markets, which do not have a physical headquarters, have a greater risk of the possibility that one of the parties does not comply with the agreement, but they also offer greater opportunities for merchants by granting greater flexibility. In addition, the fact that there is no centralized body does not mean that its participants do not have to submit to the supervision of regulatory institutions.
As in traditional markets, such as stock exchanges, companies go to OTC stock to attract financing and liquidity. It is an alternative for those companies that do not meet the requirements to be listed on the stock market.
Characteristics of OTC markets
Over the Counter markets have experienced exponential growth in the last two decades to the point that in many cases they exceed the volume of transactions in organized markets. 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 put an end to 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) entered into force in 2012.
The main characteristics of Over The Counter markets are:
- The transactions are based on contracts between the parties with a guarantee as counterparty.
- Operations are not carried out through a centralized platform but through electronic or telephone communications.
- Although it is an unsupervised market, its participants are subject to surveillance. In fact, as we have already pointed out, there is an increasing regulation that affects them.
How does the OTC market work?
In an OTC market there is a counterparty, a natural person or legal entity that sets its own price ranges, this is what is called a 'market maker'. The potential buyer or seller will contact this counterparty, normally through an intermediary or broker, and, if interested, they will buy at the sale price (Bid) or sell at the purchase price (Ask) and so on. The prices set by the market makers are negotiable, unlike an organized market.
Advantages of OTC
Among the advantages of Over The Counter markets, we can mention the following:
- Flexibility in the conditions of the contracts as they are not standardized
- You don't need large amounts of money to invest in these markets
- Cheaper financial instruments
- Wide variety of assets
- Access to financing for those companies that cannot be listed on regulated markets
- Longer hours, extend beyond trading sessions.
Disadvantages of OTCs
- Less transparency. Companies do not have to provide as much information
- Increased risk of breaches. To minimize it: diversify, not invest more than we can afford, hedging, etc.
- Less liquidity
- The price does not have to be public
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