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Thursday, August 7, 2008

What are Over The Counter (OTC) markets?

The Over-The-Counter (OTC) markets are essentially spot markets and are localized for specific commodities. Almost all the trading that takes place in these markets is delivery based. 

OTC trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is the opposite of exchange trading which occurs on futures exchanges or stock exchanges.

An over-the-counter contract is a bi-lateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement.

An over-the-counter market is a financial market where products are traded over-the-counter.

The buyers as well as the sellers have their set of brokers who negotiate the prices for them. This can be illustrated with the help of the following example: A farmer, who produces castor, wishing to sell his produce would go to the local 'mandi'.

There he would contact his broker who would in turn contact the brokers representing the buyers. The buyers in this case would be wholesalers or refiners. In event of a deal taking place the goods and the money would be exchanged directly between the buyer and the seller.

Thus, it can be seen that this market is restricted to only those people who are directly involved with the commodity.

In addition to the spot transactions, forward deals also take place in these markets.

However, they too happen on a delivery basis and hence are restricted to the participants in the spot markets.

In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors, rather than providing the order matchmaking service seen in specialist exchanges.

In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.

Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange. As such, OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad credit records.

Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes.

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