Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
OTC Contracts and Markets
An over-the-counter 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. It is mostly done via the computer or the telephone. 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 NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.
Drafting of OTC derivatives
OTC derivatives are documented under master agreements. A master agreement is a document agreed between two parties that sets out standard terms that apply to all the transactions entered into between those parties. Each time that a transaction is entered into, the terms of the master agreement do not need to be renegotiated and apply automatically.
OTC Traded Stocks
In the U.S., over-the-counter trading in stocks is carried out via market makers who use quotation services such as the OTC Bulletin Board (OTCBB) and the Pink Sheets. The US over-the-counter market is monitored by the NASD. Because such trades are not traded on any major stock exchange and there is less research done on them in the financial market, they are considered to be risky. As there is very infrequent trading in such a market, the spread (which is the difference between the bid price and ask price) is large.
OTC Market Statistics
Data provided by Pink Sheets
- Securities Quoted Exclusively on Pink Sheets 5,019
- Securities Dually Quoted on Pink Sheets and OTCBB 3,445
- Securities Quoted Exclusively on OTCBB 130