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There are various ways to place buy and sell orders in the financial world. Some platforms provide direct market access, while others allow you to trade over the counter. This guide will explain the basics of over-the-counter (OTC) trading, how it works, and the securities you can buy or sell.
So, if you’re interested in learning more about OTC trading and how to do it, scroll down for our complete guide.
Over-the-counter, also known as OTC trading, is the way of buying and selling financial instruments via decentralised networks. Anyone that’s traded cryptocurrencies such as Bitcoin will have heard of the term decentralised. The fundamental concept of decentralisation is the same way to OTC trading. However, the ways decentralisation manifests itself in the crypto sector and OTC trading is slightly different.
When you trade over-the-counter, you’re buying and selling via the telephone or, more likely, an electronic broker, i.e. a trading site. These third parties are known as brokers, and they have access to platforms that offer tradable securities.
These brokers facilitate the exchange process between two parties. This means two counterparties (a buyer and a seller) conduct their transactions through a brokerage and, therefore, outside of an exchange.
Because transactions take place through a broker or a network of brokers, the orders aren’t placed directly with an exchange. We called this a decentralised system because an exchange can be seen as a centralised point of control. So, orders that are processed outside of an exchange and through a broker are decentralised.
That’s how OTC trading works on a general level. What’s interesting is that the decentralised nature of this type of trading means that non-standard items can be bought/sold via the OTC market. This means that assets don’t always need to have a clearly defined range of quality or quantity.
The benefit of this is that smaller companies that aren’t big enough to get on formal exchanges can be trading in the OTC market. You can also trade stocks in large companies over-the-counter, but a defining feature of this market is that the rules regarding what can or can’t be listed are different.
This not only allows smaller companies to offer stock in the OTC market, it means non-standard assets can be traded in this way.
You can see the types of securities available to OTC traders later in this guide. It's important to highlight that over-the-counter trading is where buying/selling takes place across a decentralised network of brokers. This means orders aren’t placed directly with an exchange, a central authority.
There are two main ways to access the financial markets and place orders:
Direct market access trading allows you to place orders directly with an exchange. It requires specialist software that connects you to an exchange and allows you to make trades directly with counterparties. These transactions are written directly into the exchange’s order book.
Over-the-counter trading is different. Transactions aren’t carried out directly on an exchange, nor are they directly overseen by the exchange. Instead, you place orders through a broker. You access a broker’s services by telephone or electronically, i.e. over the internet via an online trading platform. Brokers are connected to an OTC network that provides access to a variety of tradable securities.
For example, the OTC Markets Group Inc. is an electronic quotation and trading system that brokers can connect to. This operator provides marketplaces for over 11,000 OTC securities. So, what you get is a system through which brokers connect to the OTC Markets Group Inc. platform.
This creates a network of brokers that can offer securities to retail customers (aka you) via the OTC Markets Group Inc. platform.
Even though you’re not trading directly via an exchange, OTC trading is still safe. Operators such as the OTC Markets Group Inc. are regulated by authorities like the Securities and Exchange Commission. Also, OTC securities are subject to reporting and regulatory standards. This isn’t always true, but, in general, OTC securities are overseen by financial regulators.
OTC trading is safe, but it’s also true that varying degrees of regulatory oversight means certain securities could be riskier to trade than others. Again, this doesn’t mean OTC trading isn’t safe, it simply means that you need to consider additional risks that may not be a problem when you trade directly via an exchange.
The OTC market can be divided into three main categories. We can use the OTC Markets Group Inc. to outline the three tiers and explain the securities available in each one:
Securities traded within this platform (i.e. tier) don’t sell for less than $5. This means you’re not trading penny stocks or stocks in companies going through bankruptcy. The stocks available in this market are typically from established companies or those listed on foreign exchanges.
For example, if you’re in the UK and wanted to trade stocks in a company listed in Germany, you could do it through OTCQX. Given the stock price and status of the companies traded within this tier, the securities are subject to strict regulatory oversight. Also, the companies listed have to meet the highest reporting standards possible.
This is the OTC market where stocks in developing companies are traded. The stock price can be below $5, and the companies still have to report their financials to official regulators. These companies are still subject to regulatory oversight. However, the regulations aren’t as strict, and the companies can be seen as niche, recently listed start-ups or small companies.
The open market consists of companies that don’t have any reporting requirements and aren’t subject to regulatory oversight. It’s not accurate to call it the Wild West of OTC trading. However, a lot of the companies in this market are not established. This is seen as the riskiest market to trade OTC securities.
You can trade a variety of OTC securities online. We’ve focused on stocks, but you can also trade the following securities over-the-counter:
Derivatives are securities that derive their value from an underlying asset. This means you’re not trading the asset, but a contract/agreement that derives its value from the asset. You can trade futures and forwards on the OTC market.
Bonds aren’t traded on formal exchanges because they’re issued by banks. Because of this, they’re traded via broker-dealer networks, which means they are OTC securities.
The foreign currency exchange market is OTC. Therefore, when you trade forex, you’re doing it via a decentralised currency exchange.
Cryptocurrency exchanges are over-the-counter markets. This is because there is no central point of authority. Exchanges facilitate peer-to-peer transactions.
There are some benefits of trading over-the-counter and a few drawbacks. As with all types of trading, nothing is guaranteed. The orders you execute aren’t guaranteed to return a profit. Some of the more specific pros and cons are:
You can try over-the-counter trading at Saxo Bank. For example, you can buy or sell forex currency pairs via our platform. Our advice to novices wanting to try any type of trading is to create a free demo account. This gives you access to a virtual bankroll and live markets for 20 days.
The demo should give you a feel for our platform and how the financial markets operate. Once you’re confident, you can verify your identity, make a deposit and start making live trades on forex, stocks, futures, commodities and more.
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