Demystifying OTC (Over-the-Counter) Markets for Investors

Where do you find stocks of influential companies, derivatives, commodities, bonds, and other securities? Most of you might think a stock exchange is the only place to find these securities. Besides stock exchanges, you can find some unlisted and less popular securities in OTC markets. An over the counter market can help access profitable stocks, debt securities, and more. Read on to understand what is the over the counter market in detail.

What is the Over-the-Counter-Market?

You already know that companies become public by launching their IPOs ( Initial Public Offerings ) in the primary market. The secondary market allows investors to trade securities among themselves. While stock exchanges are part of the formal secondary market, they are decentralised. An unorganised and non-regulated place for the trade of securities is where you can find stocks of unlisted companies, less popular derivatives, and other securities. The Securities and Exchange Board of India (SEBI) and other organisations do not pay much attention to deciding the rules for these markets. Trading in this market can happen in person or over the phone. Emails and other communication channels are also used for trading in this market

How Does the OTC Market Work?

Popular stock exchanges like the BSE and NSE work as dealers for investors. They act as an intermediary for the investor and the company/issuer. However, local dealers in these markets facilitate the sale/purchase of securities. Also, investors can communicate among themselves to buy/sell securities. Contrary to a stock exchange, this market is open 24*7. It is up to the investor to find the person or dealer who has desired securities. Usually, unlisted stocks, customised options, non-standardised futures, and other securities are available in these markets. Usually, small and unlisted companies use them to distribute their securities.

Types of OTC Securities

OTC markets offer a range of securities for investors. To start with, you can get shares of small and unlisted companies in them. Although settled companies prefer stock exchanges, the OTC equity market also has a significant trading volume. You can find bonds that aren’t available on formal stock exchanges. Similarly, investors can find futures and options in them. However, derivatives in these markets are not standardised, as visible in a stock exchange. You can find commodity, equity, forex, fixed-income , and credit derivatives in them. Like a stock exchange, they can offer access to diverse securities, mostly unlisted.

Objective of OTC Options

OTC markets are popular for their diverse options (call and put options). It is crucial to note that there is no standardisation in the OTC options market. There are no SEBI standards for deciding the strike price and expiration date for options. As a result, options sellers can create customized options with preferred strike prices and expiration dates. This freedom is not available for options available on formal stock exchanges. Many investors who want to hedge their portfolio against rising prices prefer OTC options. Besides high customizability, OTC markets also offer versatility in their options. However, it is crucial to note that these options are not backed by a stock exchange. For the same reason, counterparties might not fulfil the commitments on the expiration date. Also, learn about what is a call option in the future & option.

Benefits of OTC Options

There are numerous benefits of over the counter derivatives. Small businesses often issue their shares in OTC markets. It is because they aren’t listed on any stock exchange. You can find options tied to such stocks in the OTC market. Investors can rely on these options to hedge against rising prices and uncertainty in the market. Since an OTC option does not obligate you to exercise the contract on the expiration date, it offers flexibility. OTC options sellers also enjoy the flexibility to decide their strike rates and expiration dates. Since there aren’t standard regulations in an over the counter market, options sellers can customise their contracts.

Risks of Over-the-Counter Markets

OTC markets are not bound by SEBI regulations. It means traders can buy/sell among themselves without relying on SEBI or any stock exchange. However, counterparties often deny fulfilling their contractual obligations. Since you aren’t trading on a formal stock exchange, you cannot raise a dispute with SEBI. You can only trust the opposite party when buying an option in this market.

Besides counterparty risk, there is also a lack of transparency. Prices of different options might not be available for investment research. Even seasoned investors find it challenging to make informed decisions. Another issue is the customisation of options. Buyers might find it challenging to analyse customised terms and conditions for options. Also, it is crucial to note that OTC securities might not be as liquid as listed ones.

Differences Between the OTC Market and Stock Exchanges

OTC markets and stock exchanges differ based on numerous factors. Exchanges are established and regulated organisations, while over the counter is a decentralised market. You can find stocks, bonds, and other securities of listed companies on stock exchanges. On the other hand, an OTC market offers securities of unlisted companies and small businesses. Prices on stock exchanges are based on the supply-demand dynamics. On the other hand, the dealer or the seller in an OTC market determines the prices.

Conclusion

OTC markets are a place for the trading of unlisted securities. You can find unlisted stocks, options, currencies, and other securities in an OTC market. It is crucial to note that OTC markets aren’t regulated by SEBI, thus offering flexibility to investors. However, there are regulatory, liquidity, and counterparty risks associated with OTC markets. Learn more about an over the counter market now!